Qualified Personal Residence Trusts

A qualified personal residence trust could save a bundle in estate taxes. Here's how.

Any property in your taxable estate exceeding the federal exemption amount (presently $5.34 million) will be subject to a federal estate tax of 40%. Unfortunately, you can't simply give away your assets to reduce the value of your estate, because lifetime gifts count toward the exemption amount the same as property that passes under your will, and such gifts may be subject to a federal gift tax.

You probably know that you can give $14,000 per person per year--a married couple can give $28,000--to as many donees as you like, and such gifts will not count toward the exemption amount. But at those amounts, it might take forever to bring your total estate down to a tax-exempt level--especially if your assets are appreciating. Here's another, more efficient, way to reduce federal estate taxes.

The trust gives you the right to occupy the house for the time period you choose (the "term"), during which period you retain all income tax benefits of home ownership. After the term expires, you must pay fair market rent whenever you use the house. You can obtain a letter from a knowledgeable real estate broker to determine the amount of rent you should pay.

The estate tax "discount," or reduction in value of the property at the time it's gifted to the trust, is proportional to the length of your term. The longer your term, the greater your estate tax savings. But there's a "catch."

You must outlive the term for the QPRT to be effective for tax purposes. If you don't, the full value of the house will come back into your taxable estate. Some people feel that choosing the length of their terms is like "rolling the dice"--but remember: Surviving a QPRT with a relatively short term is better than having no QPRT at all. Terms in the range of three to fifteen years are most common.

You also get an estate tax "discount" based on your age. The older you are at the time you set up your QPRT, the more your house is discounted. But don't use this as an excuse for procrastination; for every year you wait to get started, you probably should deduct at least half a year from the length of your term.

If you're age 62 and decide on a 10-year term, for example, a QPRT could cut the tax value of your house by more than 60%. A 5-year term at age 70 yields a discount of more than 40%. (The exact discount depends on the interest rate at the time.) But the discount isn't the whole story.

In addition to the reduction in property value when the trust is set up, the QPRT allows all future appreciation of your house to escape taxation in your estate! Given the present trend of the Nantucket real estate market, simply freezing the property's current value for tax purposes could be worth hundreds of thousands of dollars in estate tax savings.

You will pay no federal gift tax if the discounted value of your house does not exceed your available federal exemption amount. If it does, you can avoid the gift tax by deeding a fractional interest into the QPRT and individually owning the remaining percentage of the house. Or a husband and wife each could put 50% into two separate QPRTs (which could have different terms if they so desire). Your lifetime gift tax exemption, if you haven't yet used any of it, presently stands at just over $5 million.

You can put a house that's mortgaged into a QPRT, and you will continue to make mortgage payments after the house is in trust. Whether these payments are considered additional gifts to the trust beneficiaries depends on how the trust is set up.

Your house indeed must be your residence for it to qualify to go into a QPRT. The existence of a rental unit attached to the house will not disqualify the property so long as the rental activity is secondary to your use as a residence.

You can maintain indirect control over the house after your term expires by having the property remain in trust during your lifetime. Although you will have no legal rights in the house, you can include provisions in the trust that will discourage the sale of the property and protect it against your children's creditors and spouses.

On the other hand, if reducing estate taxes is a major concern, a QPRT could be one of the most effective ways of reaching your goal.

There is a movement in Congress to kill "the death tax." But even if the federal estate tax were to disappear--which is unlikely--the Commonwealth of Massachusetts will continue to levy its own estate tax. Thus estate tax is almost certainly here to stay. But just in case it isn't, you can "have your cake and eat it too" by including language in your trust document that will allow your residence to be transferred back to you under specified circumstances if the QPRT is not needed for federal tax purposes. With this kind of built-in "hedge" on top of a potentially large tax discount, the qualified personal residence trust continues to be a superb tax-planning tool for those with larger estates.

For general estate and tax planning tips along with commentary on the Massachusetts estate tax law,
click HERE.

For other commentaries by Richard Loftin, click HERE.