If you answered “yes” to both questions, a Qualified Personal Residence Trust (QPRT) could be an effective way to transfer some of your wealth to you children at a reduced transfer tax cost.
A QPRT is a trust designed to hold your primary residence or vacation home for a term of years. During that period, you have the right to reside in the residence. After the end of this retained term, the residence passes to the remainder beneficiaries (typically your children).
How does a QPRT enable you to pass the residence to the remainder beneficiaries at a reduced transfer tax cost? In valuing the gift to the remainder beneficiaries, the IRS subtracts the value of your retained interest from the value of the QPRT residence. The IRS valuation tables assume that a typical beneficiary receives annual trust distributions, which in turn reduce the amount of assets ultimately distributable to the remainder beneficiaries.
However, you will not receive income distributions from the QPRT as long as it holds the residence because the residence typically does not generate income. Accordingly, the IRS tables overvalue the retained interest and thus undervalue gift of the remainder interest. Any appreciation in the value of the residence will escape estate tax at your death if you survive the retained term.
At the end of the retained term, the residence will be owned by the remainder beneficiaries. Paying rent provides an additional tax benefit by allowing you to pass additional wealth to the remainder (children) beneficiaries.
Although the remainder beneficiaries will report the rent payments as income, the income tax rates applicable to the payments may be lower than the gift or estate tax rates if applied to the same payments.
In order for a QPRT to save transfer taxes, you must survive the retained term. If you do not, the entire value of the residence will be included in your estate for Federal estate tax purposes. However, the gift made when the QPRT was created will be ignored and the transaction will be a wash for transfer tax purposes.
If the residence is sold during the retained term, you will report any associates gain (or loss) on your income tax return. Unless the proceeds are reinvested in a new residence, you will receive an annuity (designed to approximate the value of your “income interest” in the QPRT) for the balance of the term. Although the annuity would be disregarded for income taxes, you would report any actual income (interest, dividends, capital gains and etc.) realized by the QPRT on your personal income tax return.
A QPRT is not for everyone. Some people may not be comfortable with their children owning the residence or having to pay rent to their children after the end of the retained term. However, the ability to make a gift of an appreciating asset at a reduced tax cost while not having to give up financial assets may be very attractive to others.
