The Pros and Cons of Qualified Personal Residence Trusts
A qualified personal residence trust (QPRT) is a special type of irrevocable trust that's designed to remove the value of your primary residence or a second home from your taxable estate. Creating a QPRT and transferring ownership of your residence into that trust is a complex maneuver that can't easily be undone. QPRTs come with both pros and cons.
How a QPRT Works
The owner of a residence can transfer their ownership of the property into a QPRT for estate-planning purposes. They would receive a qualified term interest, sometimes called a retained income period, in exchange. This interest allows them to continue living in the home. They would begin paying fair market rent to your heirs at the end of this period if they continued using the residence.
The residence isn't included in the owner's taxable estate should they die during the retained income period, but it passes to the trust's beneficiaries at the end of the period if the owner is still living at that time.
Pros of QPRTs
A QPRT creates a legacy for your family. It will let you pass the residence on to your heirs in a manner that will encourage them to hold on to it for the long haul if you want your home to remain in the family for generations to come.
A QRPT allows for continued use of the residence. The homeowner can continue living there rent-free and can take all applicable income tax deductions during the retained income period of the QPRT.
The retained income period is the time during which the owner continues to live in residence before it transfers to a beneficiary.
These types of trusts offer a few other significant financial perks as well.
A Hedge Against Appreciation
A QPRT removes the value of your primary or secondary residence, and all future appreciation, from your taxable estate at cents on the dollar.
A homeowner could use as little as $100,000 of their lifetime gift tax exemption to remove a $500,000 asset from their taxable estate, assuming the home is worth $500,000, and depending on interest rates, the homeowner's age, and the retained income period chosen for the QPRT. This can be particularly beneficial if the value of the house increases significantly by the time the homeowner dies.
Potential Decreases in Exemptions
A QRPT also hedges against possible decreases in the shared lifetime gift tax and estate tax exemption, sometimes referred to as the unified credit.
The lifetime exemption of $11.58 million in 2020 will let you establish a QPRT without having to pay any gift taxes if the value of your home is significant. This is important because transferring your home to the trust is akin to gifting it to the trust, so gift taxes could potentially come due.
The federal gift tax and the federal estate tax share the $11.58 million unified credit. You would have $6.58 million remaining to apply to your estate if you devoted $5 million of the credit to gifts made during your lifetime.
You'll lock in the value of your residence for gift and estate tax purposes if this shared exemption should be reduced significantly in the future. You won't have to worry about how much the house will appreciate in value or what the estate tax exemption will ultimately be at the time of your death.
Further Reduce Your Taxable Estate
Paying rent at the end of the retained income period will help to further reduce your taxable estate when it ends and you must begin paying fair market rent to your heirs in order to continue using the residence. While this might initially seem like a downside, it allows you to give more to your heirs without using annual exclusion gifts or more of your lifetime gift tax exemption.
Risks Associated With QPRTs
The QPRT transaction will be completely undone if you die before the retained income period ends. The value of the residence will be included in your taxable estate at its full fair market value as of the date of your death. Some other potential drawbacks should be considered as well.
You'll Have to Pay Rent
Ownership of the residence passes to your heirs when the retained income period ends, and this eliminates your right to live in the residence rent-free. You must instead pay your heirs fair market rent if you wish to continue occupying the residence for an extended period of time.
You Could Lose Property Tax Benefits
You could also lose property tax benefits when the retained income period ends. The home will be reassessed at its current fair market value for real estate tax purposes, and you would lose any property tax benefits associated with owning and occupying the property as your primary residence.
The home could lose its homestead status for both creditor protection and property tax purposes in states like Florida unless one or more of the heirs make the home their primary residence.
Selling the Home Could Be Difficult
You could run into some significant obstacles if circumstances change and you want to sell the residence after it's owned by the QPRT. You must either invest the sale proceeds into a new home or, if you don't want to purchase a new home, you must take payments of the sale proceeds in the form of an annuity.
Heirs Will Inherit Your Tax Basis
Heirs will inherit the residence with your income tax basis at the time the gift is made into the QPRT. An heir who sells the home after the retained income period ends will owe capital gains taxes based on the difference between its value at the time the gift was made into the QPRT and the price of the sale. This is why a QPRT is ideal for a residence that heirs plan to keep in the family for many generations.
The capital gains impact might be significantly less than the estate tax impact because the estate tax rate is 40% while the top capital gains rate is 20%.
NOTE: The information contained in this article is not tax or legal advice and is not a substitute for such advice. State and federal laws change frequently, and the information in this article might not reflect the most recent changes to the law. Please consult with an accountant or an attorney for current tax or legal advice.