Achieving estate tax savings and asset protection through a QPRT

For many couples and individuals, their homes (primary or second) make up a substantial portion of the value of their estate. In larger estates, the existence of residential property poses estate tax considerations and, in the event of a lawsuit or creditor claim, exposes the property to seizure by third parties.

Protecting valuable residential real estate can be achieved through the use of a “qualified personal residence trust” (QPRT) — a type of irrevocable trust that allows the creator of the trust (or “grantor”) to transfer their primary or second home out of their personal estate. Such a transfer offers to the grantors (and, ultimately, their beneficiaries) at least two important benefits: estate tax savings and asset protection.

New threat of estate taxation. Before you assume that, because the value of your estate is safely below the $13.61 million threshold for taxation, consider this:

The tax law which provides that high level is scheduled to sunset at the end of 2025. If Congress does not act between now and then, the estate tax exemption will drop to just $5 million per individual (before inflation adjustments), and upon your death your seemingly modest estate could become subject to taxation.

The looming possibility of estate tax liability in the future, where none exists now, makes discussions of estate tax strategies a timely exercise.

CREATING A QPRT

Here are the basic steps: The owners of the home set up a QPRT, obtain an appraisal of the real property, and then convey into the QPRT the ownership of the home as a gift, for a specific, predetermined number of years, or the “term.”

The length of the term varies from case to case, based primarily on the grantors’ age and health. For example, a couple in their sixties and in good health might designate a 10- or 15-year term.

After the house has been gifted into the trust, the grantors can continue to live in the house, rent-free, for the duration of the term.

The value of the grantors’ rent-free use is known as their “retained interest.” What is the value of living in a $5 million house rent-free for 15 years? At a 6% annual return on investment, that value could easily exceed $4 million over the term of the QPRT.

(When the term expires, the grantors have two residential options: They can move to another residence, or, if they have made a paid rental arrangement with the beneficiaries, they can stay put.)

Discounted value. The projected value of the property at the end of the term is known as the “remainder interest,” an amount that, at the inception of the QPRT, is calculated based on:

• the length of the term (the longer the better, within limits – see “Timing” below);
• the amount of the grantors’ retained interest (the more the better); and
• the property’s discounted fair market value (the lower the better).

The discounted value stems from two valuation factors recognized by the Internal Revenue Code (IRC):

• restrictions on who, at the end of the term, can own the property (i.e., only the beneficiaries named in the QPRT); and
• restrictions on when the property can change hands (in our example, 10 or 15 years into the future).

A key factor in determining the amount of the discount is the prevailing IRC Section 7520 interest rate (at the time of this article: 5.2%).

Timing. A key planning objective is for the term to expire before both grantors pass away. The longer the term, the steeper the discount on the property’s remainder value; however, if the grantors die before the end of the term, the entire value of the property gets pulled back into their estate. That is why, when establishing the term, it is important to consider the grantors’ ages and health conditions. It is also a reason that the QPRT strategy declines in potential value as the potential grantors approach end of life.

BENEFITS

Estate tax savings. Consider this example: John and Mary own a home that has a current appraised value of $5 million. They create a QPRT with a 12-year term and convey their home into it. Twelve years later, the property’s market value has increased, by an average of 5% per year, to nearly $9 million. Because the residence was held in an irrevocable trust, the $4 million gain that occurred during the QPRT’s term will be estate tax-free. The grantors’ gift tax liability will reflect only the gain that occurred before they gifted the home to the QPRT.

Asset protection. If the grantors are sued during the term of the QPRT, the home is creditor-protected. They no longer own the property; the trust does.

That is an important consideration for couples whose primary residence makes up a significant chunk of their total estate, as the primary residence is one of the hardest assets to protect from creditors.

RISKS

Whether your objective is estate tax avoidance, asset protection, or both, a qualified personal residence trust can be an effective planning strategy.

A QPRT is not without its risks, however:

• It is an irrevocable trust, and once you have set it up and funded it, you cannot cancel it or change its terms.
• The term of the QPRT is based on assumptions regarding the grantors’ life expectancy; if both grantors die before the expiration of the term, the transferred real estate returns to the grantors’ estate and increases the possibility of estate taxation.
• Because the house becomes the property of the trust, the grantors cannot refinance it or use it as security for a loan.

Before you convey your residence to a QPRT, you should fully explore these and other factors with your estate planning attorney and weigh them against the benefits you intend to achieve.