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A
qualified personal residence trust
or QPRT (pronounced "cue-pert")
is a special type of trust that can
provide a significant savings in transfer
costs. A taxpayer creates a QPRT by
transferring a personal residence to
an irrevocable trust and retaining
the right to live in the residence
for a fixed term of years. Although
a taxable gift is made when the property
is transferred to the trust, If the
taxpayer survives until the end of
the trust term, the residence will
go to the beneficiaries the taxpayer
has named (typically the taxpayer's
children) with no further tax consequences.
Tax
Savings The
tax advantage of a QPRT stems from
the fact that when the residence
is transferred, the taxpayer does
not pay gift tax on the full fair
market value of the property. Instead,
the gift is computed on the value
of the property reduced by the value
of the interest the taxpayer has
retained. Suppose for example, that
Susan Taxpayer owns a personal residence
with a fair market value of $1,000,000
and is in the 50 percent marginal
tax bracket(1) for gift and estate
tax purposes. If Susan makes an outright
gift of the property, she will pay
a gift tax of $500,000 on the transfer.
If she leaves the residence to her
children at death, she will pay a
50% tax not only on the current $1,000,000
value, but also on any appreciation
on the property between now and the
time of her death. If Susan transfers
the property to a 15-year QPRT instead,
and survives until the end of the
trust term, the result is quite different. Rather
than paying tax on the full $1,000,000,
she pays a 50% tax on $1,000,000
minus the value of the 15-year retained
interest. At a 4% interest rate,
the value of a 15-year interest is
just over 41% of the total value
of the property. This means that
the value of the interest passing
to the children is only about 59%
percent of the total, or $586,290
as shown in the illustration. The
bottom part of the illustration shows
what the value of the home might
be worth at Susan’s death in 30 years,
using an annual growth rate of 3%.
When you compare the value of the
residence in 30 years to the cost
of a current transfer, the transfer
cost savings can be very dramatic!
Retaining
a Reversion One
drawback to a QPRT is that if Susan
should die before the end of the
15-year term, the value of the residence
is brought back into her estate for
death tax purposes at its then fair
market value. However, we can turn
this potential adversity into opportunity
by having Susan retain a reversion,
which is a right to recover the property
from the trust if she dies within
the term. With the reversion, Susan’s
gifts to the children is not $586,290
as shown above, but is only $450,110
-- reducing the gift tax cost even
more!
After
Expiration of the Trust Term Despite the large reduction in gift tax, many
taxpayers may have reservations about
using a QPRT because they are concerned
about having to give up their residence
at the end of the trust term. Prior
to enactment of regulations in 1997,
taxpayers could solve this problem
by repurchasing the residence from
the trust before the end of the trust
term. Now, the governing instrument
of a QPRT must prohibit the trust
from selling or transferring the
residence, directly or indirectly,
to the grantor, the grantor's spouse,
or to an entity controlled by the
grantor or the grantor's spouse.
Fortunately, an alternative strategy
is available. After the end of the
term, the donor can lease the residence
back from the children. The lease
must provide for payment of a fair
rental amount to avoid unintended
gifts from the children to the parent
(or worse, having the residence included
in the donor’s estate due to the
IRS treating the transfer as a sham).
However, such lease payments offer
an additional avenue for transferring
value to the children at no transfer
cost (although the children will
have to pay income tax on the rent
received).
Other
Rules
Although the most frequent application for a QPRT involves
the donor’s primary residence, a secondary
residence or even a vacation home can be
placed into a QPRT. However, a taxpayer
may not create a QPRT for more than two
residences. If the home is sold or
destroyed during the term of the trust,
a new home must be purchased or rebuilt
within one year. Alternatively, the proceeds
of the sale (or insurance proceeds where
the residence is destroyed) can be turned
into a Grantor Retained Annuity Trust (GRAT),
which will distribute an annual annuity
to the donor for the balance of the trust
term. (1) Based on current law, the marginal
rates for gift and estate taxes are scheduled
to decline in upcoming years.
The
purpose of this newsletter
is to stimulate thought for
our clients and professionals
with whom we network. One should
consult with a qualified financial
planning professional prior
to implementing any financial
planning strategies. If
you are a legal, insurance,
tax, real estate or mortgage
planning professional receiving
this newsletter or know of
one, please contact our office
to introduce yourself and your
services to us. We
are always seeking to grow
our referral network and expose
professional services to our
client base.
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