Qualified Personal Residence Trusts

The use of a “Qualified Personal Residence Trust” (QPRT) can provide a strong form of asset protection against creditors.  This plan is best matched to situations when there is a substantial estate tax problem and when the home (or a vacation home) has a substantial value.  However, it can also be used as a pure asset protection device for family real estate even when estate taxes are not a significant concern.

The QPRT involves making a future gift of your residence (or a vacation home) to your children at the end of a term of years selected by you.  The house is transferred into a grantor trust to hold the property until the term has expired.  However, you continue to use the home through out the term of the trust and beyond.  At the end of the term of years (selected by you), the home belongs to the beneficiaries of the trust – your children.

The house is gifted to the trust at a steep discount due to the delayed gift.  The value of the gift is calculated using an interest rate prescribed by the IRS, based on the term of years you select.  The longer the term of years, the lower the current value of the property for gift tax purposes.  As an example, assume a 50-year-old man sets up a QPRT when the IRS prescribed interest rate is 7% and the trust is to last for ten years.  The value of the future gift (10 years from the date of the gift) would be about 46% of the current value of the property.  Where the same trust is set up for 20 years, the value of the future gift would be 19% instead of 45%.

The drawback to the QPRT is if you die prior to the end of the term of years, the home is included in your estate and you’ve gained nothing in terms of estate taxes.  But, your home has been protected from creditors while the trust was in existence.  Thus, a QPRT could be worthwhile purely as an asset protection device.

If you live beyond the term of years of the QPRT, the home is transferred to your children.  Until recently, you could arrange to buy it back from them if you made the purchase before the end of the term of the trust.  However, the IRS has recently ruled that type of repurchase arrangement will result in the loss of the estate tax benefits.

If interest rates should continue to drop, the use of a Qualified Personal Residence Trust (QPRT) is less attractive as a way to reduce future estate taxes because the computed value of the future gift increases as interest rates decrease.

For example, with a 7% interest rate, the present value of $100,000 in twenty years is just $25,842.  At a 6% interest rate, that value increases to $31,180 and at 5% the present value is $37,689.  With a ten year term, the differences are not as great..  For example, the present value of $100,000 in ten years at 7% is $50,835.  At 6%, the value increases to $55,839 and at 5%, it is $61,391.  When setting up the trust  you can elect to use the highest rates for the current month and the two previous months, so if rates start back up, you may be able to catch a lower rate. (These rates do not include a life expectancy element.)

In summation, the use of a qualified personal residence trust (QPRT) allows you to make a gift of your home in trust at a deep discount for gift tax purposes.  If you survive the term of the trust, then the property goes to the trust beneficiary.  If you die before the end of that term, the property is still included in your estate.  In addition the trust will provide real asset protection from creditors.

PERSONAL RESIDENCE GIFT
A useful technique to consider in making a lifetime gift is a Qualified Personal Residence Trust [QPRT]. The QPRT is a useful tool to pass wealth from parents to adult children who are mature enough to have proven long-term stability.

Overview
The parent’s residence is placed in a Trust. The Trust has a duration selected by Parent. At the end of the term, the residence is distributed to the children. Then, the children own the residence and rent the property back to Parent for continued use as Parent’s personal residence.

If Parent dies before the end of the trust term, since he retained an interest in the residence, the entire residence is included (at its then fair market value) in his estate, and the whole plan was a waste of time and effort. But it has no adverse consequence in terms of estate planning.

If Parent lives longer than the term of the Trust, the residence is not included in his estate and substantial taxes are saved.

If the house has a mortgage, it is no problem. Parent continues to pay the mortgage and property taxes and insurance; he gets the same income tax deductions as if the QPRT did not exist.

The 2 year rollover rules and the over-55 rules still apply, so Parent can sell house #1 and buy a new home.

QPRT Benefit #1: A gift today of $100 is a $100 gift. But a gift today of $100 which you do not get until 10 years from now is taxed as if it were a $41 gift. [The taxable gift portion is even smaller if the parent is older.]

QPRT Benefit #2: A gift today of a $100 bond making 4% which you do not get until 10 years from now is taxed as a $41 gift, but is worth $148 in 10 years.

Example:
If Parent, age 65, establishes a 10 year QPRT, at the time of formation of the Trust, he is treated as making a gift (based on IRS tables) of approximately 37% of the present value of the residence, since the gift is not final for 10 years.

Sara, a widow aged 65, is worth $1.6 million, half in liquid assets and half in her home. Sara does no planning and at her death 10½ years from now, the assets have doubled in value. Sara’s heirs owe $1,208,000 in taxes.

Instead, Sara forms a QPRT for 10 years. Her gift of the house now worth $800,000 is treated as a $296,000 gift. In 10 years Sara’s children get the house (then worth $1.6) tax free.

At her death, Sara then has net worth of $1.6. She has already used up $296,000 of her tax free exemption, leaving only $304,000 which is tax free. Tax is $541,200. Sara’s heirs save $666,800.

If Sara does not want to move out of the house after the 10 year term, she may rent the house back at fair market rent. Then at her future death, the children sell the house (or live there). The problem is that since a lifetime gift is made, the full profit on the house is taxable. [For lifetime gifts there is no step-up in basis; rather, the basis is carried over from the parent, and the whole profit is taxable.]

[A QPRT can be done with an Asset Protection Trust for the children, to minimize the risk of giving the children $1.6 million in 10 years.]

This device is great if you want to transfer either your house (or vacation home) to your children in X years, before you die. For many clients this is not appropriate, as their children are too young to have proven their long-term stability. It is a perfect tool if:

  • your children are above age 30 (or otherwise have proven their maturity and stability);
  • your net worth is over $600,000 [$1.2 million if you are married]; and
  • you want to make a substantial gift to your children before your death.