It is not uncommon for someone to transfer their personal residence into a trust. Many people may be familiar with the concept of transferring their personal residence to an irrevocable Medicaid type trust, in order to begin the clock ticking on the five year look back period for transfers for Medicaid eligibility purposes. In other articles I have written, I discussed snowbirds transferring their Florida residences to a revocable trust, in order to avoid an ancillary probate in Florida. However, for people who are not seeking to remove assets from their estate for Medicaid planning purposes, or to avoid having their estate probated in two states, there is another type of trust called a Qualified Personal Residence Trust (“QPRT”).
A QPRT is a type of irrevocable trust that is designed to remove a residence from a person’s taxable estate, while affording them the ability to live in the home for a certain period of time, called the fixed term. The purpose of a QPRT is estate tax planning, by removing a residence from a person’s taxable estate using a portion of that person’s lifetime estate and gift tax exemption. The amount of lifetime estate and gift tax exemption that is used is the value of the property being transferred minus the value of the retained term. The value of the retained term is based on the length of the fixed term of the QPRT and the applicable federal rate (“AFR”)[1] for the month of the transfer. The longer the fixed term and the higher the AFR rate, the less estate and gift tax exemption that will be used during the transfer. So, the shorter the fixed term and the lower the AFR rate the more estate and gift tax exemption used for the transfer.
By way of example, if you transfer a house worth $1 million into a QPRT, with a ten year fixed term, under current AFR rates, approximately 2.09%, you would remove the house from your estate for a value of approximately $820,000, thereby saving $180,000 of your estate and gift tax exemption. The estate tax exemption savings is significant, but since we are in a low interest rate environment, not as significant, as when the AFR rate is much higher. For example, if the AFR rate increased to 5%, the same $1 million home in a QPRT with the same ten year fixed term would only use approximately $614,000 of your estate and gift tax exemption, preserving $386,000 in estate and gift tax exemption for your other assets.
Another estate tax saving to a QPRT is that upon the end of the term, in order to continue to live in and use the property, you must pay fair market rent to the QPRT. At first blush this may seem like a negative, having to pay rent to continue to live in your home, but actually this can be a positive, because the rent payments can serve as a further means to remove asset value from your estate for estate tax purposes, because the rent payments made to the QPRT do not use any portion of your estate and gift tax exemption. Additionally, the rent payments can be used to offset the cost of maintaining the property, such as paying the real estate taxes and homeowner’s insurance on the property. For houses that would have a high fair market value rent, even in a low interest rate environment, a QPRT with a short fixed term can make sense, even though more estate and gift tax exemption may be used to transfer the property into the QPRT than would be used in a high interest rate environment, because the ability to make the monthly rent payments can remove significant value from the estate over time.
Why Would Someone Want to Use a QPRT?
QPRTs primarily make sense if someone is going to have a federal taxable estate. A federal taxable estate is an estate that exceeds the federal estate tax exemption amount. For 2019 the federal estate tax exemption amount is $11.4 million per individual. In 2019 a married couple can transfer double that amount, or $22.8 million. In 2020 the federal estate tax exemption will increase to $11.58 per individual. New York State imposes an estate tax on all persons who’s estate is valued at $5.74 million and in 2020 the New York State estate tax exemption will increase to $5.85 million per individual. Due to the spread between the federal estate tax exemption and the New York State estate tax exemption, and since New York State does not impose a gift tax[2], if a person will have an estate that will not be taxed on the federal level, but will be taxed on the state level, that person can use some of their federal estate tax exemption to completely transfer the house out of their estate, rather than use a QPRT, to get their taxable estate below the New York State threshold. However, if your estate without any planning would be federally taxable, a QPRT is a means to remove a residence (which is typically a higher value asset) from your estate for estate tax purposes, at a reduced value. Additionally, as discussed above, once the fixed term ends, the rent payments to the QPRT serve as an additional means to remove asset value from your estate.
Advantages and Disadvantages of a QPRT
As discussed above, the primary benefit of a QPRT is to remove the value of a residence from your estate for estate tax purposes at a reduced cost. Additionally, the QPRT serves as an estate tax freeze, because the home and any appreciation on the home is removed from your estate for however much estate and gift tax exemption is used at that time. This means that if the value of the property increases, you will not use any more of your estate and gift tax exemption, nor would your estate have to pay estate tax on that appreciation. Additionally, during the fixed term, you can still live in the residence and will continue to receive all property tax benefits.
QPRTs do have some disadvantages. The primary disadvantage is that your beneficiaries will receive the residence you put into the QPRT at your current basis for capital gains purposes. When you purchase a property, typically, the purchase price is your basis in the property. If you sell the property for more than you purchased the property for, typically, a capital gains tax would be due for the difference between the sales price and your basis. The federal capital gains rate tops out at 20%, and New York State taxes capital gains as ordinary income, so the rate tops out at 8.82%. However, upon your passing, your heirs receive a basis “step up” to the fair market value of the property on your date of death. This means that if the property is immediately sold, there would likely not be any capital gains tax owed. If a property is transferred to a QPRT your heirs will not receive the basis step up and therefore would have the same basis as you do in the property and would therefore, likely, owe capital gains tax if the property was immediately sold. The caveat to this is that in order to receive a basis step on an asset, the asset must remain in your taxable estate. If the asset remains in your taxable estate, and your taxable estate is more than your remaining estate tax exemption, your heirs will owe estate tax on the value of the property. The federal estate tax rate is 40% and the New York State estate tax rate tops out at 16%. So, if the house remaining in your taxable estate would cause your estate to be subject to estate tax, it is better to avoid the estate tax and not get the step up in basis, than to get the basis step up avoid the capital gains tax.
Another disadvantage is that you can only create two QPRTs during your lifetime. So, if you have multiple residences, you can only transfer your primary residence and one vacation home to a QPRT. Also, each QPRT can only hold an interest in one property. So, if you were to transfer your primary residence and a vacation property, you would need to establish two separate QPRTs.
What Happens If I Die During the Fixed Term?
As stated above, the longer the fixed term the less estate and gift tax exemption used during the transfer. So, why not make the fixed term as long as possible? Because, if you die during the fixed term, the IRS completely undoes the transaction and the value of the residence will be included in your estate at its full fair market value. So, in order for the QPRT to work, you must survive the fixed term.
A QPRT can be an effective tool in estate tax planning. The estate planning attorneys at Twomey, Latham, Shea, Kelley, Dubin & Quartararo routinely advise clients on the intricacies of entering into a QPRT, managing the QPRT after the end of the term, and regularly draft and execute QPRTs for personal residences and vacation homes. The estate planning attorneys at Twomey, Latham, Shea, Kelley, Dubin & Quartararo are available at your convenience to answer your questions, review your current estate plan in conjunction with your assets, and advise on whether a QPRT is right for your estate plan.
[1] The AFR rate is a rate set by the IRS each month, the purpose of which is to serve as the minimal interest rate that the IRS will allow for private loans, without imposing imputed interest to the lender. The IRS sets three AFR rates each month, a short term, a midterm and a long term rate. The short term rate is for loans three years or less. The midterm rate is for loans longer that three years and shorter than nine years. The long term rate is for loans greater than nine years. For the purposes of a QPRT, whether to use the short term, midterm or long term AFR rate will be based on the length of the fixed term.
[2] New York State does not have a gift tax, however, New York State will “claw back” the value of any gifts made within three years of a person’s death.
