Shrinking Home Values to Enlarge Wealth Transfers
By Stephen Peterson
Originally Published March 16, 2017; Updated March 2, 2022
In the alphabet soup of estate planning jargon, the acronym QPRT is one of the more familiar—if not fully understood—terms; and it represents a popular and rather common technique for potentially passing significant wealth amongst generations with little or no gift or estate tax consequence… using family homes. The letters stand for Qualified Personal Residence Trust and depending upon the mix of various underlying circumstances—including the age of the grantor, the term or length of years for the trust, the current value of the property, and the applicable required (IRS section 7520) interest rate—these special types of trusts can enable significant valuation discounts and thus better utilize the application of one’s available Lifetime Exemption from gift and estate tax.
The current overall available amount in 2022 for the Lifetime Exemption from Gift and/or Estate Tax is $12,060,000 per individual… or a combined amount of $24,120,000 for two spouses. This means that a married couple can exempt up to about $24 million over the course of their lifetimes (and/or as bequests at death) from gift and/or estate taxation… and this amount does not include the unlimited Annual Exclusions that can also be given away by any individual each year to any number of recipients (currently $16,000 per recipient). Of course, any previous non-charitable lifetime gifting of any other assets would reduce the current available Exemption amount that could be applied against the discounted gift of a QPRT—such as outright gifts of cash above the Annual Exclusion amounts or other deliberate wealth transfers such as GRAT’s or Intentionally Defective Grantor Trusts (IDGT’s).
Moreover, a QPRT only functions as a lifetime gift and thus cannot be achieved as a bequest. It also does not qualify for using the Annual Exclusion amounts. It therefore must be completed while the grantor is still living. If the grantor does not survive the term of the QPRT, then the home comes back into that person’s taxable estate and nothing is accomplished. As such, it’s important to expect to outlive the chosen term of the trust. These trusts are “special” because they are only available for personal residences, and not for other investment real estate. A grantor can only have two active QPRTs at a time, and one of these must be the primary residence, or an undivided fractional interest in either. The second home—typically a vacation property—can be rented out by the grantor for a period of time each year, but there are rules that guide these conditions and the grantor is still required to use it too. It is also best to plan to hold the house in the trust for the full term. It can be sold within the QPRT, but that gets more complicated. Also, if the property is subject to a mortgage, there will be greater complexity… and ideally, QPRT’s work best for unencumbered homes.
The essence of a QPRT is to try to discount (or shrink) the taxable value of the transferred property as much as possible and reasonable, and then—depending upon the resulting size of the discounted gift and the availability of one’s Lifetime Exemption—have no out-of-pocket tax bill due. The factors that affect the overall valuation are:
Age of grantor(s)—the younger, the better
Term of years for the trust—the longer, the better
IRS Section 7520 rate—the higher, the better
Current value of the property—the lower, the better
Due to the lack of any annuity or cash flow obligation, though, there is less reduction in the retained interest on a QPRT and thus—unlike some other estate planning techniques—a higher 7520 rate on a QPRT is actually desirable… which is not currently the case given that interest rates remain low, as they have been for almost a decade. The Section 7520 rate that is used for all QPRT’s—regardless of the length of the term—is always 120% of the current midterm AFR (applicable Federal rate) at the time the trust is established; and as of January 2022, that 7520 rate is 1.6%. And yet, the length of the term—whether short or long—also influences the calculation of the taxable gift (and software exists that can crunch out all of the inputs… and most estate planning attorneys and/or tax advisors can assist with these calculations).
Another important factor—on top of the 7520 rate—is the underlying value of current housing prices, and in many locations those values are once again relatively high… unlike back in 2008 and 2009 during the “credit crisis” when similar QPRT’s could have been established to take advantage of the severe declines in real estate values all across the nation. So, it might presently seem that QPRT’s would not be that attractive. And yet, overall discounting capabilities (which, again, also include the length of the term of the trust and the age of the grantor) are still possible and might still be compelling. Plus, if a sizable enough estate has few other assets that can be discounted in value—like any basic stock and bond portfolio that can only be valued at current market prices for purposes of any gifting—then the family home, or homes, might offer worthwhile opportunities to be more creative with overall tax and estate planning.
Here are a few hypothetical examples that show a range of differences in resulting discounted gifts based on different circumstances; and even if the grantor was the same age in each example (not shown), it would still be possible to shelter both such homes with one’s individual Lifetime Exemption, even though the combined appraised value of both properties together is much higher.
Example A
Assume the house is worth $5 million (which is no longer such a stretch anymore in the Bay Area), the grantor is age 80, the QPRT is set up for a 9 year term, and the current 7520 rate is 1.6%.
- Age of grantor: 80
- Term of trust: 9 years
- IRS Section 7520 rate: 1.6%
- Current appraised value: $5,000,000
$1,828,900: Discounted value of the gift to QPRT
Example B
Now assume a second house—or perhaps even the same house above at a lower appraised value for whatever reason (perhaps a local economic downturn, even if just temporary), the grantor is younger at age 58, the term of the trust is now 25 years, and the 7520 rate is still 1.6%.
