August 20, 2009

The Qualified Personal Residence Trust

Reducing the federal estate tax beyond basic estate planning (a Credit Shelter Trust) will require reducing the taxable estate. The easiest way to reduce the taxable estate is to gift assets to one’s ultimate beneficiaries. Gifting, though for this purpose, requires parting with dominion and control of the assets. Retaining almost any interest will cause the “gifted” assets to be included in the purported donor’s taxable estate. There are exceptions to this rule that one cannot retain access and control over gifted assets and not be taxed on such assets at death.

Properly structured, a “Qualified Personal Residence Trust” (QPRT) is one of these exceptions. To take advantage of this opportunity, the donor must irrevocably transfer a personal residence (primary or secondary) to a trustee for the benefit of named beneficiaries (for example, the donor’s children). The donor must select in the trust document a period of time for which the transferred property will be held in trust. While the property is held in trust, the donor has the exclusive right to occupy the property without paying any rent as well as the responsibility to pay (and deduct) real estate taxes and other operating expenses.

The selection of the period of time to retain access and control of the property is critical for a number of reasons. Once the selected period is up, the donor loses access and control and if the donor wishes to use the property, he or she can only do so with the consent of the beneficiaries and must pay the fair rental value of the property. Secondly, the tax benefits increase in proportion to the length of time selected, however the donor (or spouse in certain cases) must outlive the period selected or the value of the property will be includible in the donor’s estate.

A simple example can illustrate the above. Assume Mr. Donor aged 65 owns a vacation house with a current value of $1,000,000. He is certain that upon his demise, he would like his children to own this property. Assume further that he dies 9 years and 364 days from now when the property is worth $2,000,000. If he does nothing, of course the property and its $2, 000,000 value will be included in his taxable estate. Should he transfer the trust into a QPRT and select a 5 year term, the property will not be included in his taxable estate any value. The value of the gift (which would be taxed or would reduce his lifetime exemption) would be about $550,000(the value is discounted using the current section 7520, IRC rate for the selected period and also considering the donor’s life expectancy). For the first 5 years after the transfer, Mr. Donor has the exclusive right to use the property, but must pay the annual expenses of the property. After 5 years, he must pay his children fair market rent if he intends to continue to use the vacation home (and his children agree to rent it to him. Had he selected a 10 year term, the value of the gift would be discounted even further, but sine he did not outlive the selected period, the entire value of $2,000,000 is included in his taxable estate.

A potential downside to this technique is the loss of a stepped basis, but since the long term capital gain rate is considerably less than the federal estate and gift tax rate, this appears to be an acceptable trade-off. Also, while it is true that if the donor does not outlive the period selected to retain the property there is no estate tax savings, the “nothing ventured nothing gained” approach should apply. Finally, while the donor is required to pay rent after the selected retention period, some view thai as an opportunity to pass even more of one’s assets to his or her ultimate beneficiaries free of tax.

There are however many potential complications to such a transfer, especially concerning a sale of the property while it is held in trust. If this estate tax saving opportunity is of interest, you should contact an attorney conversant with these provisions to advise you and draft the appropriate document.

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