This handout is designed to illustrate the use of a Qualified Personal Residence Trust (“QPRT”) in an estate planning context and answer some questions you may have with regard to its use.

1.0 WHAT IS A QUALIFIED PERSONAL RESIDENCE TRUST?

A QPRT is an estate planning vehicle that allows you to transfer your residence to your children at a substantially reduced estate and gift tax cost. Specifically, a QPRT is an irrevocable trust specifically sanctioned by Congress to which you transfer your residence and retain a right to live in the home for any number of years you select.

2.0 HOW DOES THIS SAVE ESTATE TAXES?

A QPRT can reduce estate taxes by allowing your home to pass to your children upon the conclusion of the term you select without gift or estate tax. While there is gift tax imposed upon the initial transfer of your residence to the QPRT, the value of the transfer for gift tax purposes is greatly reduced due to your retained ownership in the home.

Depending upon the length of the retained term you select, the amount of the gift can be as little as 25% of the current fair market value of your home. Additionally, all appreciation in the residence occurring after the initial transfer passes to your children gift or estate tax-free.

For example, assume you are 55 years old with a home worth $900,000. If the current interest rate set by the Internal Revenue Service is 7.4% and you retain the right to occupy the home for fifteen years, the value of the initial gift would be only $238,275. This gift likely would be covered by your lifetime unified credit of $1,000,000 (unless you have made substantial other lifetime gifts) so that no gift tax should be due upon the original transfer. As a result, if you outlive the fifteen year term and the home appreciated at 4% per year to $1,402,171, the entire value of the home would be excluded from estate for tax purposes at your death – a potential estate tax savings of up to $523,753.

3.0 WHAT HAPPENS IF I DON’T OUTLIVE THE TERM SELECTED?

Unfortunately, the rules for a QPRT provide that if you fail to survive the selected term, the value of the residence will be not be excluded from your estate for tax purposes. However, even if you do not outlive the term selected, you will be in no worse position than if you had done nothing because your estate will receive a credit for any gift taxes paid or unified credit utilized. Thus, the QPRT is a “win-tie” situation whereby if you outlive the term, the entire property is excluded from your estate, but if you fail to survive, the estate taxes imposed upon your death will not have increased.

In any case, to achieve the maximum estate tax benefit from a QPRT, you should attempt to select a term for which you reasonably expect to survive. However, the shorter the term, the greater the value of the initial gift. As such, these competing interests must be balanced when choosing the length of the retained term.

4.0 CAN I LIVE IN THE HOME AND RETAIN CONTROL EVEN AFTER THE TERM?

While ownership of the home automatically passes to your children upon conclusion of the term, you can effectively retain control over the residence for your entire life in the following ways:

(a) Act as Trustee. Anybody, including you, can serve as trustee over the QPRT during the retained term, and even after its expiration. If you choose to serve as trustee, the trust agreement must be specifically drafted to ensure the transfer is a completed gift and ensure nothing will be included in your estate if you outlive the term. Alternatively, you could appoint a friendly independent party or a relative to serve as Trustee and retain the power to remove and replace them at your discretion.

(b) Right to Live in Residence for Life. You can retain the right to remain in the home even after the retained term expires by renting the property from the QPRT for a fair market value rent. While renting your own home seems unusual, it actually produces an additional estate tax benefit by allowing you to shift value out of you estate to your children via the payments of rent. To ensure the right to rent the home until your death, the IRS even permits you to enter into a lease with the QPRT upon the original contribution.

(c) Leave Home in Trust. Upon the conclusion of the selected term, you can either terminate the QPRT and transfer the home outright to you children or keep the home in trust for your life. Keeping the property in trust can provide several benefits to both you and your children. First, if your children are young or if you are leaving the home to multiple children, it can facilitate better management of the property and minimize disputes among the beneficiaries. Additionally, as long as the property remains in trust, it will not be subject to your children’s creditors.

5.0 WHAT ASSETS CAN I USE A QPRT FOR?

The rule allowing QPRTs mandates that it can only be used for a “personal residence”. A personal residence includes your principal residence, plus one other residence. A husband and wife could transfer up to three separate homes – their principal residence and two vacation homes. While a mortgaged residence may be placed in a QPRT, property free of a mortgage is normally used due to the added complexity caused by the mortgage.

