Many individuals may overlook the potential estate tax consequences of owning a valuable primary residence or vacation property. Without proper planning, these assets could significantly increase the value of the individual’s taxable estate and result in higher estate taxes upon death.

What is a Qualified Personal Residence Trust?

A Qualified Personal Residence Trust (“QPRT”) is an irrevocable trust which allows the Settlor to remove a primary residence or vacation residence from the Settlor’s taxable estate at a discounted value.

How Does A QPRT Work?

The Settlor determines the term of years the QPRT will last, which should be a number the Settlor expects to survive, but long enough to result in a substantial discount for a future interest, and then transfers their residence to the QPRT. A Settlor may hold two, but not more than two, separate residences in a separate QPRT. Many clients may consider this planning with a primary residence and a vacation residence. Clients may choose to create two (2) QPRTs to own a residence to create greater discounts.

During the term, the Settlor would retain the right to use and occupy the residence. Once the term expires, the property belongs to the remainder beneficiaries of the trust (typically the children of the Settlor or a continuing trust for the children of the Settlor). If the Settlor dies prior to the termination of the term, the property will revert to the Settlor’s taxable estate.

Upon the expiration of the term, the Settlor may continue to reside at the property, but the Settlor will need to pay fair market rent to the trust. The trust remainder beneficiaries become the landlord of the property, while the Settlor becomes the tenant.

How Would This Affect My Taxes?

The estate planning goal of this strategy is to gift the value and future appreciation of the Settlor’s estate at a discounted value.

Estate Taxes

If the Settlor dies before the term expires, the full fair market value (“FMV”) of the property will revert to the Settlor’s taxable estate. There would be no transfer tax savings in this scenario.

If the Settlor survives the term, the property is removed from the Settlor’s taxable estate at a discounted value. Since the Settlor only gifts a future interest in the property to the trust’s remainder beneficiaries, the value of the property for gift tax reporting purposes is lower than its FMV. The reduced value on the gift tax return will be determined by the term of years, the FMV of the property at the time of transfer, the age of the Settlor, and the Applicable Federal Rate (“AFR”) at the time of the transfer. It is also important to note when the AFR increases, the value of the right to remain on the property increases as well, which creates a greater discount as the higher value of the right to remain on the property is subtracted from the FMV of the property.

For example, on December 15, 2022, you and your partner each decide to gift your half ownership (50%) of your $1,000,000 residence to a QPRT. You decide your QPRT will be for a term of 5 years because you are a 60 year old who feels confident you can survive this term. Your partner, also 60 years old, is more optimistic and decides to retain a term of 15 years, expecting to live until age 75. Ordinarily, each half owner’s gift of real property worth $500,000 will be valued at $500,000 for gift tax purposes. However, the IRS permits discounts in the value of a gift for lack of marketability since owning only half of a property is less desirable than owning the entire property. Based on recent tax court cases, a 10% discount may be appropriate. If you and your partner assume a 10% discount for a fractional interest in your residence (10% of 500,000 = $50,000), you and your partner would each transfer a value of $450,000 ($500,000- $50,000 = $450,000) to each QPRT.

But wait, there’s more! Since only the remainder interest in the property is considered a gift to the remainder beneficiaries of the QPRTs, we may take further discounts in the amount of the gift by the retained term of years. In this example, you retained a term of 5 years and your partner retained a term of 15 years. If December’s AFR is 5.20%, then your taxable gift is valued at $364,260 and your partner’s taxable gift is valued at $172,275. If both you and your partner survive your QPRT terms, you will have removed a total of $1,000,000 from your taxable estate (the value of the property) at a gift tax value of $536,535 (the sum of your partner’s and your taxable gifts).

Income Tax

During the term, the Settlor will be treated as the owner of the property transferred to the QPRT. As a result, all items of income, gains, losses and deductions would be reported by the Settlor on their individual income tax return.

One drawback to this strategy is there would be no step-up in basis of the property after the Settlor’s death because the property is not included in the Settlor’s estate. Therefore, the remainder beneficiaries may have to pay capital gain tax on the difference between the Settlor’s original purchase price of the residence plus capital improvements (cost basis) and the sale. This potential income basis issue should be considered in relation to the estate taxes which may be saved by avoiding inclusion of the property in the Settlor’s taxable estate.

Conclusion

Generally, a person considers their residence a long-term investment. By gifting your residence to a QPRT, you can gift a significant asset out of your taxable estate at a discount for the benefit of your descendants or other beneficiaries. If you are interested in discussing this or similar estate planning strategies, please contact Taylor Ferrara, or any of the other trust and estate attorneys in the Private Client Services Practice at Wilchins Cosentino & Novins LLP. We welcome the opportunity to assist you with estate and tax planning strategies.

This article is not legal advice and should not be taken as such or relied upon as legal advice.