Q: I read an interesting article in the New York Times about a Qualified Personal Residence Trust. Can you discuss it?
A: Because real estate continues to increase in value, it is not unusual for the family home to be worth three hundred thousand here in Northern Colorado and a million dollars or more in places like California or in cities such as New York. In the future if appreciation continues, the value could double every six to eight years.
After 2011 when the Federal Estate Tax exemption drops back to $1,000,000, the value of the family home could absorb or exceed the estate tax exemption and expose the overall estate to taxation if the family home was still part of the taxable estate.
Thus some type of defensive estate tax planning strategy seems to be desirable. Enter the Qualified Personal Residence Trust (QPRT). It can be set up for a term of years, such as five, or ten, or fifteen. The home is transferred into a trust and thereafter the former owner can continue to live in the home. But after the QPRT term ends, title to the house (along with the appreciation) shifts from the trust to the children and the value of the home plus the appreciation moves out of the taxable estate of Mom and Dad.
Pretty neat, huh? Not so fast. Despite the hype, it seems very few QPRTs are being put in place because such a trust really is not for everyone but only for a very limited and select estate planning clientele.
The assumption is that the $1,000,000 exemption will still be in place in 2011, so we must do something now to keep the house appreciation over the next five years from pushing the estate into taxable territory in 2011. First, it is likely that there will be some type of adjustment in the estate tax laws, such as moving the exemption from $1,000,000 up to $3,000,000 or $5,000,000. But remember with a couple’s marital deduction, along with other current estate planning techniques, the threshold of tax exposure right now is a great deal above $1,000,000 anyway (for a couple $5,000,000 or more). Also note that the value of the home will not be completely removed. The "retained interest," whose amount depends on various calculations, will still be included in calculating estate taxes of the transferor even after the trust ends and title is placed in the name of the children.
There are other problems associated with this estate planning tool. If the creator or creators die before the trust ends, the full appreciated value of the transferred property at date of death will be added back to the estate’s taxable amount. If the creator or creators of the trust live beyond the trust term, they then must move or start paying fair market rent.
The children will thereafter own the house but for capital gains purposes must use the parents’ original basis (what Mom and Dad paid for the house), so stepped-up basis through inheritance is lost. Also unless lease arrangements were put in place when setting up the trust, the children (or one of the children) can force the sale of the house, evict Mom and /or Dad, or lose his or her part of the property through a divorce settlement, judgment, creditor, bankruptcy, etc. The existence of a lease after the trust ends means Mom and Dad must pay rent. Such a lease will also tie up the property for the children if sale of the house becomes necessary, and cause the children increased income tax exposure because they have to report rent as income.
This arrangement also means that the $250,000/ $500,000 capital gains exemption is lost for the sale of one’s principal residence. The right to tap the house equity through a reverse mortgage is also given up, thus eliminating a significant financial liquidity safety net if later needed.
I have used a QPRT in my planning for clients, but for only for a handful of people whose estate’s were well above $1,000,000 and who had unique factors making the use of a QPRT desirable.
But for the vast majority of us, even with housing values continuing to shoot upwards, we should plan our estates for the present, building in flexibility so as the law and/or personal circumstances change, the plan can be adjusted to continue to have a tax-free estate. Otherwise we can find our "tax feet" stuck in a 2006 cement container that is no longer relevant and may even be detrimental, much like those irrevocable real estate and other types of 1980’s and 1990’s era trusts.