I am often asked, what is a safe planning technique an individual can do regarding transferring assets to their heirs? Since the family residence is one of their major assets, it is not surprising that transferring it to a special trust can lead to major benefits for all parties. The reason for this is legislation enacted by Congress that has approved this planning. This planning still works in 2010 even though estate tax this year but the gift tax is still around. In 2011 the estate tax returns under current law.
I have gone through estate tax audits with the IRS and a qualified personal residence trust is easily approved, if (i) there has been proper valuation of the residence at the time of transfer and (ii) the parent(s) follows the planning discussed below. Often, I only transfer a 50% interest in the residence which is permitted by IRS regulations. This helps when the parent(s) still wants to retain their separate interest in the residence. The parent can also transfer a vacation home under this type of planning. The IRS limits this planning to only two residences. Since this planning is done mostly between parent and child, at the end of the fixed term there will be no increase in property taxes!
A special kind of irrevocable trust can be used to transfer your residence to your children at a significantly reduced gift tax cost and with no estate tax, yet allow you to continue to live in the residence for as long as you wish. This special type of trust is known as a qualified personal residence trust (“QPRT”). (QPRTs are sometimes also referred to as “residence GRITs” or “house GRITs”.) You do not have to transfer your entire interest in the family residence. Here’s how it works:
Trust for Fixed Term. During your lifetime, you transfer your residence to the trustee, who (if state law permits like California) can be yourself. The trustee must allow you to continue to use the residence rent-free for a fixed number of years specified in the trust instrument (the “fixed term”), which should be a term you are likely to survive. During the fixed term, you will continue to pay mortgage expenses, real estate taxes, insurance, and expenses for maintenance and repairs, and will continue to deduct mortgage interest and real estate taxes on your individual income tax return. When the fixed term ends, the residence is distributed to your children, or remains in further trust for them.
There are three major advantages for this type of planning. They are:
Maintenance After Fixed Term.
Even after the fixed term ends, you can continue to use the residence in one of two ways. First, rather than immediately distributing the residence to your children, the residence can be retained in trust for your spouse’s lifetime, thus assuring that the residence is available to you. Second, you can enter into a lease with your children which will allow you to live in the residence for as long as you wish. (If you do so, however, you must pay fair market value rent to your children after the fixed term ends in order to keep the residence from being subject to estate tax on your death.)
If you survive the fixed term of the QPRT, the value of the residence will not be included in your estate for estate tax purposes. Even if you don’t survive the fixed term, the estate tax consequences will be no worse than they would have been if you hadn’t created the trust in the first place. Even though federal tax legislation enacted in 2001 repeals the estate tax, the repeal is not effective until 2010.
Reduction Of Transfer Tax Upon Initial Transfer.
A QPRT can significantly reduce transfer taxes upon the initial transfer of the residence. It is in the interest of the parent in any gratuitous transfer of property to reduce the value of the transferred property in order to reduce the applicable transfer taxes. One primary way a parent can do this is to transfer a future interest in the property while retaining a present interest. The value of the interest in property transferred in such a situation is often far less than the overall value of the property itself. For instance, if a 75-year-old parent transfers his $2 million home to his children, he has made a gift of $2 million. If, however, he gives them a remainder interest in a trust containing his $2 million home while retaining a seven-year term interest, the value of the taxable gift is only approximately $1.4 million.
Use of a QPRT as an estate freezing device. A second advantage of a QPRT is that it acts as an estate freezing device. Once a QPRT is created, the gift is complete. As a result, the value of the residence and all future appreciation on the residence have been removed from the transferor’s estate (unless, as noted above, the property is included in the transferor’s estate upon his death during the QPRT term).
For instance, suppose that a 60-year-old parent owns a $1 million home that is appreciating 7% annually. If he dies ten years later, the value of the home at that time will be approximately $2 million, representing a major asset of his estate. If he sets up a ten-year QPRT when he is age 60, the value of the taxable gift is only approximately $500,000 and his home is removed from his taxable estate. His beneficiaries now hold a remainder interest in an asset that will eventually appreciate to $2 million, while he has paid gift tax on a transferred interest worth only $500,000. Thus, the estate freezing effect of a QPRT can be of great economic advantage to a parent.
Asset Protection Advantages.
A QPRT also has limited asset protection advantages, although it is a self-settled trust. Generally, a self-settled trust is afforded little or no asset protection, since doing so would allow an individual to avoid creditors simply by placing his assets in a self-settled trust.
A settlor’s (the person who created the trust) creditors can reach trust assets to the extent such assets could be used for the settlor’s benefit. Consequently, the term interest retained by the settlor of a QPRT is subject to his creditors’ claims. But the term interest of the QPRT is a far less attractive asset to creditors than is a residence owned in fee simple. Nonetheless, the term interest is afforded little to no asset protection.
In contrast, any interest in a self-settled trust not retained by the settlor is afforded asset protection, as long as no fraudulent transfer is involved. Therefore, the remainder interest in QPRT, which would often be held by the settlor’s children, would typically be protected from the creditors of the settlor. (This assumes the absence of a fraudulent transfer, which would negate any otherwise applicable asset protection advantages that the remainder interest might carry. In sum, the QPRT does afford some measure of asset protection, adding to its attractiveness as a wealth transfer device.
The QPRT is a planning technique a parent should consider for the transfer of either the entire or partial interest of their residence. Proper valuation must be done at the time of the transfer and following the rules after the fixed term ends, in order to achieve the desired results.
About the author
D. Michael Trainotti has a general tax practice in Long Beach which emphasizes real estate, closely held businesses and estate planning matters. He has a master’s degree in taxation and is a member of the tax sections of the State Bar of California dealing with real estate, pass-through entities and estate planning. He is also a member of the same tax sections of the Los Angeles County Bar Association and the American Bar Association. Mr. Trainotti would be pleased to hear from you regarding future topics of interest or comments on this article. Please contact him directly at his office at (562) 590-8621 or by e-mail at firstname.lastname@example.org. You can also visit his website at http://www.trainotti.com