- Age of grantor: 58
- Term of trust: 25 years
- IRS Section 7520 rate: 1.6%
- Current appraised value: $3,500,000
$1,086,260: Discounted value of the gift to QPRT
By the way, for both above examples… if the current appraised value were double what is shown, then the discounted gift amount would also be double; that is how the math works on the underlying calculation… for purposes of getting a rough idea of what different gift amounts would be for other appraised values, holding the other factors constant.
An additional consideration, if applicable, is whether the gift is made jointly by a married couple and thus based on two lives. But this approach actually increases the amount of the upfront resulting taxable gift, since actuarially this makes it more likely that the gift will occur at the end of the given term (that is, the risk of death with two lives is lower). And thus, it is not common to create a QPRT based on two lives. Instead, a married couple should ideally create two QPRT’s – one for each of their 50% ownership in the (same) house.
Importantly, a QPRT is considered an irrevocable gift upon its establishment, and once the term is satisfied, the house is fully owned by the beneficiaries. However, during the term of the trust the grantor retains the right to use the property, and even after the trust expires the grantor can continue to occupy the house (if the beneficiaries agree) as long as fair market rent is paid to the new owners—presumably family members. Typically though, due to obvious considerations—including a justifiable reluctance to give up control of the family house too soon… especially a primary residence that a grantor may hope to occupy for as long as possible—these types of trusts usually get put in place later in life, and often after the first spouse passes away. Besides, the death of a first spouse also enables a full step-up in cost basis on the entire property (at least in community property states like California), and this in turn will reset the clock on capital gains and provide that additional benefit in the overall competing mix of different types of taxes that need to be considered when transferring wealth (that is, not just gift/estate taxes, but also potential capital gains taxes and income taxes).
As a result of the possible hesitancy to give up control of a primary residence (at least not too soon) and/or the desire to wait in consideration of a possible full step-up in cost basis on that same property before utilizing a QPRT (especially if there is a sizable age difference between spouses) … it could be that a second home, if available, is the better choice for an initial QPRT. And this could, and perhaps should, be achieved much earlier in life. If so, such a QPRT—for a second home—could conceivably be created using a much longer term of years for the trust (based on reasonable longevity assumptions) which in turn would provide steeper discounts on the taxable gift amount. Plus, transferring the property sooner—especially on a vacation home that might be intended to be kept anyway and enjoyed for years by successive generations—would shift any future price appreciation on that same house out of the grantor’s estate and thus further help with overall estate planning.
After the initial term expires on a QPRT, the property will have successfully passed to beneficiaries (or possibly trusts for those beneficiaries, especially if younger) and presumably these beneficiaries are the children of the grantor(s). Again, if the parent(s) want to continue to live in the house, then they will need to pay a fair market rent to the new owners (the children). But this too is not such a bad situation, since this payment of ongoing rent will enable further effective estate planning… because any such rent will both immediately benefit the new owners (with additional revenue) and commensurately reduce the value of the parent’s potentially taxable estate by an equivalent amount.
The grantor(s) also pays all homeowners insurance and property taxes during the term of the QPRT, and they also cover any normal maintenance and repairs during this period. However, any other major home improvements or remodeling would not be allowed because that would effectively enable the ability to pass an asset with more value than what was initially captured upfront in the calculation of the taxable gift; and thus, this should be clearly understood in advance, in case the grantor(s) had plans to alter the home for their own enjoyment after placing it in a QPRT.
Once the QPRT term is achieved (whether that is after a fairly short period like 5 years or something much longer like 20 years):
-the Deed to the property then passes fully to the new owners (again, presumably children);
-and at that point and going forward, all of those same basic household expenses—insurance, property tax, maintenance—become the sole obligation of the new owners (beneficiaries) for as long as the property is held.
-Fortunately, the required rent that will be paid by the occupant (parent) to the new owners (children) should be (more than) adequate to help cover these basic costs of ownership.
Finally, there are other types of taxes—especially property taxes—that need to be carefully examined in all of this, but that is beyond the scope of this article. Importantly, though, Proposition 19 in California—which narrowly passed and went into effect in early 2021—allows some new potential benefits for older homeowners transferring existing tax basis into another new home of their own; but it now also severely limits the ability of others (such as children) to inherit the existing property tax basis of an inherited home (unless one of the inheriting recipients occupies the house as a principal residence—and even then there are new restrictions). Otherwise, a full market value reassessment is now required for ongoing property tax purposes. So, this should all be deliberately examined in each situation with the help of one’s tax counsel.
While everyone’s situation is unique—and requires careful individual attention and planning—in general, QPRT’s offer potentially attractive opportunities to shrink home valuations and enlarge wealth transfers. At Sand Hill Global Advisors we work with our clients and their estate professionals to consider such planning and possible action… in conjunction with examining other needs and objectives, and the resources to provide for them. Please let us know if you would like to discuss your own personal situation.
Source: www.irs.gov
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