A Qualified Personal Residence Trust Can Remove the Value of Your Home From Your Taxable Estate
You’ve worked long and hard to accumulate a decent nest egg. You’ve even acquired a second residence to use as a vacation home for your family. Now your estate planning counsel informs you that you will have a taxable estate and suggests a gifting program to distribute your wealth to the next generation. You would like to keep the vacation home in the family, and pass it on to your children, but you’re not quite ready to give it away.
Making a gift of a personal residence to a qualified personal residence trust (QPRT) is a straightforward strategy for removing the value of your home from your taxable estate. A QPRT is an appealing estate planning device because it combines significant estate and gift tax savings while allowing you to continue to use your residence for the term of the QPRT.
Under Treasury Regulations which provide for the creation of a QPRT, an individual (“grantor”) can transfer a personal residence or vacation home to an irrevocable trust, and retain the right to live in the residence for a specific period of time (the “term”), determined when the trust is created. During the term, the grantor does not pay rent, but is responsible for all of the expenses of the home, including real estate taxes, maintenance, and ordinary repairs. As a result, during the term of the QPRT, the grantor should notice little change in his or her day-to-day life.
If the grantor lives to the end of the term, the home either passes outright, or continues in trust for the grantor’s remainder beneficiaries, free of federal estate tax. The grantor may continue to live in the home after the term by renting it from the remainder beneficiaries, who usually are the grantor’s children. If, on the other hand, the grantor dies before the end of the term, the value of the home will be included in the grantor’s taxable estate. For this reason, grantors should choose a term that they are likely to survive.
While the transfer of a residence to a QPRT is treated as a taxable gift, the value of the gift may be significantly discounted. This is because the value of the gift is determined by using tables published by the IRS (IRS tables) that take into account the length of the grantor’s retained interest, the grantor’s age, and an interest rate set monthly by the IRS, known as the “Section 7520 Rate”, for the month that the residence is transferred to the QPRT.
A number of requirements must be satisfied in order to have a qualified QPRT, including:
1. The QPRT must be structured as an irrevocable trust. Each person is permitted to create up to two QPRTs, one for a principal residence, and one for an occasional residence (such as a vacation home).
2. The trust may not hold any property other than the residence and cash to pay expenses (i.e. taxes, insurance, repairs and mortgage payments) already incurred or reasonably expected to be paid within 6 months. The Trust also may hold insurance policies on the residence.
3. The trust may permit the sale of the residence and the trust may hold the proceeds for a limited period (not to exceed two years). The proceeds of the sale may be used within the two-year period to buy a replacement residence. However, neither the grantor nor any related party or entity may purchase the residence from the QPRT.
4. The governing instrument must provide that the trust will cease to be a QPRT if the residence is no longer a personal residence of the grantor.
5. The governing instrument must provide that if the trust ceases to be a QPRT, the assets must be distributed to the grantor, or they must be held in a separate trust that qualifies as a grantor retained annuity trust (GRAT). In this case, the grantor would receive an annuity payment for the remaining term of the trust. See the January/February 2008 Tax Planning Newsletter for a more detailed explanation of GRATs.
Assume, for example, that a grantor creates a QPRT (with the grantor’s children as the remainder beneficiaries) by transferring a $1 million summer home to a trust for a 15-year term. Because the grantor will retain the right to live in the home for the 15-year term, the amount of the gift to the children will not be $1 million. Instead, the gift is the value of the home that will pass to the children at the end of the 15-year term. If the grantor is 50 years old and the Section 7520 Rate is 4.2% (the rate for August 2008), then the gift to the trust equals $464,430. Assuming that the grantor has not made any prior taxable gifts, the grantor would not pay any gift tax on the transfer because the gift would be applied against the grantor’s $1 million lifetime exemption (the amount that each person may give away tax-free under current law). If the grantor survives the 15-year term, the entire value of the property will ultimately pass to the remainder beneficiaries free of estate tax on the grantor’s death. If the property has appreciated from $1 million to $2 million by the time the grantor dies, a $2 million asset will have been transferred to the children for a gift tax value of only $464,430 and free of any estate tax.
If the grantor dies before the end of the 15-year term, the entire value of the property will be included in the grantor’s taxable estate. The $464,430 gift tax exemption originally allocated to the gift would be restored, so nothing would be lost except the cost of establishing the QPRT.
A QPRT is an excellent technique for transferring your residence at a discount with minimal impact on your standard of living. While a QPRT is a flexible vehicle that permits the sale of the residence and purchase of a replacement residence, many technical issues may arise.
The McGrath North Group specializes in gift and estate tax planning. We have implemented QPRT’s for a number of clients. If this strategy is of interest to you or your clients, please contact us to discuss the strategy further.
1. If the residence transferred to the QPRT is subject to a mortgage, each payment of principal on the mortgage is considered to be an additional taxable gift to the trust. If possible, a grantor should pay off the mortgage before transferring the residence to a QPRT.
2. If the grantor survives the QPRT term, the grantor must pay rent to the remainder beneficiaries (children) to continue to live in the residence. From an estate planning perspective, paying rent is another way for the grantor to pass money to children free of gift and estate tax. The children would have ordinary rental income, but they should have offsetting deductions, as well.
3. A QPRT can be structured so that it continues as a grantor trust for the benefit of the grantor’s children after the initial QPRT term. In that case, rent payments would be made to the trust instead of to the children. With a grantor trust, the home is treated as owned by the grantor for income tax purposes. Therefore, the rental payments would not be subject to income tax.
The grantor trust also would allow the grantor to take advantage of all of the income tax benefits associated with home ownership even though the income has been legally given away. The home may also qualify for the $250,000/$500,000 gain exclusion that applies to a sale of a personal residence if the property were sold during the grantor’s lifetime.
4. Each spouse could transfer a one-half interest in the home to a separate QPRT. In this case, additional discounts on the value of their gifts should be available because each would have made gifts of an undivided interest in real property. Furthermore, dividing the property into two QPRT’s provides a hedge against the early death of one spouse. If one of the spouses dies before the end of the term, only half of the home would be includable in the decedent’s estate.