For most folks, a large amount of their net worth is in their home. The good news is that there is an estate planning strategy for a personal residence (and even a vacation home). It’s called a Qualified Personal Residence Trust (“QPRT”).
A QPRT can minimize the value of a personal residence that is included in a gross estate. Thus, establishing a QPRT can save estate taxes without limiting the individual’s ability to use the property as a personal residence.
What is a Qualified Personal Residence Trust (QPRT)?
A grantor establishes a QPRT when an irrevocable transfer of a personal residence is made to the trust for a fixed period. This term could be for any period but will usually be 5-20 years.
During this period, the grantor will retain the right to live in the property as a personal residence. The use is unrestricted.
The grantor gets exclusive rent-free use during the term of the QPRT. The grantor will pay any ordinary, necessary and recurring property expenses such as insurance, real estate taxes, and repairs and maintenance. If the grantor pays fors a capital improvement, the cost is treated as an additional gift, with the amount of the taxable gift based on the fair market value of the improvement and the remaining term of the QPRT.
Once the fixed period ends, the property will revert to the designated beneficiaries (usually the children). However, if the grantor is still alive at the end of the term, he or she will typically lease the home from the beneficiaries at a fair value rental amount. Also, the rental payments made by the grantor will continue to reduce the value of the estate.
The transfer of the home to the QPRT is a gift. As a result, the grantor wants the value of the gift to be as low as possible. This is best accomplished when the QPRT uses a long fixed term, which reduces the value of the remainder interest.
The gift will be based on the IRS tables. Even though the grantor desires a long fixed term for purposes of gift valuation, there are problems if the grantor passes away within the fixed period. If this happens, the full value of the real property at the date of death would be included in the grantor’s gross estate. This results in no estate tax savings.
Because the grantor must survive the fixed term to get the estate tax benefit, the grantor should select a term that he or she has a good chance of outliving.
The estate tax base will only include the value of the gift on the date the property was transferred to the QPRT. Thus, the difference between the property’s FMV on that date and the value of the gift will bypass estate taxes. In addition, any appreciation of the home from the QPRT transfer date to the date of death will avoid estate taxes.
Unfortunately, a QPRT has one significant estate tax downside. The beneficiaries do not get stepped-up basis on the property at the grantor’s death.
As you can see, using a Qualified Personal Residence Trust can be a great tax planning strategy for a primary residence. In addition, most people have a lot of equity in their homes so that a QPRT can be a great starting point in the estate planning process.
Unfortunately, many people don’t consider estate planning until it is too late. Many will consider a QPRT when they are close to the end of their life. The problem with this approach is that you are just not able to get a long fixed term. Without that long-term, you just won’t get enough of a discount on the home’s value to make enough of a difference in your taxable estate.
The best scenario is for a person who is, for example, in their 50s with a sizable estate. This way, they can get out in front of the issue and set up the QPRT with a long term.
People often assume that they would lose the primary residence gain exclusion if the home is sold while in the QPRT. However, any gain on the sale of a primary residence transferred to a QPRT may qualify for the $250,000 or $500,000 gain exclusion on the sale as long as all other requirements are met.
An important issue to note is that the gain exclusion will not apply to the sale of a vacation home. The property must be a primary residence, such as a vacation home.
Simple QPRT Calculation
Let’s assume a 60-year-old has a primary home valued at $1,000,000 and wants to set up a QPRT with a 10-year term. Let’s also assume that the applicable federal rate (AFR) was 5% when the trust was created.
The first step is determining the taxable gift when the QPRT is created. You need to calculate the present value of the person’s right to live in the property for ten years (the grantor’s retained interest in the home). This amount is calculated using the AFR and the trust term.
Using the IRS-approved method, the present value based on the retained interest would be $610,970. The taxable gift would be calculated by subtracting the value of this retained interest from the value of the home:
$1,000,000 (home value) – $610,970 (retained interest) = $389,030 (gift)
With the QPRT, the person would be liable for the gift tax on $389,030 rather than the fair value of $1,000,000. In addition, any appreciation in the home’s value over this 10-year term is not subject to estate or gift tax (currently at a 40% rate).
If the home appreciated to $1,500,000 at the end of 10 years and the grantor survived, the $500,000 home appreciation passes to the beneficiaries free of any estate tax. In addition, the property receives a “step-up” in basis. This will limit any capital gains tax when the beneficiaries subsequently sell the home.
This example shows how a QPRT provides huge estate tax savings, particularly in a high-interest rate environment like ours. The higher the AFR, the lower the value of the taxable gift and the greater the tax advantage for the grantor.
Now that you understand some of the basic QPRT rules. Let’s take a look at some of the strategies that can be implemented to customize a specific situation.
A grantor can set up a QPRT for up to two residences. The trusts can be funded using:
- A principal residence utilized by the grantor.
- A vacation or secondary home.
- A fractional interest in either of the above.
The grantor can consider transferring fractional interests in a home to hedge against the chance of a premature death. For example, a taxpayer might create three QPRTs with 5-, 10-, and 15-year terms. The grantor can then transfer a 33% interest in the home to each of the trusts. Then, if the taxpayer dies in 13 years, only the 33% interest in the last QPRT is included in the taxable estate.
When setting up a QPRT, you should consider the following points:
A QPRT is considered a grantor trust for income tax purposes. This means that the trust is not a separate taxpayer (does not file a separate tax return). Instead, the income or capital gains generated during the term will be taxed to the grantor and reported on his or her personal tax return.
During the term of the QPRT, the grantor can claim an income tax deduction for real estate taxes. Furthermore, if a primary residence is used, the grantor can benefit from the capital gain exclusion if the home is sold during the QPRT term.
The strategy tends not to be as prevalent when interest rates are low due because it results in higher valuations for gift tax purposes. However, even considering our current low-interest-rate environment, now can be an excellent time for a QPRT.
A QPRT typically involves the grantor transferring their primary home or vacation home to an irrevocable trust. A QPRT is broken down into two separate interests:
1) the initial QPRT term in which the grantor retains the right to use and occupy the home rent-free for a specified term; and
2) the remainder interest in which after the QPRT term expiration and generally provides that the residence passes to a different trust for the donor’s spouse or a trust for the grantor’s children.
How to Set Up a QPRT
- Review and discuss with CPA and estate attorney. Deciding to set up a QPRT is an important estate planning decision. Make sure you consult with all parties to make sure it is a good fit in your situation.
- Establish the trust. The actual trust document needs to be drafted, reviewed and signed. The estate attorney will draft the document based on the specifics of your circumstances and state law.
- Calculate the gift value. Once the term is established, the IRS approved discount rate is applied to the fair market value of the home to determine the appropriate gift value. This is the value that will be used when filing the gift tax return.
- Transfer the home to the trust. Legal title of the home needs to be transferred to the trust. The attorney will draft the related deeds and make sure they are timely recorded.
- File gift tax return. At the end of the year, the gift tax return must be filed to report the taxable gift. This is normally completed by a CPA with experience filing gift tax returns. Most CPAs just don’t understand gift tax filing requirements.
As you can see, there are many steps involved in setting up a QPRT. These trusts can be complex so the more questions you ask the better off you are. Just follow the compliance steps above and your trust will be up and running in no time!
How to Set Up a QPRT
A Qualified Personal Residence Trust (“QPRT”) is a low-risk and potentially very high reward technique of transferring a primary residence to your beneficiaries at a low value for gift and estate tax purposes.
This proves why it is essential to start the estate planning process as soon as possible. Unfortunately, most people try to do estate planning once someone has passed away. At that point, it is just too late to implement many options.