A Qualified Personal Residence Trust (QPRT) is a powerful estate planning tool. It allows wealthy individuals to transfer their primary residence (or even a vacation home) to a trust while retaining the right to live in the property for a specified period.
The main goal of a QPRT is to reduce the value of the residence in the estate for estate tax purposes. This will thereby lower the estate tax liability that might be incurred upon the individual’s passing.
Let’s take a look at a QPRT example so you can see for yourself. Let’s jump in!
During the predetermined term of the trust (often called the “retained interest period”) the person has the right to live in the home. Once this term expires, the property will be transferred to the designated beneficiaries (typically children), who then become the legal owners of the home. If the person wants to continue to live in the residence after the retained interest period, they must then pay fair market rent to the trust beneficiaries.
The key advantage of a QPRT lies in the ability to transfer a valuable asset, to heirs at a lower estate tax basis. Since the value of the property is determined at the date the trust is established and considers the length of the retained interest period (along with current interest rates) a lower valuation is determined. This results in a reduced estate tax liability.
Assuming the person survives the retained interest period, the property is removed from their taxable estate. However, QPRTs are complex legal instruments, subject to specific rules and IRS regulations. They should be approached with careful planning and consultation to ensure they align well with the person’s estate planning goals.
Angela is a widow in her mid-60s with three adult children. She witnessed her parents’ estates devastated by estate taxes. As a result, she is determined to avoid that result for her children.
She meets regularly with her estate planning team (lawyer, CPA, and financial advisor) to discuss estate planning strategies. One result of these discussions is that Angela gives her home worth $1 million to a qualified personal residence trust or QPRT.
The trust provides that Angela can continue to live in the home rent-free for the 15-year trust term. During that time, Angela will be the trust’s sole trustee and will continue to pay all home expenses (insurance, property taxes, HOA dues, etc) for the next 15 years. As a result, her living arrangements will remain the same.
If Angela decides to sell the home, the sale proceeds will revert to the trust. In that case, the trust can either use the proceeds to buy another residence for Angela to live in or pay Angela a cash annuity for the balance of the 15-year term.
At the end of the 15 years, if Angela is still living, things will change. At that point, her three children become the “beneficial owners” of the trust. Angela will continue as the trustee and still have the option to live in the trust-owned home. However, she must start paying the trust rent just like any other tenant. The rent will flow through to her children as trust beneficiaries.
Estate Tax Savings
Because Angela has made a gift to her QPRT, she must file a gift tax return when the trust was established. Even though the home she gave away was valued at $1 million, the value of her gift (for gift tax purposes) is only $400,000. No gift tax is payable because her gift is less than her lifetime gift tax exemption amount. If she had already used up her exemption on other gifts, she would have to pay about $160,000 in gift taxes.
While Angela is setting up her QPRT, her same-age friend Kim, who owns a similar home and is just as wealthy and estate tax-averse as Angela is, does no estate planning. Because she believes the IRS may repeal the estate tax, Kim will “wait and see”—maybe the estate tax will soon disappear.
Fast forward 25 years when Angela and Kim die. The estate tax never was repealed. Angela continued to live in her trust-owned home for the rest of her life, paying rent to the trust for her occupancy for the last ten years. Both women’s homes appreciated about four percent per year and are now worth $2.6 million each. Kim’s home is included in her estate for estate tax purposes and adds about $1.2 million to her children’s estate tax bill. Angela’s home, though, is out of her estate; her children inherit it without paying any estate tax.
Angela’s children’s transfer tax “cost” of inheriting Angela’s home is that Angela used up $300,000 of her lifetime gift and estate tax exemption to make her gift to the QPRT in 2004. That much exemption is worth about $144,000 in estate taxes, so that amount, plus the several thousand dollars of professional fees required to create the QPRT, are all Angela’s children paid to inherit this asset?
The Tax Savings
The QPRT saved $1 million of estate taxes for Angela’s children. That’s not even counting the $100,000 a year in rent Angela paid to her children for the ten years she lived after the end of her 15-year QPRT term.
The children had to pay income tax on that $1 million of rental income, but their income tax rate is about 10 points lower than the estate tax rate they would have had to pay if they had inherited this money from Angela
rather than receiving it as rent. So, the rental arrangement saved another $100,000 in taxes—without even considering the appreciation the children earned by investing the rent payments they received from Angela. That appreciation would have been part of Angela’s taxable estate had she not paid rent to her children.
The QPRT Angela, created in 2004, does have some quirks. If Angela had died before the end of the 15-year term, and the trust’s assets would have “reverted” to her estate, the trust would have been canceled in that case and did not produce any estate tax savings. Another quirk is that if Angela’s children had died before the QPRT term’s end, that child’s issue would not have received a share of the QPRT. The trust would pass only to Angela’s living children.
These odd provisions were required (under our complicated tax law system) to preserve the tax-saving objective of the trust. Angela blunted their effect by buying some term life insurance: on her own life (to provide the children with a cash payout if they did not receive anything from the trust because she didn’t survive the QPRT term), and on her children’s lives (so that if a child died prematurely and lost their share of the QPRT, the child’s heirs would receive insurance cash instead).