Even in these days following the real estate property value decline, most families’ primary asset remains the family home. Protecting the family home from potential creditors and avoiding paying estate tax on the family home when it goes to the next generation is a primary goal of many home owners.
A relatively recent tool increasingly used is a type of irrevocable trust common called the Qualified Personal Residence Trust which essentially transfers the home into a trust which allows the home owner to remain in the home for life while ownership is in the Trust and eventually goes to the next generation or whomever the home owner desires. See our article on Wills and Trusts for a general description of trusts.
A qualified personal residence trust ("QPRT") is provided for in Internal Revenue Service regulations. It should not be confused with a Revocable Intervivos Trust (a "Living Trust" or “QTIP”). A QPRT takes advantage of certain provisions of the law to allow a gift to the QPRT by its creator or "Settlor") of the personal residence, often for the ultimate benefit of children, at a "discounted" value. This can remove the asset from the Settlor's estate, reducing potential estate taxes upon the Settlor's death. If a trust adheres to the requirements in the regulations, it would not be subject to certain special valuation provisions of Internal Revenue Code which limit such discounts, and the retained and remainder interests will be valued under traditional gift tax valuation rules at a lower rate.
Further, creditors of the Settlor (and beneficiaries) will have a difficult if not impossible time seeking to attach the asset, especially if the home was transferred a significant period of time before the judgment accrued.
There are some disadvantages and certain requirements, which are discussed in this article.
The Basic Structure:
When creating a QPRT, the “Settlor” is the original owner of the residence and creates the trust, reserving the right to live in the house for a specified period of time. This interest is called the “Retained Interest” in the asset. At the end of that period, the ownership of the residence goes to the beneficiary or beneficiaries. This interest is called the “Remainder Interest.” If the Settlor is still alive after the vesting and wishes to keep living in the home, he or she executes a lease with the beneficiaries who are now the owners and remains living there paying rent. The lease can be made when the trust is first created so that the Settlor knows that no matter what, he or she may continue to live in the home.
The effect is to transfer ownership of the home away from the Settlor to the Trust and ultimately to the Remainder Beneficiaries yet give the Settlor the right to live in the home and achieve possible tax benefits and avoid the ability of creditors of the Settlor to seize the home.
A QPRT can reduce the overall transfer tax cost -- that is, estate and gift tax cost -- of the transfer. For gift tax purposes, the original transfer will be treated as a gift of the remainder to the Remainder Beneficiaries (for example, the children) and the Settlor must file a gift tax return at the time the residence is transferred to the trust. The value of the remainder for gift tax purposes is derived by first determining the fair market value of the entire property, and then subtracting the value of the retained interest. The value of the retained interest is a function of the length of the trust term, calculated in conjunction with interest rates published by the IRS for making present value calculations (Applicable Federal Rate ("AFR") IRC Section 7520).
Usually, the longer the term of the trust, the larger the value of the retained interest, the smaller the value of the remainder, and the smaller the taxable gift for gift tax purposes. The amount of gift tax due will usually be offset by the Settlor's unified credit so there frequently will not be any out of pocket payment, but the Settlor's credit (against future taxable gifts or estate tax) will of course be reduced. Beginning in 2011, the gift tax exemption is five million dollars, so most homes will not result in gift tax liability under the current gift tax regime when transferred into the trust.
A fractional interest -- that is, less than 100% -- of the home can be gifted to the QPRT in the event that the value of the home, term of the trust and applicable interest rates result in a taxable gift in excess of the lifetime transfer exclusion.
The Term of the Trust and the Tax "Bet":
If the Settlor dies before the trust has terminated, the residence will be included in his or her taxable estate, and estate tax will be paid on it, because the Settlor retained the use of the property for a period that did not end before his or her death. That is, the tax benefit purpose of the trust will have been defeated.
If the Settlor does not die during the trust term, however, the property will be distributed to the Remainder Beneficiaries without further transfer tax. As mentioned above, when the trust term is relatively long, the value of the gift to the remainder beneficiaries will be relatively low, and the gift tax cost of transferring the residence to the trust will be correspondingly low. In contrast, when the trust term is relatively short, the value of the gift to the Remainder Beneficiaries will be relatively high and the gift tax cost of transferring the residence to the trust will also be high.
