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Home in on tax savings with an RPM trust

If you wish to transfer a personal residerKe to the next generation at a low tax cost, a Remainder Purchase Marital (RPM) trust is worth a look. Although a qualified personal residence trust (QPRT) is a more common vehicle for transferring a home, an RPM trust offers several advantages, including increased flexibility and the elimination of mortality risk.

QPRT pros and cons

A QPRT is a type of grantor retained income trust. You transfer your home to an irrevocable trust, retaining the right to live in the home for a specified term. At the end of the term, ownership of the home goes to your children or other named beneficiaries. (You can, however, arrange to continue living in the home by paying fair market rent.)

Your children’s future interest in the home (called a remainder interest) is considered a taxable gift. To calculate the gift’s value, the present value of your right to live in the home is subtracted from the fair market value of the home at the time you establish the trust.

If you’re married, using an RPM trust to transfer a home eliminates mortality risk and can offer greater flexibility than a QPRT.

Present value is calculated using IRS tables that take into account your age, the length of the trust term and the current Section 7520 discount rate. The older you are, the longer the trust term and the higher the Sec. 7520 rate, the lower the value of the taxable gift to your beneficiaries.

A QPRT allows you to transfer your home at a reduced tax cost because gift tax liability is based on your beneficiaries’ remainder interest, which is a fraction of the home’s current value. Plus, it freezes the value of your home for gift and estate tax purposes: Any appreciation in value in excess of the Sec. 7520 rate goes to your beneficiaries tax free. Also, QPRTs are specifically authorized by the Internal Revenue Code, thus providing some peace of mind that the IRS won’t challenge its tax benefits.

QPRTs aren’t without their drawbacks, though. The most significant is mortality risk: If you don’t survive the trust term, the home’s full value will be pulled back into your taxable estate.

In addition, QPRTs are subject to several restrictions that limit their flexibility. For example, they generally can’t hold assets other than a personal residence. They also lose their tax favored status if the home ceases to be used as a personal residence or is sold and not replaced with another personal residence within two years.

The RPM alternative

If you’re married, using an RPM trust to transfer a home eliminates mortality risk and can offer greater flexibility than a QPRT.

The main downside may be that, unlike QPRTs, RPM trusts aren’t specifically authorized by law and have not been fully tested in the courts, so there’s less certainty about whether they’ll withstand an IRS challenge. But as of this writing, there’s no indication from the courts that a properly structured RPM trust won’t achieve its intended purposes.

Here’s how an RPM trust works: You transfer a personal residence (or other property) to a trust. (If you own the home jointly, your spouse will have to transfer his or her interest to you first, but the transfer can qualify for the marital deduction.) At the same time, you give your spouse an income interest (while the trust holds the home, this would mean the right to live in it) in the trust for life or for a term of years and sell the remainder interest to your children or other beneficiaries. (You receive the proceeds from the sale and might recognize a gain or a loss, depending on how the transaction is structured.)

Because you retain no interest in the RPM trust, the property is immediately removed from your estate - eliminating the mortality risk. (Remember, this is unlike a QPR T, where you must survive the trust term for the property to be removed from your estate.) And, if the RPM trust is designed properly, your spouse’s interest should qualify for the estate tax marital deduction without being included in his or her estate.

So long as your beneficiaries pay adequate and full consideration for their remainder interest (based on Sec. 7520 tables), there’s no gift or estate tax. You can even design an RPM trust that terminates if you die during the trust term. That way, if you don’t survive the term, your beneficiaries will receive the property early. (Be aware, however, that your spouse’s income interest will terminate when the trust terminates, so to continue to live in the home, he or she will have to rent it from your beneficiaries.)

If your beneficiaries have the resources to buy their remainder interests, you can fund an RPM trust without generating gift taxes. Otherwise, you may have to make taxable gifts to finance their purchases.

It’s important to note that, all else being equal (the home’s value, the trust term and the Sec. 7520 rate), the remainder interest in an RPM trust will be worth more than the remainder interest in a QPRT because of the elimination of the mortality risk. So an RPM trust can be more costly than a QPRT.

On the other hand, because the mortality risk is eliminated, you can use a longer trust term to reduce the purchase price. (See “Comparing prices” on page 3.) Also, at least a portion of any gifts you make to fund your beneficiaries’ purchase of the remainder interest may qualify for the annual exclusion; the gift of a remainder interest in a QPRT won’t qualify.

As mentioned, an added benefit of RPM trusts is flexibility. For example, a home held in an RPM trust could be rented out, and your incomebeneficiary spouse would receive the rent. Or the home could be sold and the proceeds used to buy, for example, income investments such as bonds and dividend-paying stocks. Either option could be beneficial if the home no longer meets your needs. The cash flow from the trust could be used to pay rent on a more suitable home or to pay other expenses.

You get what you pay for

RPM trusts can cost more than QPRTs, and they aren’t officially sanctioned by the Internal Revenue Code. But by eliminating mortality risk and providing the flexibility to rent out or sell your home, they may well be worth it.
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