The Qualified Personal Residence Trust, or QPRT, became popular a couple of decades ago as a way to save gift and estate taxes. Now that many of the earlier trusts are expiring, families have to proceed carefully to protect their tax benefits.
Let’s take, for example, the case of a man called Brian. In August 1997, Brian met with his estate planning attorney. Because he was a widower with a net worth of $3 million at that time, and only a $600,000 federal unified gift and estate tax exemption, the attorney convinced him to transfer his $1 million home into an irrevocable trust (a QPRT) with a 15-year term. During the next 15 years, Brian continued to live in his home rent-free, and assuming he was still living at the end of the term, ownership of the house would then transfer to his children.
Since Brian gifted a future interest in the property to his children, the Internal Revenue Service granted him a valuation discount for the value of the interest he retained in the home. If he had died before the end of the QPRT term, the home and any other assets in the trust would have reverted back to his estate, essentially canceling the trust without realizing any tax savings. The IRS also granted Brian an additional valuation discount for the possibility of this reversion. These valuation discounts were calculated based on Brian’s age, the IRS-approved Section 7520 applicable federal rate of interest at the time he created the trust, and the length of the QPRT term.
Due to these valuation discounts, the value of Brian’s gift was only about $460,000 for federal gift tax purposes, even though his home was worth $1 million. Because the value of the gift was below Brian’s $600,000 lifetime exemption, he owed no gift tax upon creating and funding the QPRT. Thus, the QPRT provided the potential for significant gift and estate tax savings, not only on the value of the house at the trust’s creation but also on any future home appreciation thereafter.
Fast-forward almost 15 years - 14 years and eight months, to be exact. Within four months, the QPRT term will end. Brian is currently in good health; his home has a current fair market value of $2 million; and his net worth excluding the value of the home is now $4.65 million. With a current federal unified gift and estate tax exemption of $5.12 million, if Brian passed away after August, he would have shielded over $1.5 million from federal estate taxes. Establishing the QPRT was a great decision.
However, he wants to continue living in the house after the trust term ends, so he visits his estate planning attorney to consider his options.
The attorney informs Brian that in August, at the end of the QPRT term, his children will replace him as trustees. At that time, his children will most likely dissolve the trust and transfer title of the property into their individual names or into an entity, such as a limited liability company, that they own equally. If Brian continues to live in the house at that time, he will need to start paying his children fair market rent. Otherwise the IRS will contend that there was an understanding between Brian and his children that, at the time they took ownership of the home, he would retain use of the property rent-free for the rest of his life. Such an arrangement would result in the residence being included in Brian’s gross estate at his death, and all that great estate planning would go to waste.
Further, the attorney mentions the possibility that Congress will allow the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act (“TRA 2010”), which President Obama signed into law in 2010, to sunset on January 1, 2013, causing the estate tax exemption and top estate tax rate to return to $1 million and 55 percent respectively, resulting in a much higher estate tax bill if the house is included in Brian’s estate.
Because of his net worth and the possible sunset of TRA 2010, Brian decides that he has no qualms about paying his children fair market rent. Not only will he avoid undoing his estate plan, he will also benefit from transferring additional wealth to his heirs, in the form of rent, without incurring gift tax. However, depending on the amount of deductions related to the property (such as real estate taxes, insurance, repairs, maintenance, and depreciation), the rental income may generate additional income tax liability for Brian’s children.
To ensure that Brian receives the benefits of the QPRT, he will need to take the following steps.
- If he has not already done so, Brian should inform his children that the QPRT exists, and that they will become the owners of his home when it ends.
- Before the trust term ends, Brian will need to enter a lease agreement with his children. (This will demonstrate to the IRS that there was no implied agreement between Brian and his children that he would continue to reside in the home rent-free at the end of the trust term, and further, that Brian’s children have sole right to possession of the home.)
- After the deeds have been signed and recorded with the county, Brian will want to contact his insurance company to cancel his homeowner’s insurance and obtain a renter’s policy.
Brian should also make sure his children know to take some steps of their own to ensure the transfer goes smoothly. They should:
- Either obtain a letter stating the fair market rent from a local real estate broker or pay for a fair market rent appraisal. (The payment of fair market rent will help avoid an IRS challenge that Brian continued control and enjoyment of the home, so as not to bring the home back into his estate.)
- Hire a real estate attorney to draft the formal lease agreement. The agreement should be for at least one year and provide for automatic renewals unless canceled by either party. Further, the rental amount should be revisited at the end of each lease term to ensure that Brian continues to pay fair market rent.
- Have the real estate attorney draft the necessary legal documents to allow the children to accept trusteeship after the QPRT term ends, and to transfer title of the property from the trust to either their individual names or to the entity they establish to hold the property.
- If the children plan to hold the property in an LLC, to limit their liability against a lawsuit from someone that gets injured on the property, they should also have the attorney draft the LLC formation documents.
- Obtain an appraisal to determine the home’s fair market value, since they will be converting the property to a rental home. They will need the market value in order to claim a depreciation deduction against rental income.
- Obtain new title insurance on the property once they become the owners.
- Once they own the house, they should also obtain homeowner’s insurance and inform the insurer that the home will be used as a rental property. This may increase the cost of insuring the property. However, the children should also mention that they will be renting it to their parent, the previous owner, and not some unrelated third-party, as this may result in either minimal or no increase in premium.
A well-managed QPRT can provide substantial estate tax savings. However, if you do not take the necessary steps to wind it up properly, Uncle Sam may still get a stake in the house.