In theory, a QPRT will afford the greatest transfer tax savings when the Settlor is young and the trust term is long. For a elderly Settlor, the risk of death before expiration of the trust term is greater and has to be weighed against the expenses of creation and administration of the trust, as well as the loss of stepped up basis, discussed below, and the loss of alternative strategies such as annual exclusion gifts of interests in the property to those who would otherwise be remainder beneficiaries.
Potential Tax Savings:
The calculations involved in determining the valuation of the gift are complex and a good CPA is required to advise. As an example, if the term of the trust was set at five years, it is likely that the value of the gift would be about two thirds of the value of the property, and the gift tax would probably be about 40% of that. If, on the other hand, the trust term were set at ten years, the value of the gift would be closer to 40% of the present value, and the gift tax would be about 40% of that. The obvious disadvantage with the longer term is that it reduces the likelihood that the Settlor will outlive the trust term; that is, it increases the chance that none of the hoped-for tax benefits of the trust will be realized. The longer term also increases the likelihood of substantial market appreciation, i.e., a large trade-off of capital gains tax savings for transfer (estate and gift) tax savings.
Loss of Capital Gains Tax Savings the Tradeoff:
The effects of a carry-over income tax basis must also be considered. This concerns the income tax liability to the remainder beneficiaries if they sell the residence either following the Settlor's death or following termination of the trust. If they were children of the Settlor, for example, and were to take the residence by inheritance, it would have an income tax basis "stepped up" to its value as of the date of the parent's death. On the other hand, if the QPRT "bet" succeeds, i.e., if the Settlor outlives the trust term and the children take the remainder under the terms of the trust, their basis will be the same as the Settlor's. They would get no stepped up basis. If there is substantial market appreciation over the price the Settlor paid, the increased capital gains tax may well offset the lower gift tax achieved by the QPRT.
Permanence:
Recall that a QPRT is an irrevocable trust. Unless the trust ceases to qualify as a qualified personal residence trust, the Settlor cannot expect to regain ownership of the residence, and when the trust term expires according to the provisions of the trust instrument, the residence will automatically pass to the Remainder Beneficiaries. After expiration of the trust term the residence may be unavailable to the Settlor either as a residence or as an asset that can be sold if financially necessary. A lease could be created to have Settlor remain in possession but it is important to realize that the property is thereafter owned by the Remainder Beneficiaries.
Administrative Burden and Expense:
Because the trust is irrevocable, it must keep its own books and file annual federal and state income tax returns. The expense and bookkeeping should be considered.
Effect on Property Tax (California):
The property tax benefits of Proposition 13 will not be lost when the residence is transferred to children through the medium of a trust. Further, the original transfer of the residence to the QPRT does not require any reassessment of taxes under Proposition 13, as no "change in ownership" will have occurred for Proposition 13 purposes as long as the Settlor retains the right to use and occupy the residence.
Use of Premises Upon Distribution from Trust:
The Settlor may be required to leave the personal residence when it is distributed, at the end of the trust term, to the remainder beneficiaries, although they may also permit the Settlor to remain and pay rent for its use. It may be tax risky to enter into a lease arrangement before the end of the original trust term since if, before the residence is transferred to the trust, there is any lease arrangement, whether formal or informal, that the Settlor will not in fact lose the use of the residence on expiration of the trust term, but will have some right to remain in the residence beyond that time, it is possible that the trust might not be recognized as a QPRT by the IRS and the tax advantages of the trust would be totally lost. There is little law on this subject and most people consider the risk worth taking.
Sale from the Trust; Capital Gain Exclusion:
If the residence is sold from the QPRT during the trust's term it can be replaced with another residence. If it is not replaced, the proceeds are returned to the Settlor or the trust may be converted into a "Grantor Retained Annuity Trust" (GRAT) which makes periodic payments to the original owner. Note that because the QPRT is considered a "grantor trust" it can take advantage of the Settlor’s capital gains exclusion ($250,000 per person).