6.0 CAN THE RESIDENCE BE JOINTLY OWNED?

A jointly owned home (such as property held as community property) can either be transferred to one QPRT or transferred to separate QPRTs. If multiple QPRTs are selected, you may choose different terms for each QPRT. This can allow you to select a longer term for a younger spouse or hedge your bets against a premature death by choosing a short term for a portion of the residence. Alternatively, if one spouse is substantially younger or in better health, the older spouse could transfer their interest in the home to the younger spouse and have the younger spouse form the QPRT.

7.0 WHAT IF I SELL THE RESIDENCE?

The rules relating to QPRTs specifically allow you to sell your home while in the QPRT as long as a replacement home is purchased with two years after the sale. If you purchase a less expensive home, or choose not to purchase a replacement home, the difference between the former and current values simply converts into an annuity that is paid to you throughout the remainder of the term.

8.0 WHAT ARE THE INCOME & PROPERTY TAX CONSEQUENCES OF A QPRT?

During the term, the QPRT will be a grantor trust so that you as grantor continue to be treated as owner. As a result, property tax payments made by you will continue to be deductible. Additionally, if you sell the home, you can still qualify for the capital gains exclusion of $250,000 ($500,000 for married persons) applicable to personal residences.

As for property taxes, the initial transfer of your home will not cause a property tax reassessment because the QPRT is a grantor trust for which there is a reassessment exception. When the QPRT ceases to be a grantor trust (upon distribution to your children and/or the conclusion of the term), the transfer could trigger a reassessment. Even in this case, however, the transfer may not cause reassessment if it qualifies for the parent-child property tax reassessment exception.

9.0 WHAT ARE THE DISADVANTAGES?

(a) Lose Stepped-up Basis in Home. Generally, when an individual dies and property is included in their estate for tax purposes, the property receives a new fair market value basis so that an immediate sale of the property will not give rise to capital gains. However, because your residence passes to your children without tax at your death with a QPRT, your children will take your current basis in the property. Thereafter, a sale will produce capital gains tax. However, if your estate is substantial, your children still will achieve overall tax savings with a QPRT due to the comparatively lower capital gains rates (25% maximum state & federal capital gains rate vs. maximum 40% estate tax rate). Additionally, the capital gains could be wholly avoided if your children qualified themselves for the $250,000 personal residence exclusion or held the residence until their death.

(b) Extra Costs & Hassles. As with all estate planning techniques, there are implementation costs such as legal fees and appraisal costs. However, if you outlive the term selected, the estate tax savings will far outweigh these costs. Additionally, because QPRTs are typically unfamiliar to banks, refinancing the property inside the QPRT often entails greater difficulty. Therefore, if you intend to refinance, it may be advisable to refinance the property before transferring it to the QPRT.

10.0 WHEN SHOULD I CREATE A QPRT?

You should create a QPRT for your home(s) as soon as possible for the following reasons:

(a) Possible Changes in Law. Prior budget proposals have advocated that the law allowing QPRTs be repealed. While it is unclear whether such proposal will be passed by Congress, creating a QPRT now would ensure that you are able to use this technique since the proposed repeal would only be effective for transfers occurring after the date the proposal is passed by Congress.

(b) Increasing Real Estate Values. Because real estate values in Southern California are down from their highs a few years ago, now is a good time to create a QPRT since this technique “freezes” the value of the residence at its current value if you outlive the selected term and all future appreciation passes to your children without estate or gift tax.

(c) Higher Chance of Surviving Term. The younger you are when you create the QPRT, the longer you can safely select a retained term and be confident that you will outlive the term. Because the value of the initial gift is based primarily on the term selected, you can save substantial gift taxes upon creating the QPRT by choosing a longer term.

(d) Asset Protection. As an additional benefit to both you and your children, creating a QPRT may protect your home from both your and your children’s future creditors. With respect to your creditors, because the QPRT is irrevocable and you have only retained the right to live in the home for the designated term, your future creditors will only have limited access to the property during the term. Once the term is completed, if the property remains in trust for your children, the property can be completed protected from both your and your children’s creditors.

Clay R. Stevens © 2013