If you own a residence or a second home and expect to pay federal estate tax and want to pass the property to your children, then you should consider a Qualified Personal Residence Trust (QPRT). You transfer your personal residence or vacation home into the QPRT in exchange for continued rent-free use of the property for a specific number of years (trust term). Assuming you survive the trust term, the residence either passes outright to the beneficiaries of the trust or can remain in trust for their benefit. It is important that you understand that you can continue to use the property once the title has been transferred to the QPRT, but when the term ends you will have to pay rent to the new owners.
A QPRT is valuable because it reduces your taxable estate and freezes the gifted property value so all the appreciation is excluded from your estate. The valuation of this transfer is dependent upon several factors including the trust term, life expectancy of the grantor and the IRS §7520 interest rate for the month of the transfer.
For example if Regina, age 65, on September 15, 2014, transfers her beach home with $1 million market value to a QPRT, she retains the right to use the home for a term of 10 years. Assuming she outlives the 10-year trust term, the house would pass to her three children. The Internal Revenue Code §7520 rate in the month of the gift (September 2014) is 2.2% so the initial taxable gift would be valued at approximately $425,000. So long as Regina’s lifetime taxable gifts have not exceeded $5.34 million which is the 2014 limit, no federal gift tax would be payable, although she would have to file a federal gift tax return. In any event, if Regina survives for the full trust term, the residence will pass to her three children with no additional gift or estate tax inclusion. Assuming the beach home was worth $2.5 million at the end of the 10 year term, Regina would have been able to transfer a $2.5 million beach home to her three children at a transfer tax inclusion of $425,000. Because a QPRT is a future interest gift, the $14,000 annual gift exclusion is not available. However, if Regina does not outlive the ten year trust term then fair market value of the beach home is brought back into her estate while the earlier taxable gift of $425,000 is removed. If the beneficiaries inherit the house before the trust term ends they will get a step up in basis to the fair market value of the property for federal income tax purposes. However, if the beneficiaries sell the house after the trust term they get the grantor’s basis. So if Regina’s basis is $550,000 and the beneficiaries sell the house for $2,500,000, they would have to pay federal income tax on the capital gain of $1,950,000.
After the 10 year trust term Regina could lease the beach home from her three children. Lease payments are another means to benefit heirs without any further gift or estate tax consequences. However, the children would have to pay income tax on the net lease income.
The older you are and the longer the trust term, the smaller the taxable gift. However, you must outlive the trust term. Therefore, your current health and family medical history should be a major focus of QPRT planning. In addition you should ensure the beneficiaries have the same opinion of what to do with the property after the trust term ends. If you have any questions please contact Gregory J. Spadea at 610-521-0604, of Spadea & Associates, LLC in Ridley Park, Pennsylvania.