Many taxpayers assume their estates will escape federal and state estate taxes because they underestimate the worth of their most valuable asset—their principal residence or vacation home. When an individual dies, the value of the residence is included in the estate just like any other asset. If the value of the estate exceeds $5,490,000.00 in 2017, the estate may be subject to a federal tax rate of 40%. While it’s possible for the Trump Administration and the Congress to modify the estate tax structure, or even provide for a sunset provision as it did in 2010, chances are the next Administration and/or Congress will bring the estate tax back.
In today’s California real estate market, the values of personal residences have skyrocketed. A popular estate planning technique is to reduce the size of an estate by transferring a residence to a qualified personal residence trust (QPRT). A properly structured QPRT will freeze the value of the residence at the time the trust is created, resulting in significant estate tax savings. Although minimizing estate taxes and expected appreciation are strong incentives for creating a QPRT, the prevailing federal interest rate under IRC section 7520 (discussed below) is also an important factor when deciding when to implement one.
PUTTING IT TOGETHER:
Before considering QPRTS, Taxpayers first must understand the mechanics of creating and funding such a trust and the potential savings, benefits and disadvantages.
Step 1. Transfer of property to a QPRT. The grantor creates a QPRT for a term of years and designates beneficiaries, usually children. The grantor contributes the residence to the trust, thus removing it from his or her own name and creating a taxable gift. The fair market value of the residence is discounted for gift tax purposes. This gift does not qualify for the annual gift tax exclusion since the transfer of a residence to a QPRT is not a gift of a present interest.
Step 2. Use of residence. The grantor retains the exclusive rent-free use, possession and enjoyment of the residence during the term of the QPRT. The grantor pays any ordinary and recurring expenses such as real estate taxes, insurance and minor repairs. If the grantor makes a capital improvement, the cost is treated as an additional gift to the trust and the amount of the taxable gift is based on the fair market value of the improvement, as well as the remaining term of the QPRT.
Step 3. For the QPRT technique to be effective for estate tax purposes, the grantor must outlive the term of the trust. If the grantor dies before the trust term expires, the date-of-death value of the QPRT will be included in the grantor’s estate and subject to estate taxes. However, the grantor’s estate will receive full credit for any tax consequences of the initial gift to the QPRT and the grantor is no worse off than if he or she had not created the QPRT.
Step 4. Termination of the QPRT. If the grantor outlives the term of the trust, the residence passes to the beneficiaries at the end of the term.
Step 5. Rental of residence. At the end of the QPRT term, the grantor can lease the residence back from the beneficiaries at fair market rent, thereby allowing the grantor to continue living in the house. Note that the rental payments the grantor makes further reduce the value of his or her estate.
Step 6. Other considerations. If the property ceases to be used as a personal residence, the trust ceases to be a QPRT and the trustee must distribute the assets outright to the grantor or convert the QPRT to a grantor retained annuity trust (GRAT). A GRAT provides for the payment of an annuity for a fixed term with the balance passing to the remainder beneficiaries at the end of the term. A QPRT also will convert to a GRAT if the residence is sold while it is in the QPRT and the sales proceeds are not reinvested in a new residence.
Planning point. Any gain recognized on the sale of a principal residence that has been transferred to a QPRT may qualify for the $250,000/$500,000 gain exclusion from the sale of a principal residence, provided all other IRC section 121 requirements are met. The exclusion of gain does not apply to the sale of a property that is not a principal residence, such as a vacation home.
A grantor may establish a QPRT for no more than two residences. The trusts can be funded using (1) a principal residence; (2) a vacation home or secondary residence; or (3) a fractional interest in either.
Planning point. The transfer of fractional interests in a residence can be used to hedge against the possibility of premature death. For example, a taxpayer might create three QPRTs with terms of 5, 10 and 15 years. The taxpayer transfers a 33% interest in her residence to each of the trusts. If she dies after 12 years, only the 33% interest in the last QPRT is included in her estate.
INTEREST RATES AND INCOME TAXES:
The federal interest rate under section 7520 is one of the main factors that drive the favorable tax outcome of valuing the gift of the residence. The higher the federal interest rate, the lower the gift value and the lower the potential gift tax. Conversely, a low federal interest rate usually translates into lower estate tax savings. When federal interest rates are low, one should carefully consider whether a transfer to a QPRT is the right estate planning strategy for their clients.
In recommending that clients setting up QPRTs, we take into account certain income tax considerations:
- A QPRT is a grantor trust for income tax purposes. This means the trust is not a separate taxpayer and all of the income or capital gain during the term is taxed to the grantor and reported on his or her personal income 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 still benefit from the capital gain exclusion if the residence is sold during the QPRT term.
THE DISADVANTAGES:
As with any estate planning technique, QPRTs aren’t right for everyone. There are some concerns.
- The grantor has a predetermined limit (the trust term) on the right to occupy the residence and must relinquish ownership of the property at the expiration of the QPRT term. The beneficiaries, generally the grantor’s children, then have ownership of the home and will collect fair market rent from the grantor. Since some taxpayers might find this situation awkward, they should carefully evaluate the nontax factors, including family relationships, before setting up a trust.
- If the beneficiaries sell the residence they may incur a significant income tax liability. If the QPRT had not been created and the children inherited the residence at the grantor’s death, they would have received a step-up in basis to the value of the property on the grantor’s date of death. If the grantor survives the QPRT term, there is no step-up in basis and the children’s basis carries over from the grantor. Thus it’s important that the estate tax benefits of setting up the trust outweigh any later income tax consequences of losing the stepped-up basis.
- If the residence transferred to the QPRT is subject to a mortgage, there may be some complexity in accounting for the monthly mortgage payments and minimizing the tax consequences. If possible, pay off the mortgage before transferring the residence to a QPRT.
BALANCING ACT:
| The decision to create a QPRT requires the balancing of the potential estate tax savings, based in part on current interest rates, against the consequences of relinquishing ownership to the next generation. |
Transferring a residence to a qualified personal residence trust (QPRT) is a popular estate planning technique that can help reduce the size of the grantor’s estate. If structured properly, the QPRT will freeze the value of the taxpayer’s residence at the time he or she creates the trust and result in significant estate tax savings.
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