The Pros and Cons of Qualified Personal Residence Trusts
NOTE: State and federal laws change frequently and the following information may not reflect recent changes in the laws. For current tax or legal advice, please consult with an accountant or an attorney since the information contained in this article is not tax or legal advice and is not a substitute for tax or legal advice.
A Qualified Personal Residence Trust, or QPRT for short, is a special type of irrevocable trust that is designed to remove the value of your primary residence or a second home from your taxable estate at a reduced rate for federal gift tax and estate tax purposes.
Because creating a QPRT and then transferring ownership of your residence into the trust is, for all intents and purposes, a transaction that can't be easily undone, you will need to understand all of the pros and cons associated with using a QPRT before deciding if you should include one as part of your estate tax plan.
Benefits of Using a QPRT
- Removes the value of your primary or secondary residence, and all future appreciation, from your taxable estate at cents on the dollar. For example, if a home is worth $500,000, then depending on the homeowner's age, interest rates, and the retained income period chosen for the QPRT, the homeowner could use as little as $100,000 of his or her lifetime gift tax exemption to remove a $500,000 asset from his or her taxable estate. This is really a big bang for the buck, particularly if the value of the house increases significantly, say, to $800,000, or even $1,000,000, by the time the homeowner dies. And with today's depressed home values, now is a good time to consider establishing a QPRT.
- Allows continued use of the residence and tax benefits. During the retained income period of the QPRT, the homeowner can continue to live in the residence rent-free and will be able to take all applicable income tax deductions.
- Hedges against possible decreases in lifetime gift tax exemption and estate tax exemption. If the value of your home is significant, then the current lifetime gift tax exemption of $5,340,000 will allow you to establish a QPRT without having to pay any gift taxes. And if in the future the estate tax exemption is reduced significantly, say down to $1,000,000, then you will have locked in the value of your residence for gift and estate tax purposes and won't have to worry about how much the house will appreciate in value or what the estate tax exemption will be at the time of your death.
- Creates a legacy for your family. If your home is of the type that you want your family to hold on to for generations to come, such as a beachfront condo, cottage on a lake or a ski lodge in the mountains, then using a QPRT will allow you to pass on the residence to your heirs in such a manner that will encourage them to want to hold on to it.
- Paying rent at the end of the retained income period will help to further reduce your taxable estate. When the retained income period of the QPRT ends, you'll have to pay fair market rent to your heirs in order to be able to continue to use the residence. While this may appear to be one of the detriments associated with using a QPRT, it will actually allow you to give more to your heirs without having to use annual exclusion gifts or any more of your lifetime gift tax exemption.
Risks Associated with Using a QPRT
- Selling a home owned by a QPRT can be difficult. What happens if your circumstances change and you want to sell the residence owned by the QPRT? Selling a home owned by a QPRT can be tricky - you'll either have to invest the sale proceeds into a new home or, if you don't want to replace the residence, then take payments of the sale proceeds in the form of an annuity.
- Heirs will inherit the residence with your income tax basis at the time of the gift into the QPRT. This means that if the heirs turn around and sell the home after the retained income period ends, then they will owe capital gains taxes based on the difference between your income tax basis at the time of the gift into the QPRT and the price for which the home is sold. This is why a QPRT is ideal for a residence that the heirs plan to keep in the family for many generations. But keep in mind that with the estate tax rate currently at 40% and the top capital gains rate currently at 20%, the capital gains impact may be significantly less than the estate tax impact.
- When the retained income period ends, you'll have to pay rent to use the residence. Once the retained income period ends, ownership of the residence will pass to your heirs, and so you will no longer have the right to occupy and live in the residence rent-free. Instead, you'll have to pay your heirs fair market rent if you want to continue to live in the residence or use it for any extended period of time. But, as mentioned above, this potential drawback can be turned into a benefit by allowing you to give more to your heirs in a gift tax-free manner.
- When the retained income period ends, you may lose property tax benefits. Once the retained income period ends, there may be negative property tax consequences, such as causing the home to be reassessed at its current fair market value for real estate tax purposes and losing any property tax benefits that are associated with owning and occupying the property as your primary residence. In Florida, the home may lose its homestead status for both creditor protection and property tax purposes unless one or more of the heirs decide to make the home their primary residence.
- If you die before the retained income period ends, the QPRT transaction will be completely undone. If you die before the retained income period ends, then the entire QPRT transaction will be undone and the value of the residence will be included in your taxable estate at its full fair market value on the date of your death. (But note that the lifetime gift tax exemption that was used when establishing the QPRT will be completely restored.) That's why setting up a QPRT is really a gamble - the longer you decide to make the retained income period, the lower you'll make the value of the taxable gift that you'll be making, but you have to outlive the retained income period for the transaction to work. In the end, even if you choose your retained income period wisely based on your current health and expected future health, life is really unpredictable and can undo even the best-laid plans.