The generous $5.12 million gift tax exemption for single filers and $10.24 million for joint filers, is scheduled to revert to $1 million and $2 million, respectively in 2013. It’s true that Congress may decide to temporarily extend the current gift tax exemption through 2013, since we’re in an election year, but we expect it to eventually be reduced within the next couple of years. This pending tax change coupled with a depressed real estate market, offers homeowners a compelling opportunity to transfer property to a trust for significant tax benefits.
How a qualified principal residence trust (QPRT) works
This an irrevocable trust that allows a homeowner to transfer their principal residence (or vacation home) to a QPRT at a discounted value for the ultimate tax benefit of their beneficiaries. The homeowner, which is also known as the settlor, can continue to live in the home during the term of the trust while maintaining a retained interest in the property. It is important to understand that the residence appreciates tax-free while it is held in the trust, which effectively reduces or eliminates the gift tax on the property and keeps it out of the settlor’s estate.
When does setting up a QPRT make sense?
If you own property that will be worth well over a $1 million, then a QPRT is worth considering. Any appreciation in the property will transfer to the beneficiaries tax-free, which can save hundreds of thousands and sometimes millions of dollars in taxes in the future.
What are the risks of the QPRT?
The settlor is effectively predicting that they will not pass away during the term of the trust. If that were to occur, the trust would effectively be cancelled and the property would be included in their estate. However, the settlor is effectively in the same position that they would have been had they not setup a QPRT. The only loss would be the time and legal fees incurred while setting up the trust.
If the property is eventually sold by the beneficiaries, the capital gain would be based on the settlor’s original cost basis in the property as opposed to the value at death. If the QPRT wasn’t setup, the cost basis of the property would be adjusted to the fair market value at the time of death. For instance, if the property was originally purchased for for $1 million and appreciates in value to $3.5 million at the time of death and the beneficiaries sell it shortly thereafter, they would pay taxes on a $2.5 capital gain. If a QPRT wasn’t setup, the cost basis on the property would be $3.5 million, which means that the beneficiaries would pay little to no capital gains taxes. However, that same property that wasn’t held in a QPRT would be subject to estate taxes which could be 35%-55% based on historical tax rates, which exceeds long-term capital gain rates. Therefore, the tax savings would likely be greatest if the property was held in a QPRT.
Another factor to consider is the rent that the settlor will have to pay the beneficiaries to live in the residence after the term of the trust. But, there are ways around it. You can write a promissory note for the FMV of the rent to be paid by the estate later on. The other issue that comes up is whether or not the beneficiaries have to rent you the property. Provisions in the trust can demand it, which eliminates that risk for the settlor.
Can you get a mortgage during the trust term?
Technically, you can obtain a mortgage. However, banks are usually adverse to it, so don’t count on it unless you plan to terminate the trust by breaching the agreement.
Can I sell a home still?
If you decide to sell the home and purchase another home, the purchase of the replacement home must occur within two years of when the original home in the QPRT was sold, or the trust will no longer qualify as a QPRT. If this happens, the trustee has to distribute the sale proceeds back to the settlor or convert the trust to a Grantor Retained Annuity Trust (GRAT) within 30 days.
Is a QPRT irrevocable?
Yes, but with well written provisions and agreement by the trustee and beneficiaries, there are ways around it.
What’s the final analysis?
This decision should be reviewed careful, but the benefits far outweigh the costs. In addition, provisions can be written in the trust agreement to provide a significant amount of protections and flexibility to the settlor.
More Questions? Ask your gift tax questions online.
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