Qualified Personal Residence Trusts for Tax Savings Purposes

Utilizing a qualified personal residence trust (QPRT) can be an effective tax-savings solution for high-net-worth individuals. You can leverage your federal gift and estate tax exemption now while transferring your primary or secondary home to your beneficiaries for their long-term use and enjoyment.

Plan Ahead with a QPRT

As a homeowner wanting to keep your home in the family, while not burdening your heirs with significant estate taxes when you pass, a qualified personal residence trust may be the solution. QPRT allows you to transfer ownership of your home for tax purposes. As the grantor, you are able to retain the right to live in your home for a specified number of years, as well as determine the beneficiaries who will receive the home when that period ends. Once that defined period ends, ownership of the home passes to the beneficiaries established in the QPRT, typically children or a trust for them (there are less-favorable rules if the beneficiary is a grandchild). At this point, you can continue living in the home by entering into a formal written lease and paying fair market value rent.

Understanding the Tax Component

When your home is transferred into a QPRT, a gift is made to your beneficiaries that is either subject to gift tax or uses a portion of your gift and estate tax exemption. In either case, a gift tax return must be filed. Typically, transfer tax is assessed on a gift’s fair market value at the time of the gift, but with a QPRT the value of the taxable gift is not the full fair market value of the home. Rather, the value of the gift is effectively discounted to reflect the retained interest (i.e., the value of your reserved time in the home) for the term of the trust. Once the trust term ends, the beneficiary receives the home with no additional tax triggered.

The amount of the gift to your beneficiaries is the present value of the remainder interest in the trust, which is calculated by subtracting your retained interest from the fair market value of the house when transferred into the trust. The retained interest is calculated for gift tax purposes using the Section 7520 rate set by the IRS each month. Current 7520 rates can be found on the IRS website.

Using this rate to calculate the value of the gift of the residence contributes to a favorable tax outcome. The higher the federal rate, the lower the gift value — and the lower the gift and estate tax credit used on the transfer of the home into the QPRT. Conversely, a low federal interest rate translates into lower gift tax savings. Additionally, the longer the reserved right to live in the property, the lower the gift tax value, but as noted, you must outlive this term for this technique to be effective.

Provided the donor survives the defined term, the value of the home plus any appreciation will completely avoid estate tax because the home will have been removed from the donor’s estate.

Lastly, during the trust term, you can claim an income tax deduction for paid real estate taxes to the full extent permitted under current tax law. However, in certain jurisdictions that provide property tax exemptions or homestead exemptions, the transfer to a QPRT or the transfer at the end of the reserved time might result in the exemption no longer being applicable. Be sure to check your local law. After the term ends, if you opt to remain in the house and thus pay rent, no income tax is due on the rent paid if the then owner is a grantor trust. If the then owner is an individual or a non-grantor trust, rent will trigger income tax.

Potential Tax Consequences

It is important that your beneficiaries want to keep this property in the family. When a home is transferred to a QPRT, your beneficiaries will receive an income tax cost basis equal to the donor’s cost basis at the time of the gift, called a carryover basis. If the home has appreciated substantially in value from the time you bought it, the increased capital gains tax that the beneficiaries could owe upon the sale of the home may reduce, or even offset, the estate tax savings. This is less of a concern if your beneficiaries do not intend to sell the home.

Additionally, depending on where your residence is located, you could be affected by a re-evaluation of property tax liability, higher property taxes or even a loss of some property tax exemptions or abatements.

Considerations Before Opting for a QPRT
Before pursuing a QPRT, consider the following:

• You must survive the time period stated in the trust. If you pass away before the period ends, the value of the home will be included in your estate for estate tax purpose, just as it would have been had you not created the QPRT. Although you can opt for a shorter term, this would result in a larger gift to your beneficiaries and thus a smaller tax savings. Your age and health should be key determinants of the time period selected.
• You can split the home between multiple QPRTs. Using more than one QPRT, each with a different term, could be a useful hedge to the mortality risk. If you fail to survive the term of a longer QPRT, there could still be tax benefits from surviving one or more shorter-term QPRTs. This approach enables you to take advantage of a fractional interest discount on the value on funding each QPRT, increasing the tax savings.
• You can split the home between you and your spouse. This would result in two owners and two QPRTs. If one spouse fails to survive the term, at least half of the tax benefits can still be achieved through the surviving spouse’s QPRT. Moreover, this enables each spouse to take advantage of a fractional interest discount on the value of his or her partial ownership interest, thus increasing the effectiveness of using the gift and estate tax exemption.
• You, your spouse and/or dependents must live in the home for the entire term. The house must be used as a primary or secondary residence at all times. If there is a possibility that you may sell the house, a replacement home must be purchased within two years of the sale. If the sale proceeds are not reinvested in a new residence within two years, the trust must be converted to a grantor retained annuity trust.
• Holding cash in a QPRT is permissible in two instances. If cash is needed for the initial purchase of a home, it must take place within three months of the cash transfer. If you reasonably anticipate needing cash for the payment of certain trust expenses, such as mortgage payments and improvements to the home, this can be held in the QPRT for up to six months, but keep in mind that both would constitute additions to the QPRT, with a subsequent gift tax return required.
• It is typically not recommended to transfer mortgaged property to a QPRT. The income tax complexity of the transaction increases exponentially, as does accounting for the mortgage payments since they are considered gifts to the remainder beneficiaries. Further, if the mortgage is greater than your basis, the IRS will treat the difference as a sale by you. This is not a problem during the time the QPRT is deemed a grantor trust, but would be if the mortgage remains after such status terminates. A QPRT is especially useful if the property is not subject to a mortgage, lien or line of credit.

Discuss QPRTs with a Team of Experts

A QPRT can be an effective way to take advantage of current estate and gift tax exemptions, but the solution may not work for everyone. It is important to discuss your unique circumstances with your legal and tax professionals before pursuing a QPRT.