The long-debated issue as to what constitutes a complete disposition of interests in real property for purposes of irrevocable trusts was recently settled by the Tax Court of New Jersey in the matter of Estate of Mary Van Riper v. Director, Division of Taxation.
In Van Riper, Mary Van Riper and her husband, Walter Van Riper, established an irrevocable trust in 2007, which this article will refer to as the “Irrevocable Trust.” The sole asset in the Irrevocable Trust was the Van Ripers’ marital home, which was transferred to the Irrevocable Trust in exchange for one dollar.
The Irrevocable Trust permitted Mr. and Mrs. Van Riper to live in their marital home for their respective lifetimes and for the residence to be irrevocably transferred to the couple’s niece upon the second of Mr. and Mrs. Van Riper to pass away. Mr. Van Riper passed away three months after executing the Irrevocable Trust, while Mrs. Van Riper passed away in 2013.
Under New Jersey law, the transfer of property to an irrevocable trust during an individual’s lifetime, which is commonly known as an inter vivos transfer, is generally subject to New Jersey estate and inheritance tax if such transfer is (i) in contemplation of the transferor’s death or (ii) intended to take effect at or after the death of the individual initiating the transfer of property. However, inter vivos transfers that are an “irrevocable and complete disposition of all reserved income, rights, interests and powers in and over the property transferred” and take place more than three years prior to a transferor’s death are expressly exempt from inheritance tax. N.J. Stat. Ann. § 54:34-1.1. The “Irrevocable Disposition Exemption” to the inheritance tax has been part of New Jersey law since 1955, surviving numerous legislative changes. Three elements must be met in order to gain eligibility for the Irrevocable Disposition
- a transfer of real property by deed, grant, bargain, sale, or gift must occur
- the transferor must be entitled to some income, right, interest or power in the transferred property
- the transferor must irrevocably and completely dispose of all reserved income, rights, interest and powers in and over the transferred property at least three years prior to the transferor’s death.
In Van Riper, the Tax Court made two critical rulings which clarified the Irrevocable Disposition Exemption. First, the Tax Court held that the Van Ripers’ rights under the Irrevocable Trust constituted a retained life estate interest (meaning a right to live in the couple’s marital home during their respective lifetimes). Second, the Tax Court determined that the Irrevocable Disposition Exemption’s retention of the life estate interests, even though the property was subject to an irrevocable disposition, was not a complete disposition of such property. As such, the Tax Court determined that the transfer of the Van Ripers’ marital home from the Irrevocable Trust to the Van Ripers’ niece was subject to inheritance tax.
Despite the Van Riper decision, the Tax Court’s clarification as to ambiguities in the wording of the Irrevocable Disposition Exemption will likely assist taxpayers in the long term. The Van Riper court accepted the New Jersey Division of Taxation’s contention that a life estate was implicitly formed, even though the Irrevocable Trust lacked explicit reference to a deed which transferred the property from the Van Ripers to the Irrevocable Trust.
In a typical scenario that we encounter, the transfer of real property into a trust for $1.00 constitutes a gift with a transferred basis equal to the transferor’s basis. The life estate will be deemed to be included in the decedent’s gross estate and will be subject to a step-up in basis to the fair market value of the property at the decedent’s date of death. This step-up in basis can be extremely beneficial if the property has a low basis. For example, assume a property was purchased for $100,000 and had a value of $450,000 at the decedent’s date of death. If the owner of the property transferred the property to an irrevocable trust in exchange for $1.00 but did not retain a life estate and the property was sold for $450,000, a capital gain of $350,000 would be realized; however, the step-up in basis may result in no capital gains tax if the property is sold after the date of death of the decedent and the initial transfer is characterized as an implied life estate, as the New Jersey Division of Taxation advocated (and the Tax Court accepted) in Van Riper.
Be sure to speak with your legal professionals about utilizing the Van Riper case to carefully plan and draft your trust documents to fully leverage the Irrevocable Disposition Exemption.
Peter Y. Fu is an attorney in Cooper Levenson’s Business & Tax and Cyber Risk Management practice groups. He concentrates his practice on sales and use tax, enterprise risk management, and commercial transactions. Peter is licensed to practice law in New Jersey and Florida. Peter may be reached at 609.572.7556 or via e-mail at firstname.lastname@example.org.
Jarad K. Stiles is an attorney in Cooper Levenson’s Business & Tax and Elder Law practice groups. He concentrates his practice on business succession planning, estate and asset protection planning, elder law planning, and tax controversies. Jarad holds an LL.M. in Taxation. Jarad is licensed to practice law in New Jersey, New York, and the United States Tax Court. Jarad may be reached at 856.857.5594 or via e-mail at email@example.com.
Michael L. Salad is an attorney in Cooper Levenson’s Business & Tax and Cyber Risk Management practice groups. He concentrates his practice on estate planning, business transactions, mergers and acquisitions, tax matters and cyber risk management. Michael holds an LL.M. in Estate Planning and Elder Law. Michael is licensed to practice law in New Jersey, Florida and the District of Columbia. Michael may be reached at 609.572.7616 or via e-mail at firstname.lastname@example.org.