An estate planning technique so effective and popular that the president of the United States recently proposed its abolition is the Qualified Personal Residence Trust, better known as QPRT (pronounced “Qpert”). Whether QPRTs will be abolished is difficult to predict. However, under current law, this technique could provide significant estate tax savings as a component of your estate plan.
A QPRT allows you to transfer your residence, your vacation home, or both, to your children at a gift tax value well below the fair market value of the transferred real estate. To create a QPRT, an irrevocable trust is created and your residence (or vacation home) is transferred to the trust. Typically, when a husband and wife determines to take advantage of a QPRT, two irrevocable trusts are created and each spouse transfers a one-half interest in the home to his or her respective trust.
Under the trust document, each spouse retains the right to occupy the real estate transferred for a set number of years. At the end of that set number of years, one spouse’s trust provides that the principal of the trust (one half of the interest in the real estate) is given to your children while the other trust provides that the principal will continue in trust for the benefit of the nondonor spouse for his or her lifetime.
At the death of that spouse, the principal (the other one half interest in the real estate transferred) is given to your children. Under such an arrangement, you can assure that at least one spouse has the right to live in the transferred real estate for his or her lifetime.
To illustrate the tax advantages, assume the value of your home is $600,000, you and your spouse are 50 years of age and you transfer the home in trust for 15 years. Under IRS tables used to value your children’s interest in the trust, if the transfer had been made in November 1998, the value of the gift to your children would be $205,038 (one half from each spouse). If the term of the trust were 20 years, the value of the gift to your children would be $134,340 (again, one half from each spouse).
Any such gifts to your children would reduce, dollar for dollar, each spouse’s “applicable credit amounts” ($625,000 per person for 1998, but to increase to $1 million by 2006). This applicable credit amount represents the amount of property each of you may give to your children, or other nonspouse beneficiaries, during your life or upon death, free of federal gift and estate taxes.
Thus, by using the QPRT, you have: (a) given an asset to your children with a fair market value of $600,000 at a significantly reduced gift tax value; and (b) removed the appreciation in your home from your estate.
These tax advantages are only achieved if you survive for the term of your trust. Therefore, when choosing the term, you should choose a term of years well below your life expectancy when the gift is made.
During the term the real estate is in the QPRT, the trust property must consist almost exclusively of the real estate initially placed in trust. You may, however, sell the real estate in the trust and substitute another residence. Also, if the property is sold during the term of the trust and you don’t wish to purchase another home, it is possible to retain the proceeds of the sale in the trust and pay yourself an annuity until the end of the trust term.
The primary disadvantage of a QPRT is that your home will not be includable in your estate at your death, and therefore, will not receive a step-up in basis. If the home were includable in your estate at death, and your children were to sell the home shortly after your death, your children would probably pay little or no capital gains tax on the sale, since their basis in the home would be the fair market value of the home at your death.
However, if your children receive your home under an effective QPRT arrangement, their basis in the home will be your basis (i.e., the amount you paid for the home plus any improvements made to it). But even if your children realize capital gains on the sale of your home, those gains are presently taxed at 20 percent, significantly less than the federal estate tax rate, which starts at 37 percent and could be as high as 55 percent.
While QPRT is not for everyone, it provides an attractive method of reducing estate taxes and should be explored. Since proposals for its abolition have been considered, you may miss an opportunity if you wait too long.
John Houston is a director with Houston Harbaugh, a downtown Pittsburgh-based law firm. John Hartzell is an associate with Houston Harbaugh and a Certified Public Accountant in Pennsylvania. For more information on this subject, contact Houston at [email protected] or Hartzell at [email protected].
