A Qualified Personal Residence Trust (QPRT) is an excellent tool for persons with large estates to transfer a principal residence or vacation home at the lowest possible gift tax value. The general rule is that if an individual makes something special of property in which they retains some benefit, the property is still valued (for gift tax purposes) at its full fair market value. Basically, there is no reduced amount of value for the donor’s retained benefit.

In 1990, to make sure that a principal residence or vacation residence could pass to heirs without forcing a sale of the residence to pay estate taxes, Congress passed the QPRT legislation. That legislation allows an exception to the overall rule described above. As a result, for gift tax purposes, a decrease in the residence’s fair market value is allowed for the donor’s retained interest.

For instance, assume a father, age 65, includes a vacation residence valued at $1 million. He transfers the residence to a QPRT and retains the right to utilize the vacation residence (rent free) for 15 years. At the end of the 15 year term, the trust will terminate and the residence will undoubtedly be distributed to the grantor’s children. Alternatively, the residence can stay in trust for the advantage of the kids. Assuming a 3% discount rate for the month of the transfer to the QPRT (this rate is published monthly by the IRS), today’s value of the future gift to the children is only $396,710. This gift, however, could be offset by the grantor’s $1 million lifetime gift tax exemption. If the residence grows in value at the rate of 5% per year, the worthiness of the residence upon termination of the QPRT will undoubtedly be $2,078,928.

Assuming an estate tax rate of 45%, the estate tax savings will undoubtedly be $756,998. The net result is that the grantor will have reduced the size of his estate by $2,078,928, used and controlled the vacation residence for 15 additional years, utilized only $396,710 of his $1 million lifetime gift tax exemption, and removed all appreciation in the residence’s value during the 15 year term from estate and gift taxes.

While there is a present lapse in the estate and generation-skipping transfer taxes, it’s likely that Congress will reinstate both taxes (maybe even retroactively) a while during 2010. Or even, on January 1, 2011, the estate tax exemption (that was $3.5 million in 2009 2009) becomes $1 million, and the top estate tax rate (which was 45% in ’09 2009) becomes 55%.

Despite the fact that the grantor must forfeit all rights to the residence by the end of the word, the QPRT document can give the grantor the right to rent the residence by paying fair market rent once the term ends. Moreover, if the QPRT is designed as a “grantor trust” (see below), by the end of the term, the rent payments will never be subject to income taxes to the QPRT nor to the beneficiaries of the QPRT. Essentially, the rent payments will undoubtedly be tax-free gifts to the beneficiaries of the QPRT – further reducing the grantor’s estate.

The longer the QPRT term, small the gift. However, if the grantor dies during the QPRT term, the residence will be brought back in to the grantor’s estate for estate tax purposes. But since the grantor’s estate may also receive full credit for just about any gift tax exemption applied towards the original gift to the QPRT, the grantor is not any worse off than if no QPRT had been created. Moreover, the grantor can “hedge” against a premature death by creating an irrevocable life insurance coverage trust for the advantage of the QPRT beneficiaries. Thus, if the grantor dies through the QPRT term, the income and estate tax-free insurance proceeds may be used to pay the estate tax on the residence.

The QPRT could be designed as a “grantor trust”. Which means that the grantor is treated because the owner of the QPRT for income tax purposes. Therefore, through the term, all property taxes on the residence will undoubtedly be deductible to the grantor. For exactly the same reason, if the grantor’s primary residence is used in the QPRT, the grantor would be eligible for the $500,000 ($250,000 for single persons) capital gain exclusion if the primary residence were sold through the QPRT term. However, unless each of the sales proceeds are reinvested by the QPRT in another residence within two (2) years of the sale, a portion of any “excess” sales proceeds should be returned to the grantor each year through the remaining term of the QPRT.

A QPRT isn’t without its drawbacks. First, there is the risk mentioned above that the grantor does not survive the set term. Second, a QPRT can be an irrevocable trust – after the residence is positioned in trust there is absolutely no turning back. Ki Residences Singapore Third, the residence will not receive a step-up in tax basis upon the grantor’s death. Instead, the foundation of the residence in the hands of the QPRT beneficiaries is the same as that of the grantor. Fourth, the grantor forfeits all rights to occupy the residence at the end of term unless, as mentioned above, the grantor opts to rent the residence at fair market value. Fifth, the grantor’s $13,000 annual gift tax exclusion ($26,000 for married couples) cannot be used in connection with transfers to a QPRT. Sixth, a QPRT is not an ideal tool to transfer residences to grandchildren because of generation skipping tax implications. Finally, by the end of the QPRT term, the property is “uncapped” for property tax purposes which, based on state law, you could end up increasing property taxes.