The Qualified Personal Residence Trust (QPRT)
Written by Doug Custer, CFP®
How do you keep that vacation home in the family? How do you keep any home in the family for that matter? We frequently explore such questions with clients. One often overlooked solution is a vehicle called the Qualified Personal Residence Trust (QPRT). A QPRT can be an especially attractive estate planning tool in fast growing real estate markets, such as the Puget Sound region, Silicon Valley, southern California, Denver, New York City, Boston, and Washington D.C. A QPRT provides a family the opportunity to remove most of the present value and future appreciation of their home from their estate.
A QPRT is a type of irrevocable trust, and thus cannot be easily changed. After the trust is established, the home is transferred into it for a period of time designated in the trust as the “retained income period.” The parents continue to live in the home during the retained income period. After the retained income period, the property transfers to the ultimate beneficiaries. Because the gift to the children isn’t immediate, for gift tax purposes the value used at the time the home is transferred into the trust is discounted. The rationale for this is that the net present value of a gift that won’t be received until a point in the future is worth less than its actual value today. The discounted value is based on both the length of the retained income period and the IRS discount rate used at the time the home is transferred to the trust. (An example will be provided below.)
If parents wish to continue to live in the residence, as is often the case, they would pay fair market rent to their children, further reducing the size of their estate. Since individuals and married couples can have up to two QPRTs, a QPRT can also be a good vehicle for leaving a vacation or second home to the next generation, while also reducing the size of the parents’ taxable estate.
It’s important to consider estate tax implications when planning for a QPRT. The recent tax legislation doubled the amount that could previously be passed on without federal estate tax. The exemption amount in 2018 is $10,980,000 per individual ($21,960,000 for married couples, assuming proper planning).
Many individuals or couples have estates below $10,980,000 or $21,960,000, respectively, so they assume that they don’t need to worry about estate taxes. That is not necessarily true. For one thing, estates that are well below the limits right now may grow beyond those levels in the future, and/or future legislation could cut exemption amounts to far lower amounts. Even barring those scenarios, estates that are far below federal exemption level may be subject to state estate taxes at much lower values.
Fourteen states and the District of Columbia impose estate taxes of their own. Furthermore, states have been reluctant to raise their exemption amounts because they rely on that tax revenue (and can’t print money the way the federal government can). Washington state, for example, has a 2018 estate tax of 10% to 20% on all taxable estates over $2,193,000 (although certain family businesses get an exemption of $2.5 million). A married couple can shelter twice that much, i.e., up to $4,386,000, by utilizing a credit shelter trust, which protects (shelters) the exemption of the first person to die, rather than making the surviving spouse’s estate too large. Still, Washington’s exemptions are only 1/5 as high as the federal exemptions, so many more people in Washington (and other states with state estate taxes) need additional estate planning to ensure that family assets—such as their home or vacation home—go to the next generation.
That brings us back to the subject of QPRTs. Although a QPRT involves gifting (while you’re alive), rather than leaving assets in your estate after death, the two are closely related. Technically, federal estate taxes are based on the “unified federal estate and gift tax table.” Any gift of more than $14,000 per year requires that the giver file a gift tax return, and the amount of the gift that’s over $14,000 directly reduces the giver’s estate tax exemption by that amount, meaning less of your assets are exempt when you die.
Here’s an example of how a QPRT might be set up and implemented:
Jack and Jill, ages 60 and 58, own and live in a lakefront home in Washington state worth $1,000,000. They wish to bequeath the home to their two grown children who’ve expressed a desire to keep the home to use as a vacation getaway for their families. Jack and Jill set up a QPRT and transfer the home into the trust, using a 20-year term, i.e., “retained income period.” During that time, they continue to live there. The future gift is valued at a discounted “present value” (PV) of $361,230, because, according to the current IRS discount rate (2.4% as of January 2017) for such transfers, that is the present value of a future transfer (20 years hence) of $1,000,000.
Jack and Jill will need to file a federal gift tax return and (assuming that they separately used their $14,000 gift allowances) $361,230 is the amount of “taxable” gift. What this really means is that they are using up $361,230 of their $21,960,000 combined federal estate exemption. No tax is actually due with the return because the gift is well beneath the federal exemption amount; and Washington state does not have a gift tax. If Jack and Jill survive the full 20-year term, the home would pass to their two children and Jack and Jill could continue to live in the home and pay their children fair market rent (further reducing the size of their estate).
Furthermore, let’s say that, over the 20-year period, the value of this hypothetical home increases to $2,500,000 (that’s only 3.6% a year compounded, which very well could occur, especially in the markets listed above). Jack and Jill would have transferred a $2.5 million in property out of their estate, while using up only $361,230 of their estate tax exemptions.
A few caveats:
- If the grantor should pass away during the trust term (retained income period), the fair market value of the home at the time of passing would be brought back into the estate (replacing the taxable gift made at the time the trust was established).
- If the home is sold during the trust term (retained income period), the proceeds must be re-invested into a new residence within two years or the QPRT will need to be terminated and assets distributed to the grantor or the trust converted to a grantor retained annuity trust (GRAT). We’ll cover GRATs in a future article.
- It’s best to transfer non-mortgaged residences into a QPRT because future mortgage payments would count as additional “gifts” to the trust.
- Because transfer of the home via a QPRT is considered a gift, the beneficiaries would retain the grantors original cost basis. In the example above, Jack and Jill’s cost basis on the home would not “step-up” on their passing, since they gifted the home during their lifetime and received an estate tax benefit for doing so. For this reason, the ideal scenario is to gift property through a QPRT that the beneficiaries plan to retain. Even if they do plan to sell the property, however, the QPRT might still be advantageous for the beneficiaries because the potential capital gains tax on its sale may be far less than the estate taxes (currently up to 40% federal plus up to 20% state in the WA example above) if the property remains in the estate.
The purpose of this article is to provide you with the basic characteristics, features and benefits of a qualified personal residence trust (QPRT). It is by in no way intended as legal advice. This discussion is not comprehensive; there are many details and nuances involved with gift and estate tax planning, as well as with QPRTs, that we have not addressed. We believe that the information herein is accurate, but cannot guarantee that it applies to you. We encourage you to meet with your own attorney to review your estate plans, and ask if a QPRT might be appropriate for your circumstances, plans, and legacy goals.
This is part of a series on different types of trusts to show how/why they can be useful in financial and estate planning.
Doug Custer is a Financial Advisor with Viridian Advisors (www.viridianadvisors.com). Assurance, Tax, Consulting, Accounting services offered through Viridian Tax and Accounting, Corp. Financial Planning and Investment Management services offered through Viridian RIA, LLC.a Registered Investment Advisor
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and cannot be invested into directly. The information provided is not intended to be a substitute for specific individualized tax planning or legal advice. We suggest that you consult with a qualified tax or legal advisor.
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