How to Get the Best Estate Tax and Asset Protection Planning for Your Home
Congress added qualified personal residence trusts to the law as a way to allow the parents to transfer a home's equity to the children at a reduced transfer tax cost. As with most estate tax planning, QPRTs also make it more difficult for a creditor to get to that valuable equity.
What Is a QPRT?A QPRT is an irrevocable trust to which you transfer your residence. The QPRT lasts for a fixed number of years. You retain the right to live in the residence for that term of years. At the end of that term of years, the QPRT ends and the home is distributed to an irrevocable trust for the benefit of your children. That means that if you wish to continue living in the residence at the end of the term of years, you must pay rent to the trust for your children.
A QPRT is a way to make a gift to the children at a very low gift tax cost because the gift is made today, but the children do not receive it for many years. Also, the gift only works if the parent survives the term of the QPRT; otherwise, the residence comes back into the parent's estate.
If the residence is community property, then we usually prepare one QPRT for each spouse.
What Is an Example of How a QPRT Works?Mom and dad are 60 and 65; the home is worth $1,000,000. Mom's QPRT is for 20 years; dad's is for 15 years. Mom's gift is $500,000 minus (i) her retained right to live in the home for 20 years and (ii) the chance that she won't survive for 20 years = $120,000. Dad's gift is $160,000. However, each has $1,000,000 of lifetime gift tax exclusions, so they owe no current gift tax. (Note: the $12,000 per donee annual gift tax exclusion is unavailable for these gifts.)
Mom survives for 20 years. The home is appraised for its fair rental value and they lease it from the children's trust. When mom later dies, her half of the home will not be included in her taxable estate. Dad dies before the end of his QPRT's 15 year term; the QPRT ends and that 1/2 of the house will be distributed back to dad's estate, which means it will pass - under their living trust - to mom.
What Are the Advantages of a QPRT?1. The opportunity to pass the residence to the children at no current gift tax cost.
2. It is not an "aggressive" tax technique. If the IRS audits the parents' gift tax returns, the challenge will not be to the technique, but to the appraisal.
3. It is a "heads you win, tails you do not lose" situation. If the parent survives the term, the residence is excluded from the parent's taxable estate; if the parent dies before the end of the term, the residence is included in the parent's estate - however, the estate is recovers any previously used gift tax exclusion.
4. Once the residence has been in a QPRT for several years, it is difficult, if not impossible, for a creditor to reach the equity.
5. It does not change the income tax consequences. The parents continue deducting interest on the mortgage; if the home is sold the parents can use their $250,000 per person capital gain exclusion and invest the proceeds into the next home (also owned by the QPRTs).
What Are the Disadvantages of a QPRT?1. The parents cannot refinance the residence, in the QPRT, and withdraw money to live on. The QPRT trustee can refinance the residence and use the proceeds to improve the residence, or to get a better loan.
2. Most lenders will not want to lend to an irrevocable trust. Lenders often ask parents to "take the residence out" of the QPRT, put the new loan on, and then transfer it back in to the QPRT. This may work, but only if there is an agreement between the QPRT trustee and the parents. This agreement should provides the parents are merely the QPRT trustee's "agents" or "nominees," not equitable owners of the home. This agreement should be for the period of time the home is placed in the parents' names to facilitate the refinance.
3. When the term ends, the parents will have to pay rent to continue living in the residence. Of course, for some parents that is an advantage: it gives them the chance to pass more money out of their taxable estate to their children.
4. The equity in the residence is unavailable to retire on. However, if things go poorly for the parents financially, the trustee can sell the residence and use the equity to pay the parents an annuity for the reminader of the term.
What Is Required to Establish a QPRT?There are significant costs required to establishing a QPRT. The costs include (i) a good quality appraisal of the residence (since this will be attached to the Federal gift tax return to be submitted to the IRS, the appraisal should have color photos of the comparable properties); (ii) the QPRTs (irrevocable trusts) themselves, which are several thousand dollars; (iii) a children's trust to be the recipient of the house at the end of the QPRT's term (the children can directly receive title at the end of the term, but dealing with children directly is not a good idea for many reasons, beyond the scope of this legal guide); (iv) the calculation of the gifts; and (v) the Federal Gift Tax return.