As everyone is well aware, the housing market has tumbled a bit over the last two years, and home values have fallen substantially, in some places by as much as 30-40%. Is there any silver lining to be found? Sure.
When a person talks in terms of estate planning, lower values are beneficial as the estate/gift tax levies against the transfer of wealth. The lower the wealth, the lower the gift or estate tax. Accordingly, transferring a personal residence (often the biggest asset in any person's estate), after it has decreased in value could allow for substantial tax savings. How? The following discussion provides one tax saving mechanism utilized by people who expect to have a taxable estate when they die.
Qualified Personal Residence Trusts
A married couple or an individual can dramatically reduce the overall tax costs of passing property to children or other beneficiaries by transferring a personal residence to a qualified personal residence trust ("QPRT"). In a QPRT, the creator retains the right to occupy the residence for a fixed period of years, at the end of which it will be retained in trust for the benefit of others or will be distributed outright to the children or other designated beneficiaries. Importantly, a couple or an individual can transfer a principal residence, a vacation home, or both, to a QPRT. (Each individual can create up to two QPRTs.)
A QPRT is simply an irrevocable trust to which an individual (the "grantor") transfers a personal residence, reserving the right to occupy the residence for a term of a certain number of years. At the end of the term, the trustee of a QPRT either distributes the residence to the designated beneficiaries – usually the grantor's children – or retains the residence in trust for later distribution to the beneficiaries. If the trust continues, the trustee can lease the residence back to the grantor at a market rental rate without causing the residence to be included in the grantor's estate.
Minimal Gift Tax Cost
For federal gift tax purposes, the transfer of a residence to a QPRT involves a gift by the grantor of the actuarially determined value of the right to receive the property at the end of the term. Therefore, the amount of the gift is not the full value of the residence. Instead, the amount of the gift is the value of the residence reduced by the value of the grantor's retained right of occupancy. Here the grantor gets a tremendous break – the value of the grantor's retained right of occupancy is calculated by applying the current federally prescribed rate of interest to the full value of the residence. In essence, the interest retained by the grantor is treated as having a value equal to the present value of the right, for the term of years, to receive interest at a fixed rate on the full value of the residence at the time the QPRT is established.
The value of the taxable gift may be further reduced by providing the grantors with a retained reversionary interest for the fixed term, or a general power of appointment. However, one wants to tread carefully as the 3 year lookback provided by I.R.C 2035 may extend the grantor's required survival time by an additional 3 years beyond the fixed term to maintain the tax benefits of the QPRT.
Finally, QPRT's may be set up with fractional interests in real property. When a grantor transfers only a fractional interest in real property multiple valuation discounts are allowed, including, but no limited to, the tenancy in common discount. This could provide an additional 20 to 40% decrease in the amount of the taxable gift upon creation of the QPRT.
Potential Estate Tax Savings – Little or No Downside Risk
If the grantor survives the term of a QPRT, none of the date of death value of the residence is includible in his or her estate for federal estate tax purposes. There is essentially no downside tax risk: If the grantor dies during the term, the tax position of the grantor is no worse than if the QPRT had not been established. In such a case, the full value of the residence is includible in his or her estate. Below is an example illustrating how creating a QPRT can reduce the grantor's estate tax liability by almost $1 million:
Parent (P), age 60, transfers his vacation residence, worth $1 million, to a QPRT. Under the terms of the QPRT, P retained the right to use and occupy the residence for 12 years, after which the trustee was to distribute the residence to P's daughter (D). Assuming P's retained interest was worth $682,924, P made a gift to D of less than one-third of the present value of the residence – only $317,076. The gift tax cost of the gift is offset by applying part of P's unified credit against the tax. For gift tax purposes, each person has a unified credit which is equal to the tax cost of making a taxable transfer of $1,000,000. If P outlives the QPRT's 12-year term, the residence will not be included in his estate for tax purposes, even though its value may have increased to $2 or $2.5 million. On the other hand, if P dies during the 12-year term, the value of the residence will be included in his estate for estate tax purposes.
If P does not create a QPRT and retains his residence until his death 12 years later, when the residence is worth $2.5 million and he owns other assets worth $3 million, about $900,000 in estate taxes will be due from his estate. (This assumes that the estate tax will remain in effect after 2009 and the unified credit will shelter up to $3.5 million.) On the other hand, if P transfers his residence to the 12-year QPRT described above, lives for more than 12 years, and dies leaving $3 million in other assets, no estate tax will be due on his death. Of course, if the residence were included in P's estate for estate tax purposes, its income tax basis would be increased in the hands of the beneficiaries to its federal estate tax value in P's estate – $2.5 million. If the residence is transferred to a QPRT and not included in P's gross estate, the basis of the residence would not be increased by reason of P's death.
Rules Regarding QPRT’s
The present law allows each individual to transfer no more than two residences to QPRTs, one of which must be his or her principal residence. A personal residence subject to a mortgage can be transferred to a QPRT, but the tax consequences are more complicated (additional gifts that require gift tax returns to be filed may take place each year in which the grantor makes payments on the mortgage). Overall, the tax results are simpler and better if an unencumbered residence is transferred to a QPRT.
In general, a QPRT cannot hold any property other than one personal residence, which may include related buildings that are used for residential purposes and land reasonably appropriate for residential purposes. Thus, furniture and furnishings cannot be transferred to a QPRT. If a residence held in a QPRT is sold during the grantor's retained term, the proceeds must be (1) reinvested in a new residence within two years, (2) converted to a qualified annuity payable to the grantor for the remaining term, or (3) distributed to the grantor. If a residence is sold during the term of a QPRT, the grantor is treated as having made the sale for income tax purposes. In most cases, the grantor, who is treated as the owner of the residence for income tax purposes, can exclude up to $250,000 (or $500,000 for married couples) of gain on the sale of a personal residence held in a QPRT.