Creditor Protection:
Although the question is complicated and dependent upon a number of factors which would have to be analyzed for each situation, including the length of time between the creation of the QPRT and a creditor's attempt to reach its assets, a QPRT will furnish a degree of protection from the Settlor’s creditors. Put simply, the Settlor no longer owns the home and while the Settlor may have a right to live there, that is a right difficult if not impossible to attach. The creditor would have to seek relief based on the theory of a Transfer to Defraud Creditors and if the right steps are taken in the creation of the Trust, that would be a difficult claim to make.
The Usual Process to Create the Structure:
A good attorney and CPA is required to maximize the chances for a successful structure capable of achieving the tax and creditor protection results. This is not a task for preprinted forms or the amateur. The steps, however, are not complicated.
1. Step One – Consult with CPA and Legal Counsel and Draft and Execute the QPRT Trust Agreement. The first step in establishing a QPRT is drafting and executing an appropriate trust agreement. The identity of the trustees, beneficiaries and successor trustees will have to be decided, and further decisions involve, how long you want to retain the right to live in the residence before it passes to the Remainder Beneficiaries, and then who will be the ultimate beneficiaries of the trust when the you are deceased or the time of the Trust ends. These decisions are critical since the QPRT is an irrevocable trust and its provisions cannot be easily changed. The Trust must be notarized.
2. Step Two - Fund the Trust with the Residence. The next step is to transfer ownership of the residence into the name of the QPRT. This is done by recording a new deed from your name into the name of the trust in the Recorder’s office.
3. Step Three - Obtain an Appraisal of the Residence for Gift Tax Purposes and Involve the CPA. The next step is to obtain an appraisal of the residence as of the date of the transfer into the name of the QPRT. This is necessary to establish the fair market value of the property for gift tax purposes. At this point, a CPA is again required to review the tax position of both the Settlor and the Remainder Beneficiaries.
4. Step Four - Report The Transfer to the IRS. The next step is to file a Form 709, United States Return, with the IRS, which will be due on April 15 of the year after the transfer the residence into the QPRT. This is necessary because the transfer of the residence into the QPRT is deemed to be a gift to the ultimate beneficiaries of the trust for federal gift tax purposes.
5. Step Five – Continue Living in and Taking Care of all Costs of the Residence. During the retained income period of the QPRT, you'll go about your home ownership activities as usual. This means that you'll be able to continue to live in the residence rent free and take all appropriate income tax deductions. And you'll also be required to maintain and repair the property for the benefit of the ultimate beneficiaries of the QPRT.
6. Step Six – The Trustee Files Requisite Tax Returns and Maintains Bookkeeping Records. During the period of the Trust, separate accounting records and tax returns will have to be filed for the irrevocable trust. The CPA should be able to easily do that task.
7. Step Seven – At the End of the Trust Period, Transfer Ownership of the Residence to the Ultimate Beneficiaries. When the retained income period ends, the trustee of the QPRT must transfer ownership of the residence from the name of the trust into the names of your ultimate trust beneficiaries. This is done by recording a new deed from the name of the trust into the names of the trust beneficiaries in the land records where the property is located.
8. Step Eight - Pay Fair Market Rental After the End of the Trust. Once the retained income period ends, it may be necessary to pay fair market rent if you want to continue to live in the residence full time or if you want to use it at times. Payment of rent will help to further reduce the value of the taxable estate and pass more of your assets on to your ultimate beneficiaries without using any more of your gift tax exclusion since the rent payments won't be considered gifts to your beneficiary.
Conclusion:
The twin benefits of avoiding estate tax and protection from creditors make this a useful tool, especially with the current estate and gift tax regime which allows a five million dollar exemption. This increase in exemption under the recent law puts the majority of homes in the United States into the category of being available for transfer without immediate payment of gift tax.
But the process is not for everyone. The cost of creating and maintaining the Trust, the fact that the home is transferred now and the transfer is irrevocable, and the loss of the capital gains stepped up basis are factors that have to be considered and advice from competent professionals is vital.
That said, the saving in estate tax may be worth hundreds of thousands of dollars and the protection from creditors may be of even greater value. It is a tool well worth considering.