Qualified Personal Residence Trusts
Living in Your Estate Tax Shelter
Background Lotte Schmidlapp has a house currently worth $1.2 Million. Lotte is 53 years old. She wants to live in their house as long as she can. She’s also concerned about estate taxes.
Lotte's hairdresser, Laverne, told Lotte that she has a "deal" for her. Continue to live in your house. Give your house to your children using a discounted value for gift and estate tax purposes. Remove all post gift appreciation from your taxable estates.
A hair-brained idea, or something "permanent"?
What Laverne had a mind was a Qualified Personal Residence Trust ("QPRT"). Boiled down to its essentials, you transfer a residence to a trust, while retaining the right to live in it for a period of years (the “occupancy period). After the occupancy period, the residence passes to, or in trust for, your beneficiaries. The value of the gift is “discounted” because it is a gift of the current value of the house reduced by the value of the retained right to live in it rent free.
Using our “Lotte” example, she created a trust, retaining a ten year occupancy period. In calculating the value for gift tax purposes, we subtract the value of their ten year occupancy right. The value of a ten year deferred gift of a $1.2 Million for a 53 year old is approximately $750,000. This is the amount of estate and gift tax exemption which Lotte used. Suppose the house has appreciated at 3% per year and, at the end of the ten year occupancy period is worth $1.6 Million. If Lotte had not used QPRT, that value, would be subject to estate tax. On this example, her children saved approximately $255,000. NOTE: This is based on a 45% estate tax rate and a 15% capital gains tax rate.
What if she wants to stay in the house?
Remember that Lotte had two goals. Save tax and stay at home. After the occupancy period, she would have to pay fair market rent to her children or the trustee. This is not a bad thing. It lets them make further tax free gifts.
Some QPRT variations
A person is not limited to one QPRT. He or she can do them for each of two residences. We sometimes create QPRTs with partial interests in houses to obtain further valuation discounts.
Escape may be difficult
Suppose that you want to downsize? You can replace a house in a QPRT with a smaller one and leave the excess sale proceeds in the trust. However, if you believe that you might need to sell the house and use the proceeds personally, a QPRT may not be right for you. Getting out of the arrangement may be difficult. There may also be some significant tax costs if you are successful in getting your house back.
This is an extremely simplified overview of QPRTS. Properly planned and executed, they can save significant taxes. Let's look at some of the advantages and disadvantages:
- They do not disrupt your lifestyle. You continue to live at home and watch appreciation pass to children tax-free.
- A QPRT is a "Statutory" transaction. It has much more predictable results than other types of estate tax strategies.
- You can’t simply sell the house and purchase new one.
- May have to rent house back from children. This may be an advantage because, after the trust term, further "tax-free gifts" could be made to children.
- Possible loss of "stepped up" income tax basis at death.
- If you die during the occupancy period, the house is back in your estate. However, if you had kept it, it would be in your estate anyway.