One of the most difficult problems in an estate plan often is the family home or vacation home.
It is an especially significant problem for estates that are likely to be taxable.
A principal residence or vacation home is likely to have significant value. The key to reducing estate taxes is to remove property from the estate.
Yet, you probably want to retain use of your home or vacation house.
A vacation home also can create probate problems. It’s going to be in a different area than your principal residence.
That likely means the vacation house will require a probate process that is separate from the rest of the estate.
Multiple probate processes increase the cost of settling the estate and could result in delays.
One solution is the qualified personal residence trust. It’s a classic estate planning tool that still works.
IRS regulations on the qualified personal residence trust are detailed, making it easy for the estate planner to avoid traps and mistakes.
Suppose “Max Profits” has a $1,000,000 vacation home, and is age 60.
He wants his children to inherit it, but he wants to continue using the home.
To meet his goals, Max creates an irrevocable trust and transfers the house to the trust. Under the trust terms, Max has use of the home as his own for 20 years.
If Max is still alive after 20 years, the home is out of his estate.
It likely has appreciated and is worth significantly more than $1 million, but Max removed it from his estate and incurred any gift taxes when it was worth only $1 million.
When he drafts the qualified personal residence trust, Max has some options for how the house will be treated after 20 years.
Title to the house can be transferred directly to Max’s children or other beneficiaries he named for the trust.
Or the house can remain in the qualified personal residence trust and be available for the use of the beneficiaries under terms established in the trust.
If Max wants to continue to use the home after the 20 years, he’ll need the permission of the trustee or the children. He should pay rent for any use of the house.
When Max transferred title of the house to the trust, he made a taxable gift. The annual gift tax exclusion couldn’t be used, because the gift to his children was not of a present interest.
The children had no rights to the property for 20 years. He had to use part of his lifetime exemption or, if that already was used, pay gift taxes.
The value of the gift wouldn’t be the market value of $1 million. The gift tax computation is in IRS regulations, and the value of the gift is its present value calculated using current interest rates and the length of the trust.
Each month the IRS publishes the interest rates to be used for these and other computations, known as the adjusted federal rates or the section 7520 rates.
If the applicable interest rate for the month the property is transferred to the qualified personal residence trust is 2.2% and the trust term is 20 years, the taxable gift is $375,430 of the $1 million value.
If the trust term were less than 20 years, the taxable gift would be higher. If the interest rate were higher, the value of the gift would be lower.
Note: If Max doesn’t survive more than 20 years, the full value of the house is included in his estate as though the trust never were established. When creating a qualified personal residence trust, it is important to set the trust term for a period that is less than the Life Expectancy of the property owner.
The qualified personal residence trust can be used with a principal residence. If Max used the trust with his main home and survived 20 years, he would have several options.
He could move into a different home. He might have been planning to downsize at that point in his life anyway.
He also could remain in the home but pay his children or the trust fair market rent. That would be another way to benefit his children, by paying them rent on the home.
The rent would avoid any gift tax consequences. Most qualified personal residence trusts, however, are done with homes other than the principal residence.
The grantor of the trust (Max in the example) and his or her spouse are not permitted to purchase the home from the trust as any point.
During the trust term, Max is treated as owner of the property for federal income tax purposes. He pays and deducts the real estate taxes and any mortgage interest.
If the home is sold during the trust term, the qualifications for tax-free treatment are determined by looking at Max’s ownership and residence of the property.
After a sale of the property during the trust term, the proceeds must be reinvested in a new residence within two years.
If the proceeds aren’t reinvested, the trust must either terminate and distribute the proceeds to the grantor or convert to a grantor retained annuity trust (GRAT).
In next week’s edition of retirement watch Weekly, I’ll share more estate planning advice for passing on a home to your heirs.
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