Trusts & Estates
March 24, 2022
Leveraging the Federal Gift and Estate Tax Exemption Through a Qualified Personal Residence Trust
A qualified personal residence trust (QPRT) offers homeowners with taxable estates the opportunity to leverage their federal gift and estate tax exemption by transferring their primary or vacation home to children and descendants to keep in the family for long-term use and enjoyment.
What is a QPRT?
A QPRT is an irrevocable trust by which you, as the grantor, transfer ownership of your home while retaining the right to live there for a specified number of years. When that term of years expires, ownership of the home passes to the remainder beneficiaries outright or in continued trust. You may continue to live in the house after the expiration of the term, but you must enter into a formal written lease and pay fair market value rent to the new owner.
The key is that you must survive the term of years to benefit from the QPRT. You may ask if a shorter term would be best; however, the shorter the term of years, the larger the gift to the remainder beneficiaries and the smaller the tax savings. You must find the right balance, taking your age and health into consideration. If you die before the term ends, the home will be included in your estate for estate tax purposes as it would have been had you not created the QPRT. In that case, the downside is the cost of drafting and setting up the QPRT.
You may also want to consider splitting the home between you and your spouse so there are two owners and two QPRTs. If one spouse fails to survive the term, at least half of the benefits can still be achieved through the surviving spouse’s QPRT. Moreover, this enables each spouse to take advantage of a fractional interest discount on the value of his or her partial ownership interest, increasing the efficiency of the use of gift and estate tax exemption.
A note on the Section 7520 rate
With a QPRT, the grantor gifts a personal home for a term of years, and the value of the gift is discounted for gift tax purposes using the Section 7520 rate set by the IRS each month (in March 2022, the rate is 2%). The Section 7520 rate is used in calculating the value of the gift of the residence and contributes to a favorable tax outcome. The higher the federal rate, the lower the gift value — and the lower the gift and estate tax credit used on the transfer of the home into the QPRT. Conversely, a low federal interest rate translates into lower gift tax savings. Nevertheless, the ability to discount the value of the gift of the home, however minimally, will always be more advantageous than making an outright gift.
The 7520 rate is to be used to value certain charitable interests in trusts. Pursuant to Internal Revenue Code 7520, the interest rate for a particular month is the rate that is 120% of the applicable federal midterm rate (compounded annually) for the month in which the valuation date falls. That rate is then rounded to the nearest two-tenths of 1%.
When a home is transferred into a QPRT, a gift is made to the remainder beneficiaries that is subject to gift tax or that uses up a portion of the gift and estate tax exemption, and a gift tax return must be filed. Typically, transfer tax is assessed on a gift’s fair market value at the time of the gift. However, in this case the value of the taxable gift isn’t the full fair market value of the home, as it would be with an outright transfer. Rather, the value of the gift is effectively discounted to reflect the retained interest for the term of the trust, that is, your right to live in the home for a period of time. The beneficiary must wait to receive the home, and the amount of your gift to them is the present value of the remainder interest in the trust. IRS tables and current interest rates are used to determine the amount of the discount.
Moreover, provided the donor survives the term of years, the value of the home, plus any appreciation, will completely avoid estate tax because the home will have been removed from the donor’s estate.
A QPRT is a grantor trust used for income tax purposes. This means that during the trust term, the grantor can claim an income tax deduction for real estate taxes paid to the full extent permitted under current tax law. (Be sure to check local law. In certain jurisdictions that provide property tax exemptions or homestead exemptions, the transfer to a QPRT might cause loss of the exemption.) The value of the home is essentially frozen for gift and estate tax purposes at the time the trust is created, potentially resulting in significant estate tax savings on the appreciation of the home had it not been transferred into the QPRT.
Downside to a QRPT
There is a significant downside to the QRPT, however. When beneficiaries receive property upon the owner’s death, under current tax law they generally receive an income tax cost basis that is stepped up to fair market value. However, because a home transferred to a QPRT is a gift in trust, the remainder beneficiaries receive an income tax cost basis equal to the donor’s cost basis at the time of the gift (carryover basis) instead. If the home has appreciated substantially in value, the increased capital gains tax that the remainder beneficiaries could owe upon the sale of the home may reduce, or even offset, any gift and estate tax savings. If the home is intended to be preserved for use by future generations of your family for years to come, this is less of a concern.
If you’re interested in creating a QRPT, consult your Glenmede Relationship Management team.
This presentation is intended to provide a review of issues or topics of possible interest to Glenmede Trust Company clients and friends and is not intended as investment, tax or legal advice. It contains Glenmede’s opinions, which may change after the date of publication. Information obtained from third-party sources is assumed reliable but is not verified. No outcome, including performance or tax consequences, is guaranteed, due to various risks and uncertainties. Clients are encouraged to discuss anything they see here of interest with their tax advisor, attorney or Glenmede Relationship Manager.