Introduction to Qualified Personal Residence Trusts
For many of us, our home is our most significant asset. For wealthy families, transferring a home can create large estate or gift tax bill. The law considers every parcel of land to be a unique asset. There is only a finite amount of land available both in a specific area and in the world in general. This unique characteristic is part of the reason why the price of real estate tends to increase over time, even if you discount the effects of inflation. If you are concerned about estate taxes, you want the IRS to value the property at as low a value as possible for estate and gift tax purposes. One way to do this is: gift away the property now, and then rent the property back from the person you gifted it to. By doing this, you will pay gift taxes on the current value of the house, rather than paying estate tax on the future value. The main issue with this plan is that you are giving away control over your home. Also, you can’t make the gift conditional on you being able to lease the property, or pay below market rent on the property, or else the IRS may invalidate the transaction and charge estate tax on the future value anyway. There is a trust that you can create that will allow you to minimize the value of your home for estate tax purposes and minimize most of the loss of control problems you encounter by simply giving away your home. A Qualified Personal Residence Trust (QPRT) is a trust that allows you to transfer a home or vacation home to a beneficiary in a way that reduces estate taxes.
How Does A QPRT Work?
A QPRT is a split interest trust where the homeowner lives rent-free the home for a period of years, after which the home goes to a second beneficiary or a trust. At this point, the homeowner can rent the home back from the beneficiary or trust at a market-value rent. The IRS values the home at the time the trust goes into effect, and discounts that value by the homeowner’s retained interest in the property. In this case, the homeowner’s retained interest is that they are able to remain in the home rent-free for a specified term of years. To put it another way, because the beneficiary will receive the property years in the future, the IRS values the gift at a much lower value than if they received the gift now. The IRS determines the exact discount based on the length of the trust, the gift givers age, and the current §7520 rate (currently 2.4%).
You may have noticed that the gift giver’s age is included as a variable that the IRS uses to determine the value of the retained interest. There is a very important reason for this, and it leads us to one of the flaws of the QPRT. With a QPRT, it is very important that the homeowner survives the trust term. If the owner dies during the trust term, the full value of the home will be included in their estate. While nobody knows when they will pass away, when creating a QPRT, you should be conservative and tend towards a shorter term. The discount is lower if the term is shorter, but you lower the risk of losing all of the benefits of the QPRT.
QPRT Tax Consequences
Capital Gains Taxes
In terms of capital gains taxes, the beneficiary will receive the home with the same basis as the current owner of the house. If the original homeowner transfers the property at their death, the new owner receives the property with a “stepped-up” basis of the fair market value at the time of death. When you are deciding on whether to create a QPRT, your basis in the property is an important consideration. You are saving a lot in estate taxes, but how much are you losing in capital gains? This concern is somewhat diminished by the fact that capital gains taxes are usually much lower than estate taxes.
The main estate tax benefit of a QPRT comes from the reduction in the value of the home. The fact that you are removing the property from your estate at its value when you create the trust increases this benefit. If the assets continue to appreciate, the added value will not go into your estate. Remember though, these benefits only come about if you live through the initial trust period. Additionally, the fair market rent that you pay to remain in the house escapes estate and gift tax, though it is ordinary income to the beneficiary. You cannot use any of your annual gift exclusions with this trust. The reason for this is because to use your annual gift exclusion, you must give gifts of a present interest. Since you are giving the home in the future, you aren’t giving anything of present interest. Present interest means that the recipient can use, possess, or enjoy either the gift or income from the gift immediately.
How a QPRT affects estate taxes is best shown in an example:
A 60 year old grantor transfers a $1,000,000 home into QPRT with 10 year term
At the current, June 2017, §7520 rate of 2.4% the initial value of the gift is $788,861.
The IRS further reduces the value of the gift, because of the grantor’s age, to a final value of $673,578.
At a 40% gift tax rate, the QPRT reduces gift taxes versus giving the home outright by over $130,500.
If the home appreciates to $1,500,000 in 10 years the estate taxes savings by using the trust versus giving the house away at that point is over $330,500
If the homeowner had created the trust with a 20 year term, the final gift value would have been $361,034.
The IRS considers QPRT to be grantor trusts, so all taxes and tax benefits pass through to the original homeowner during the trust period. After the trust period is over, the IRS taxes the rent as ordinary income to the new owner of the home. This can be a beneficiary, or a trust. Keep in mind, if you have a trust hold the property after the initial trust term, that trust income tax brackets reach their highest tax rates very quickly.
Additional Things to Consider With QPRT
QPRT have a number of requirements in order to get the positive tax treatment that makes them valuable. One of the biggest of these requirements is that you can only use them for a primary residence or one vacation home. For something to be considered a vacation home, you need to spend at least 14 days there a year or, if you rent out the property, more than 10% of the number of days you rent it out. E.g. if you rent it out 200 days a year, you need to spend at least 21 days there for it to qualify.
A married couple can protect up to three properties if they share a primary residence. A married couple can also split their interest in a home into two separate QPRT. The reason why you might do this is to cut, by half, the impact someone passing way during the trust period. One of the QPRT will lose its value, but the other QPRT will still provide estate tax benefits for 50% of the property.
Many times people create an irrevocable trust to act as remainder beneficiary of the QPRT(s); this will give you additional control over the distribution of the property. You can create rules in the beneficiary trust on how the property can be used and to whom it will be distributed. This gives you a lot more control over the property vs. giving the property outright. In order to avoid the property in the beneficiary trust being included in your estate, you cannot be the trustee or beneficiary of this trust. You can reserve the right to change trustees at will; however, this power usually allows you to maintain some additional control.
If you have a mortgage on the property, you can still use a QPRT. However, a mortgage will decrease the QPRT’s benefits. The IRS will consider the mortgage payments that you make to pay off the mortgage as additional gifts to the trust beneficiary. Also, if you improve the home in the QPRT, the IRS also considers those improvements additional gifts to the trust. You can sell the home, but you must reinvest the proceeds in a new home or convert the trust to a grantor retained trust.
QPRT are valuable tools for those who worry that they may be subject to estate taxes. The current trend has been to reduce the number of people who are subject to these taxes, but there is no way to tell if this trend will continue in the future. With a QPRT, you lock in the value of your home, for gift and estate tax purposes, at a highly discounted value. These types of trusts might not be for every homeowner, but, for wealthy families a QPRT is an investment that can create huge future savings.