A qualified personal-residence trust allows you to give your home to your children and avoid estate taxes.

If you are like most people, your residence is the most valuable part of your estate - the concentration of your wealth and the result of appreciation over the years. If you have a second home, lake property or a condominium, it may be at least as valuable as your primary residence. And you probably wish to pass the property on to your heirs without having to liquidate it to pay estate taxes.

If you find yourself in this situation, a qualified personal-residence trust can be a helpful tool in your estate planning. With a properly established QPRT, you can give your home to your children, continue to live in it for a period of time, remove it from your estate and protect the property from estate taxes. The IRS does not require the residence to be your primary residence, only a personal residence.

Another key incentive for the use of the QPRT, or any trust for that matter, is the benefit of continued management of your assets over time. This concept can be very comforting in case of illness or some other form of incapacity over the years.

How it works

Briefly, the QPRT is a form of grantor-retained interest trust. The person establishing the trust (trustor) retains an interest in the trust assets (a residence, in this case) for the term of the trust. If the trustor dies before the end of the term of the trust, the residence will revert back to the trustor's estate to be disposed of in his will or the state's intestacy laws, and no benefits accrue to the estate.

However, if the trustor outlives the term of the trust, the residence will pass to the named beneficiaries and be removed from the estate in its entirety. Outliving the term of the trust does not mean the trustor is out in the cold. The trustor usually continues to live in the residence after the trust ends, paying a reasonable monthly rent to the beneficiaries, who now own the residence. This monthly rental payment also moves additional cash out of the trustor's estate. IRS regulations further permit reasonable amounts of cash for the residence's operating expenses, improvements and even replacement to be paid to the trust to enable the trust to operate over its term.

Does this sound too good to be true? Read on; there is more!

With a QPRT, it all begins with the trustor (i.e., owner of the residence) irrevocably deeding the residence to a trustee for his named beneficiaries, usually one or more of the trustor's children. The trustor must carefully consider how long he wants the trust to last. This is a very important consideration: Too long a term can effectively destroy a trustor's primary tax advantage, i.e., keeping the home out of the estate. Ideally, the trust term should be at least 10 years, but less than your life expectancy.

Tax benefits

Tax considerations are usually the chief motivation behind the QPRT. The most important benefit lies in the concept of the time value of money. Giving away a dollar today is worth more than giving away a dollar tomorrow, due to inflation, appreciation and the earnings that dollar could be making. So by putting your residence in a QPRT now, you are giving away less than if you waited until next year.

The IRS recognizes this concept and allows you to value your taxable gift today based on the estimated future value of the residence and the length of the trust term. The IRS offers charts that help you to determine the future value of your gift, based on the term of the trust and the prevailing federal interest rates.

What does all this mean? Instead of letting your residence pass through your estate and be valued at your date of death, deeding your house to a QPRT today will allow you to be assessed a gift tax at its present value. Basically, you make a completed gift of the residence in trust and remove it from your estate, but you don't transfer it until the trust ends, i.e., at a predetermined future date.

Once the present value of the "future" gift of the residence is established and the residence is placed into the irrevocable trust, a gift tax may be due. You are responsible to pay any gift taxes at the time of creation of the trust.

However, the gift taxes can be taken as a credit against your estate at the time of your death. And if you live at least three years after you pay the gift taxes, the dollar amount of the gift taxes paid also is removed from your estate.

Another tax benefit is the reasonable monthly rent to be paid if you outlive the term of the QPRT. A little caution here would be wise: The IRS will consider what the fair rental value of the residence is and compare it with what you are paying.

If your payment is considerably less, the IRS may see the payment as an additional taxable gift. It is best to overpay on the rent a little rather than underpay.

Let's assume you place a personal residence in a trust under the following circumstances:

  • The present fair-market value of the residence is $500,000;

  • Based upon the IRS tables, the present value of the residence is $126,419;

  • Your projected gift tax rate at death will be 55%;

  • You select a term of 15 years;

  • The current applicable interest rate is 9.6%;

  • The current inflation rate is 3%; and

  • The value of the residence at your death is estimated at $778,984 (3% inflation over 15 years).

Finally, for this example, assume that you outlive the trust term. After all, if you don't, then the trust fails and the fair market value of the residence at your death will be included in your estate, and you will be back to square one. (See table below.)

Without QPRT:
Value of residence at death: $778,984
Estate tax paid on residence: $428,441
Net to beneficiaries after transfer: $350,543
With QPRT:
Value of residence at death: $778,984
Estate taxes paid: 0
Less tax paid on gift [55% of $126,419 ]: $69,530
Net to beneficiaries: $709,454
Net to beneficiaries with QPRT: $709,453
Net to beneficiaries without QPRT: $350,543
Increase in net transfer to beneficiaries with QPRT: $358,910

This increase of almost $359,000 in net transfer doesn't even reflect the added benefit of monthly rent payments after the term of the trust has expired to the beneficiaries. Remember, the rent after the trust terminates is another way to decrease your gross estate.

This example is rather straightforward. You'll need to ask many more questions before you decide if a QPRT is right for you. If you are interested in this concept, contact a qualified estate-tax attorney, who can review your estate, determine how much of it is your residence and provide the legal documents necessary to implement this concept.

A qualified personal-residence trust is an extremely valuable estate-planning tool and can save thousands of dollars in estate taxes. However, be sure the shoe fits, or it will not wear well.