There are many ways to utilize trusts to reduce estate tax liabilities. The Qualified Personal Residence trust (commonly known by its acronym “QPRT” and pronounced “Q-Pert”) is a great way to pass real estate to one’s heirs while minimizing gift and estate taxes. It is a simple concept: the owner of a personal residence transfers it into a trust, but retains the right to live in the residence for a specified number of years. At the end of that period, the beneficiaries of the trust become the owners of the residence.
Let’s take a look at an example of how a QPRT works:
In 2002, the owner of a personal residence creates a QPRT, and transfers ownership of their residence into the QPRT. Because the beneficiaries of the trust cannot take ownership for a specified period of time, the value of the gift is discounted. This discount is based on several factors, including the age of the donor, the number of years the donor will retain the right to occupy the property, the appraised value of the property, and the current IRS actuarial tables. For example, if the donor in 2002 established a 20 year QPRT to hold a $1 million residence, the discounted value of the home (based on the interest rate in effect in January, 2002) would only be $192,270.
Trust Agreement Terms
A QPRT trust document may allow for the following:
- The donor could be the sole Trustee of the QPRT, and make all management decisions.
- The trust would continue for a specified number of years, after which the property could be transferred either outright to the remainder beneficiaries, or in further trust for their benefit. The number of years that the QPRT is designed to continue requires careful thought since the tax benefits are lost if the donor dies before the QPRT ends. A longer trust term increases the tax advantages, but also increases the risk that premature death will erase those advantages.
- During the term of the QPRT, the donor would be entitled to all rights of occupancy, and would be responsible for all costs of maintenance.
- If the residence is sold during the term of the QPRT, another home can be purchased to replace it in the trust. If a replacement home of equal value is not purchased, the unused cash proceeds must either be distributed back to the donor (thus forfeiting the tax benefit), or the cash must be invested and the donor will be paid an annuity for the balance of the QPRT term (thus reducing, though not necessarily eliminating, the tax benefit), after which the remaining trust assets will be distributed to the remainder beneficiaries.
Considerations When Forming a QPRT
The objective of the QPRT is to reduce inheritance taxes by removing the property from the donor’s estate. If the donor’s death occurs after the QPRT has ended, the donor’s taxable estate for federal estate tax purposes will include only the value of the remainder beneficiary’s future interest in the residence when the trust was created, and all appreciation in value after the date of the gift will have been removed from the donor’s estate.
On the down side, if the donor has survived the QPRT term, the residence will not receive a “step- up” in its income tax cost basis to estate tax value, because the residence will not have been taxed in the donor’s estate. For this reason, the QPRT is best suited for a home likely to stay in the family until the children’s deaths, when the residence will get the desired step-up in basis. However, even if the property is later sold by the children, the capital gains tax (at least under current tax law) will be far less than the estate tax that, otherwise, would have been due had the QPRT not been created.
During the QPRT term, the donor will be treated for income tax purposes as if he or she were still the owner of the property; i.e., the donor can deduct real estate taxes, take advantage of tax elections on the sale of the property, etc. If the property is sold by the QPRT, a capital gains tax will be due in the same amount as if the donor still owned the property. And, the donor must pay the capital gains tax out of the donor’s own funds, which often produces a good estate tax result because payment of the tax reduces the donor’s taxable estate.
If the donor dies before the completion of the term of years specified in the QPRT, the trust will end and the property will be disposed of by the donor’s Will or Revocable Trust. The tax advantages will be lost, but there will be no tax detriments—taxes will be calculated as though the QPRT had never been created.