1/2/2013 - The U.S. Federal Estate Tax exemption and rate were permanently modified by the Taxpayer Relief Act of 2012.
A qualified personal residence trust, or QPRT, can reduce the federal estate tax associated with transfers of real property to heirs, reduce the federal gift tax associated with such transfers, and, provide asset protection.
Federal Estate & Gift Tax
A trust settlor (sometimes called a grantor or truster) must transfer his/her ownership of a residence to an irrevocable grantor trust while retaining the right to use the residence for a term of years. The IRS characterizes the transfer of the remainder interest, i.e. the interest in the residence after the term of years has expired, as a completed gift to the trust beneficiaries and the settlor must file a gift tax return for the present value of the remainder. Note that a such a gift is not eligible for the federal gift tax annual exclusion, because it is a future interest.
The key to minimizing the present value of the remainder interest in the residence, is to choose the longest reasonable term of years possible because the longer the term of the trust, the lower the present value of the remainder interest, which results in a smaller gift. Although the calculations involved in determining the value of the remainder interest are complex (IRC § 2701), a trust with a term of twenty (20) years, for example, will allow a much lower valuation of the remainder interest than a trust with a term of one (1) year.
Choosing the longest reasonable term of years is complicated by the fact that if the settlor is not alive at the expiration of the term of years, the value of the residence will be included in the settlor's estate. As such, the settlor must balance his/her desire to reduce the gift tax with the reality of his/her life expectancy in order to reduce the federal estate tax.
Federal Estate Tax Uncertainty
During 2011 & 2012, the effective unified federal estate and lifetime gift tax exemption is $5 million dollars per person or $10 million per legally married couple. This means that people can transfer their assets to heirs, while alive or dead, without being subject to federal estate or gift tax if the value of the decedent's estate and the lifetime gifts not subject to the annual gift tax exemption, does not exceed the effective unified federal estate and gift tax exemption.
This current effective unified federal estate and gift tax exemption, i.e. $5 or $10 million, is likely more than sufficient to cover the entire estate for most Americans. However, in 2013 the exemption is set to drop to $1 million per person or $2 million per married couple if Congress does not act and would result increase the number of people subject to the federal estate and gift taxes.
Federal Capital Gains Tax
Because a residence owned by a QPRT will not be included in the gross estate of the settlor, unless the settlor does not outlive the QPRT term, the beneficiaries of the trust will not receive the step-up in basis, which they would have received if the residence was included in the gross estate of the settlor. Without a step-up in basis, and if the property has appreciated substantially since acquired, the beneficiaries will be liable for capital gains based upon the settlor's cost basis as opposed to the fair market value of the property at the settlor's death, i.e. stepped-up basis. However, if the beneficiaries make the residence their primary residence, the personal residence exclusion may cover all or part of that appreciation if the residence is later sold.
Because a QPRT is irrevocable, it is not legally owned by the trust settlor and cannot be used to satisfy creditors' claims unless it was fraudulently transferred to the trust, used to guarantee a debt, or similar action.
This brief overview of some important considerations associated with a qualified personal residence trust (QPRT) is by no means comprehensive. Always seek the advice of a competent professional when making important financial and legal decisions.