Changes to the estate tax laws in past years made fewer people subject to taxes at their death, but many fear that the future could bring a return to higher estate tax rates and lower exemptions. As a result, taking advantage of strategies like creating a qualified personal residence trust, or QPRT, can be smart in trying to make the most of high current exemptions while they last. A qualified personal residence trust allows you to make a gift of your primary residence or vacation home at a future date while locking in a discounted value of the home. That lower value can reduce the amount of gift and estate taxes you'll owe, or eliminate taxes entirely in some cases. Although there are some potential pitfalls, the QPRT strategy makes sense for many people who are comfortable with the implications.
What a qualified personal residence trust looks like
A QPRT is a relatively simple form of trust. The property owner funds the trust by transferring a deed for the property into the name of the trust. According to the terms of the qualified personal residence trust, the former property owner retains the right to use the residence rent-free for the entire term of years that the trust specifies. The property must continue to be used as a residence throughout the term of the trust. At the end of the term, the property is transferred to the beneficiaries of the trust, who are usually children, grandchildren, or other family members.
After the trust terminates, the person who created the trust can no longer live in the residence without paying rent. Typically, however, the recipients of the home can lease the property back to the former owners.
Why a QPRT can be a smart move
There are two primary advantages to using a qualified personal residence trust. First, the person creating the trust can claim a reduced value of the gift to the trust's beneficiaries that takes into account the delay in their receiving the property. The exact value of the gift depends on the length of the QPRT and prevailing interest rates at the time the trust is created, but it's not uncommon for the value of the gift to be half or less of the property's current fair market value.
Second, the QPRT freezes the value of the home for gift tax purposes. That can be especially valuable in real estate markets in which property values are increasing substantially. When you combine these two factors, the QPRT lets you transfer a personal residence -- often the estate's largest asset -- at just a fraction of its value by the time the trust terminates.
Why QPRTs don't always work
However, there are some limitations on how valuable qualified personal residence trusts can be. The most important thing to remember is that in order to get the benefits of a QPRT, the person creating the trust must survive beyond the end of the trust's term. If the trust's creator dies before the QPRT terminates, then the property gets pulled back into the creator's estate at its full value at the time of death.
By contrast, many people aren't comfortable with the idea that they'd have to pay rent to their children or grandchildren after the QPRT's term ends. Nevertheless, from an estate planning perspective, rent payments can be even more valuable, as they represent additional money that goes to heirs without any estate or gift tax consequences.
Finally, keep in mind that even though the estate tax benefits of QPRTs are substantial, they come at a cost. When the beneficiaries of the trust take possession of the residence, their tax basis in the property is equal to whatever the previous owner's tax basis was. Typically, what that means is that upon the sale of the property, the heirs will have a large capital gains tax liability -- even though if the property had stayed in the original owner's estate, it would have gotten a step-up in tax basis that would have eliminated future capital gain. Because the estate tax rate of 40% is higher than the maximum capital gains tax rate of 20%, this is a trade-off that's usually worth paying.
Qualified personal residence trusts can sound a bit complicated, but as an estate planning strategy, QPRTs are relatively straightforward. By taking action now, you can ensure that your most important asset will go to your loved ones with a minimum of estate tax hassle in the future.