With home values skyrocketing and interest rates increasing, protecting a family's personal residence from future transfer taxes has recaptured the attention of professional advisors across the country.
One technique frequently used by estate planners to shift ownership of a personal residence or vacation property to the next generation is a qualified personal residence trust, or QPRT. This technique is specifically authorized in the tax code and allows your clients to remove a personal residence from their estate at a significantly reduced gift tax cost.
By properly educating your clients regarding the benefits of QPRTs, you are creating a wonderful opportunity to minimize future transfer taxes for a personal residence or vacation property while maximizing the opportunities
Creating a QPRT
Your client, the "grantor," creates the QPRT by executing an irrevocable trust agreement, complying with the detailed and stringent requirements of the tax code and then transferring the personal residence to a QPRT, normally by a deed. The QPRT allows the grantor to retain the right to use the personal residence for a specified number of years — the QPRT term — after which the residence typically is held in trust for the benefit of the grantor's spouse and/or children. If the grantor survives the QPRT term, the residence is excluded from the taxable estates of both the client and his or her spouse.
If the grantor dies during the QPRT term, the residence reverts to the grantor's taxable estate. The method of calculating federal estate tax, however, would reflect the gift tax consequences that resulted from the creation of the QPRT. Consequently, in the event the grantor dies during the trust term, his or her estate should be in the same federal estate tax position that it would have been had the QPRT not been created. For this reason, many financial professionals view QPRT planning as a "heads you win, tails you break even" proposition.
Computing the gift
To determine the amount of the gift to the QPRT, the fair market value of the residence transferred is reduced by (a) the value of the retained term interest and (b) the value of the retained reversionary interest, both of which are actuarially determined under IRS tables.
For example, with respect to a March 2023 transfer based upon the applicable federal rate (currently 4.4%), a 60-year-old grantor, a residence valued at $1 million and a 20-year QPRT term, the gift to the QPRT would be valued at only $245,210 (a 75.479% discount). A longer QPRT term and higher interest rates combine to generate a smaller taxable gift, but the grantor must survive the term to achieve the benefits of the planning.
In addition to the tax benefits, the QPRT provides the added benefit of freezing the value of the residence as of the date the QPRT is created. If the residence in the example above increases in value from $1 million to $3 million during the 20-year term, the appreciation is also removed from the grantor's taxable estate.
The QPRT transaction will require the filing of a gift tax return, which should include a professional appraisal supporting the value of the residence at the time of the gift. To minimize IRS scrutiny, the appraisal should comply with requirements of Treasury Regulation
Client's rights during the QPRT term
During the QPRT term, the grantor will be entitled to unfettered use of the residence. Since the QPRT is a Grantor Trust for income tax purposes (meaning that all trust items of income and deductions are reported by the grantor) the grantor would be entitled to claim deductions on his or her individual income tax return for property taxes paid with respect to the residence to the extent otherwise allowable.
In addition, because the QPRT is a Grantor Trust, the grantor could exclude up to $250,000 (or $500,000 if married and filing jointly) of any gain recognized on the sale of a primary residence owned by a QPRT if certain holding periods are satisfied.
If the grantor wishes to sell the residence during the QPRT term, the QPRT could purchase a replacement residence. If the QPRT does not replace the residence (or replaces it with a residence of lesser value), the excess sale proceeds would be held in an Annuity Trust for your client's benefit. Adding funds to acquire a more expensive residence will be treated as a new gift.
Client's access to residence after QPRT term
After the QPRT term expires, the residence, now excluded from the taxable estates of the grantor and his or her spouse, would be owned by a Remainder Trust for the benefit of the grantor's spouse and/or family — but not the grantor. However, if the grantor's spouse is living, the grantor could continue to occupy the residence based on the grantor's status as the spouse of the beneficiary of the Remainder Trust.
Alternatively, the grantor could lease the residence from the Remainder Trust by paying fair market value rent to the Remainder Trust. The payment of rent by the grantor usually is tax advantageous since it allows the grantor to transfer additional funds to the Remainder Trust free of gift tax. In addition, if the Remainder Trust is structured as a Grantor Trust, the grantor's rental payments to the Remainder Trust would be completely disregarded for income tax purposes, and should not result in taxable income to the Remainder Trust.
