Trusts that Save Taxes and Families

The family residence often is one of the most valuable assets in a person’s estate. Despite recent price declines in numerous markets, many people own homes worth far more than they paid for them. The residence often accounts for a significant portion of a person’s net worth.

The personal residence can create both estate tax and estate planning problems. As a significant portion of the estate, the home could be subject to estate taxes. Since a person needs a place to live, it is difficult to give away the home or take moves that can reduce estate taxes on other assets. The estate planning problem is that heirs frequently disagree over what to do with the family residence. Some want to sell; some want to move into the home; others want it to stay in the family and be shared in some way.

Often these problems can be solved with the qualified personal residence trust (QPRT).

The concept is simple. You create an Irrevocable Trust and name the beneficiaries, who usually are your children. The home is transferred to the trust. A provision of the trust is that you retain the right to live in the home and treat it as your own for a period of years. After the period has passed, the trust takes full title. When you drafted the trust, you might provide that the trust continues and manages the home, or you can state that title is transferred to the beneficiaries. You can decide if the beneficiaries receive equal or unequal ownership and set some rules or guidelines about how the home is to be shared or sold.

The benefit of the QPRT is that once the period of years has passed, the home is out of your estate. All the appreciation that occurred after you bought the house will avoid estate taxes.

The price for this advantage could be gift taxes. When you transfer the home to the trust, the home’s value is divided into two portions. One is the present value of your right to live in the home for the period of years; the other portion is the present value of the beneficiaries’ right to receive the home after the period of years. This second portion is subject to gift taxes. IRS tables that use current interest rates, the period of time you will live in the home, and the value of the home to determine the value subject to gift taxes.

For example, suppose a married couple, ages 62 and 60, transfers a $500,000 home to a QPRT. If their period in the home is reserved at five years, the taxable amount is around $346,664. If the period is 15 years, the taxable amount is about $116,642. (The actual numbers vary as interest rates change.) There might not be any gift tax due if the owners have not used up their $1 million lifetime gift tax exclusions, but that will limit other opportunities to make tax-free lifetime gifts. The owners avoid estate taxes on the entire future value of the home by paying gift taxes on part of today’s value.

You can see that the longer the period the owners have rights to the home, the lower the gift tax. The trade off is that if the owners die during that period, the entire value of the home is included in their estates. Setting up the QPRT would have provided no tax benefit.

One recommendation is to set the term to coincide with when the owner is likely to move anyway, either to retire, downsize, or enter an independent living facility. Another recommendation is to buy a term insurance policy covering the length of the period if the owner qualifies for life insurance. In the event of premature death, the insurance covers the estate taxes.

What if the period expires and you desire to remain in the home? There are several options at that point. Keep in mind that the trust or the beneficiaries are the legal owners of the home and everyone must act accordingly.

Most frequently, the parents stay in the home and pay fair market rent to the trust or the children. Another option is to buy the home back from the trust or the beneficiaries. This gets some cash or other assets out of the estate but puts the home back in. A purchase also might result in capital gains taxes to the children. In addition, the IRS is suspicious of the re-purchases and will examine all details of the transactions closely, including whether fair market value was paid for the home.

More information on QPRTs and other aspects of estate planning can be found in Estate Planning Made Easy by David T. Phillips and Bill S. Wolfkiel, available on amazon.com.

The QPRT can be used for any residence that has kitchen, toilet, and sleeping facilities. This includes vacation homes, RVs, and boats. You will need an estate tax expert to structure the details of the QPRT.