Estate planning

By Scott Hill 

As property values around the country have soared in recent years, many families now list their primary residence and vacation homes among their most valuable assets.  As such, these homes are excellent candidates for beneficial estate planning techniques.  One of the more straightforward of these techniques is the use of a Qualified Personal Residence Trust (QPRT).  Gifting a primary residence or a second home to a QPRT is a clear-cut way in which grantors can significantly reduce the value of their taxable estate with minimal disruption to their daily lives and ultimately pass more assets along to their heirs. 

How it Works

Following a third party appraisal, the grantor transfers title of the home to the QPRT for a term of years.  During that term the grantors continue to use and enjoy the property as they always have; nothing really changes.  At the end of the term, the home will then pass – either outright or in trust – to the designated beneficiaries who will become the new owners.  Even though they are no longer owners, the grantors can still have use of the property, but they will need to pay reasonable rent to the new owners for that right.  If the grantor does not survive through the term of the QPRT, the home would be pulled back into the grantor’s taxable estate and nothing would have been accomplished.  So, it’s important that the grantor be expected to outlive the term of the trust. 

The utilization of a QPRT has multiple benefits from a gift and estate tax planning perspective.  It’s important to understand that a taxable gift is made to the beneficiaries at the time the property is gifted to the trust.  However, for gift tax valuation purposes the value of the home is not the fair market value at the time of transfer; rather it is the projected residual value of the property at the end of the term.  This means that for tax purposes, the value of the gift could be much less than current market value.  If the value of the gift is determined to be less than the grantor’s lifetime gift tax exemption amount of $1 million, then exemption is applied and no out-of-pocket cash will be due to cover the gift tax liability.

The use of a QPRT will also freeze the value of the home at the time the gift is made, meaning that any future appreciation on the property will happen outside of the grantor’s estate.  If property values should continue to rise anywhere near the pace of recent history, the fact that the value of the home was frozen for estate tax purposes will be a huge advantage for the beneficiaries of the QPRT and will greatly leverage the tax exemption that the grantor utilized in making the gift. 

In addition, both spouses could establish their own QPRT, granting an undivided one-half interest in the property to each of their own trusts.  This could result in additional discounting of the amount of the gift and further leverage any amount of tax exemption used.  The establishment of a separate QPRT for each spouse also increases the likelihood that at least one spouse will survive the term of the trust. 

The last tax benefit comes upon the termination of the trust when the property passes outright to the children – assuming that the children were the beneficiaries of the trust.  At this point, the grantors can still use the property.  However, they will have to pay the new owners fair market rent.  These cash payments will further reduce the amount of the taxable estate as they are made to the children over the years.

Things to Consider

As stated above, a QPRT often makes great sense from a tax and estate planning perspective.  However, there are also many subjective concerns prior to entering into this transaction.  For most, the primary concern should probably be whether or not the grantors are ready to pass ownership of the property on to the next generation.  Do they feel that their children are ready to become owners of an expensive property, and do they feel that their children will be able to effectively handle a co-ownership arrangement?  If not, would they feel comfortable naming only one child as the beneficiary of the trust?  These types of questions must be considered, and answered, by the potential grantors when contemplating the establishment of a QPRT.

As another point of deliberation, some potential grantors don’t like the idea of leasing property they once owned.  For this reason, it often makes the most sense to gift a second or vacation home to a QPRT rather than the primary residence.  Once the property is gifted to the trust, the grantors can no longer remodel or alter the property at will.  This is another prime consideration for potential grantors.

Maximizing the QPRT

Also, a QPRT generally provides the greatest benefit if the grantors and their heirs intend to hold onto the property at least through the term of the trust.  A home held within a QPRT can be sold, but a sale introduces additional complexity to the arrangement and could result in a diminished benefit for estate tax planning.  Oftentimes, the sale of a home will defeat the original purpose of the tax planning that was done.  Furthermore, a home within a QPRT can be subject to a mortgage.  However, a mortgage also introduces an additional layer of complexity and most find it preferable to transfer a home free of debt. 

As an example of how a QPRT works:  Suppose husband and wife, both age 65, own a primary residence in town and a vacation home at the beach.  The vacation home is appraised at $1 million.  The house at the beach is filled with wonderful family memories and has become a cherished property by the children and the grandchildren.  In 2006, the couple transfers ownership of the beach home to a QPRT.  The QPRT has a 10-year term and names the couple’s two children as beneficiaries.  Based on the current IRS discount rate of about 6 percent, the residual value of the home at the end of the 10-year term, and thus the value of the taxable gift, would only be approximately $526,000 (or $263,000 per spouse).  This figure is below each grantor’s lifetime gift tax exemption of $1 million, meaning that no out-of-pocket tax liability will be due. 

Further, suppose that over the 10-year term of the trust, the $1 million home appreciates in value to $2 million.  Therefore, using estate tax exemption in the amount of $526,000, husband and wife have passed a $2 million asset to their heirs.  In addition, the couple will not notice any appreciable change in their enjoyment of the property during the term of the trust, or afterward, as long as reasonable rent is paid to the new owners.

In summary, QPRTs are an excellent way to reduce estate tax liability and to leverage the value of a gift to heirs while ensuring that a beloved property remains in the family.  However, family dynamics driven by the future use and ownership of the residential property must be carefully considered prior to placing the home in trust.