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Qualified personal residence trusts

By Emanuel V. DiNatale, CPA

In 1990, the U.S. Congress passed legislation that opened an unusually generous opportunity for people who want to minimize the impact of estate taxes on children or other heirs by making a pre-death gift of their residences. Called the Qualified Personal Residence Trust (QPRT), this estate planning tool is an excellent means for individuals with large estates to transfer assets at the lowest possible values.

The QPRT legislation was drafted because Congress wanted to ensure that a family residence could pass to the heirs without forcing a sale of the residence to pay the estate taxes on the property. In most instances, if a person makes a gift in which he or she retains some benefit, the gift is either not considered to have been made for estate tax purposes, or the gift is valued at full fair market value, even though the person receiving the gift does not have full possession of it because the gift is subject to the retained benefit.

To achieve its goal of protecting personal residences from forced estate tax sales, Congress allowed an exception to these general rules. In consideration of the retained interest, the exception allows a reduction in the fair market value of the residence when calculating the value of the gift.

For example, without this exception, a gift of a residence worth $100,000 and subject to the right of the donor to live in the residence for 15 years would be valued at $100,000 for gift tax purposes. However, with the passage of this law, the same $100,000 gift of the residence made in January 1999 would be valued at only $29,959 for gift tax purposes.

The benefit of this tax law comes with conditions. To receive the benefit, the donor must outlive the term chosen to use the residence. If the donor does not outlive the term, the gift must be treated as if it was not originally made for estate and gift tax purposes. Therefore, the residence will be included in the estate. The estate, however, will receive credit for any gift tax paid, which means that the only downside is the lost opportunity of making a completed gift.

There is another new condition under the law. If the donor decides at the end of the term that he or she wants to repurchase the residence, the heir will have to pay income tax on the sale if there is a taxable gain. Consequently, the donor may want to rent the property from the heir instead of repurchasing it. Renting will also transfer funds from the donor’s estate, because the rents are not subject to gift tax.

The mechanics of establishing a QPRT are comparatively simple. The residence is transferred to a trust that names the persons who are to receive the residence at the end of the stated term, usually a child or children of the donor. The donor is the trustee and maintains control of the trust and the residence during the selected term. The donor is still considered the owner for income tax purposes and gets to take the income tax deductions related to the property. He or she also receives the tax benefits associated with the sale of a principal residence.

Take a 58-year-old man who owns a home valued at $200,000. He wants to leave it to his daughter, but he doesn’t want the estate taxes to be so heavy that she will have to sell the house to pay them. After consulting with his estate-planning attorney and his accountant, he transfers his home to a QPRT for 15 years, with his daughter as beneficiary. He continues to live in the home, maintain the property, pay the taxes and the mortgage, and deduct the tax and mortgage-interest payments from his income tax.

The transfer is a taxable gift, but the taxable value of the gift is $59,418, so the daughter only lists $59,418 as taxable income. Moreover, the QPRT “freezes” the value of the house at that level, so an increase in the house’s value will not affect the gift tax.

After 15 years, the residence becomes the property of the daughter, and she owes no taxes on the gift, even if the value has gone up substantially. If the father wants to keep living in the house, he can arrange to rent it from his daughter.

QPRTs can also be used for vacation or second homes. Let’s apply the above example to a vacation condo at a mountain resort. The donor and his daughter would get many of the same benefits, except that the tax benefits of selling a principal residence would not apply.

In both examples, if the father were to die before the end of the 15-year term, the house or condo would be considered part of his estate. However, any gift taxes that had been paid would be credited to the estate.

A single taxpayer can use a QPRT for two qualified residences. A married couple thus can make gifts of four residences. A QPRT is an excellent estate tool for the transfer of vacation homes and for people with taxable estates who don’t want to transfer income-producing property but are willing to transfer a house which does not produce revenue.

A word of warning: there have been discussions in Congress and the Executive Branch about eliminating the QPRT exception. So far, Congress has not shown any desire to do so. Nevertheless, taxpayers who want to benefit from this estate planning vehicle should act now, in case the government decides to takes it away.

Emanuel V. DiNatale, CPA, Shareholder, is director of the Estate Planning Group of Alpern, Rosenthal and Company, Pittsburgh’s largest independently owned accounting firm.

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