Planning for the disposition of your home can be a challenge. From a gift and estate tax perspective, the earlier you transfer an asset to your children or other beneficiaries, the lower the tax cost. But what if you want to continue living in your home indefinitely?
An effective solution to this dilemma is a qualified personal residence trust (QPRT). When you transfer your home to a QPRT, its value for gift tax purposes is heavily discounted and any future appreciation is removed from your taxable estate. Plus, you retain the right to stay in the home for many years.
Do you need a QPRT?
With gift and estate tax exemptions currently at record-high levels – $5 million for 2011 and 2012 – a QPRT may seem unnecessary. But even if your total estate is well within the exemption amount now, it’s difficult to predict whether it will be within the exemption in, say, two years, let alone in 10 or 20 years.
Keep in mind that, unless the law is changed, the exemptions will drop to $1 million in 2013. In addition, as the economy bounds and home and other asset values grow, there’s an increasing chance that gift and estate taxes will become an issue for you down the road. And if your estate is already at or near the $5 million level, strategies like the QPRT will be valuable even if current exemption amounts are extended.
Regardless of your estate’s size, there are also nontax reasons for using a QPRT. For example, it provides your home with against creditors.
How does it work?
To take advantage of a QPRT, you transfer your home to an irrevocable trust, retaining the right to live there for a specified period. At the end of the trust term, the home goes to your children or other beneficiaries. But even after the term ends, you can arrange to continue living there in exchange for fair market rent.
QPRTs must meet several technical requirements. Most important, they're prohibited from holding assets other than a personal residence, insurance and enough cash to cover the trust's expenses. A QPRT is considered a “grantor trust,” so you pay the mortgage, taxes and other expenses (and, if appropriate, deduct them on your income tax return).
What are the tax benefits?
Transferring your home to a QPRT is a taxable gift to your beneficiaries, but the value of the gift isn’t the home’s current market value. Rather, it’s the present value of your beneficiaries’ remainder interest in the home. That value is only a fraction of the home’s current value, and at the end of the term your beneficiaries receive the home tax-free, regardless of how much it has appreciated.
To determine the remainder value, you take the home’s current fair market value and subtract the present value of your right to live in the home during the trust term. The value depends on several factors, including the current market value of the home, your age, the length of the term and the IRS-published “discount rate” in effect when the QPRT is established.
Generally, the lower the home’s current value, the older you are, the longer the trust term and the higher the discount rate, the lower the value of the remainder interest. Real estate values are generally depressed now, so it may be a good time for a QPRT – even though discount rates are also low.
What are the pitfalls?
QPRTs require careful planning to preserve their tax advantages. One critical consideration is mortality risk. For a QPRT to work, you must outlive the trust term; otherwise the home’s full value will be included in your estate. So selecting the right trust term is a delicate balancing act. A longer term reduces the size of your gift but a shorter term minimizes mortality risk.
Another pitfall involves what happens when the trust term ends. If you continue to live in the home but don’t pay fair market rent, the IRS may treat the transaction as a transfer with a retained life estate and include the home in your estate. The best way to avoid this result is to sign a written lease and follow its terms.
A safe bet?
If you plan to stay in your home indefinitely, a QPRT is worth a look. It has the potential to produce significant tax savings and, with careful planning, has little downside. Before you take action, discuss with your estate planning advisor whether a QPRT is right for your family’s situation.
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