Bill owns a vacation mountain home that his family has enjoyed for many years. After giving it some thought, Bill has decided that he would like to give the home to his children, now, rather than waiting to pass it on at his death.
Estate Plan Concerns
Investment Expected to Grow Annually
The home is located in a thriving resort community. It is presently worth $1,000,000 and several realtor friends have informed Bill that he could reasonably expect the property to grow at an 8% annual rate for the foreseeable future.
Gift Tax Exemption Shelter Available
Understanding that he has a $1,000,000 gift tax exemption to shelter the gift from tax, Bill’s initial inclination is to transfer the property to his children, which would avoid any gift tax and allow all future growth in the property’s value to escape estate tax in his estate.
But, he wonders whether there might be a better way, and he also thinks that use of a trust to hold the property could make sense.
Estate Plan Solution
After obtaining advice, Bob decides that it would be best to use an estate planning technique known as a “Qualified Personal Residence Trust” (or, “QPRT”) to transfer the home to his children.
Qualified Personal Residence Trust (QPRT) Process
- Bill creates an irrevocable trust for the purpose of holding the mountain home for the benefit of him and his children.
- Bill transfers title to home to the trustee of the QPRT.
- Bill retains the right to use the home for a specified period of years (10 years is assumed), after which time his interest in the trust (and his right to use the home) ceases. However, after this 10-year retained interest period, the trustee has the discretionary power to rent the home to Bill (assuming the home is retained in trust).
- At the end of Bill’s 10-year retained interest period, the trustee holds the home for the exclusive benefit of Bill’s children (or distributes the home to them, outright, depending on the terms of the trust).
- If Bill’s 10-year retained interest period ends while he is alive, the entire value of the home will avoid estate taxes. However, if he dies during this period, the entire value of the home will be includible in his taxable estate and be subject to estate taxes.
- The taxable gift is only $466,690 which can be sheltered from gift tax by Bill’s gift tax exemption.
- Tax-Free Property Transfer: Personal residence can be transferred to children free of gift and estate tax.
- Less Exemption Used: Amount of gift tax exemption needed for the QPRT is typically much less than for an outright gift.
- Long-Term Retention of Property: If grantor desires, residence can be retained in trust long-term for the benefit of grantor’s children.
- Maintain Residence: Grantor retains right to continue using the residence for a fixed period of years.
- Rent Option Still Exists: After the grantor’s right to use the residence ceases, grantor may rent it from the trust.
A Qualified Personal Residence Trust (QPRT) is a special type of irrevocable trust that can be used by an individual to transfer a personal residence (either a primary or secondary residence) estate tax free to his or her children, provided that the trust satisfies the requirements of Federal Treasury Regulations under Internal Revenue Code §2702.
Generally, a QPRT would be appropriate for a residence that is expected to grow in value at a significant rate for the foreseeable future.
Grantor Transfer Property to Trust and Retains Limited Residence
Generally, the individual (often referred to as the “grantor”) creates an irrevocable trust, which provides that the trustee will hold and manage the residence for the benefit of the grantor and his or her children.
The grantor reserves, in the trust instrument, the right to possession and use of the residence for a specified period of years.
At the end of this period of time, the grantor’s interest in the trust (and any right to use the residence) terminates. Thereafter, the trustee either retains the residence in trust for the exclusive benefit of the children or distributes the residence outright to the children, depending on the terms of the trust instrument.
Renting is an Effective Asset Transfer Technique
If the residence is to be retained in trust after the grantor’s retained interest period ends, the trustee is typically authorized in the trust instrument to rent the residence to the grantor, at an arm’s length market rate. In this way, the grantor can continue to enjoy the use of the residence after his or her right to use it as a beneficiary of the trust has ended.
While renting “his own residence” might initially seem unattractive to a grantor, such an arrangement could be an effective technique to transfer assets to the trust.
For example, if the trust instrument is drafted so that the QPRT is classified as a “grantor income trust” for federal income tax purposes, the income tax consequences of renting to the grantor could be neutralized and the rent paid by the grantor to the trust could be accumulated and invested for the children (or distributed to the children) without being subject to gift tax.
Consequence of Grantor Death During Retained Interest Period
The estate tax consequences depend on the time of the grantor’s death. If the grantor outlives the grantor’s retained interest period, the entire value of the residence (including appreciation) will pass to the children (or in trust for their benefit) free of estate tax.
However, if the grantor dies during the retained interest period, the value of the residence would be includible in his or her gross estate for federal estate tax purposes, and therefore subject to estate tax. For this reason, in designing the QPRT it is important to specify a retained interest period that the grantor has a high probability of surviving.
Longer Wait for Children Equals Lower Gift Tax
The taxable gift for gift tax purpose is determined at the time the grantor transfers the residence to the QPRT and is calculated by multiplying the current fair market value of the residence by an actuarial factor from tables provided by the IRS.
The resulting taxable gift is the actuarial value of the children’s remainder interest in the trust. Generally, the longer the grantor’s retained interest period (i.e., the longer the children must wait to receive their interest), the lower the taxable gift.
Calculations Will Vary According to Current Market
Unless otherwise stated, actuarial calculations are based on the assumptions that the client is 65 years old and the Applicable Federal Rate (AFR) is 5.00%.
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The following notice is required by the IRS: Any U.S. Federal tax advice contained in this communication is not intended to be written or used, and cannot be used or relied upon, to avoid tax-related penalties under the Internal Revenue Code, or to promote, market or recommend to another any tax-related matter addressed herein.