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A Qualified Personal Residence Trust (“QPRT”) is a special kind of irrevocable trust that can be used to transfer your residence to your children at a significantly reduced gift tax cost.

How This Technique Works.  During your lifetime, you transfer your residence to a trust and retain the right to continue to live in the residence rent-free for a fixed number of years specified in the trust instrument.  During the fixed term, you will continue to pay real estate taxes, insurance, and expenses for maintenance and repairs, and will continue to deduct real estate taxes on your individual income tax return.  A QPRT can hold either your primary residence or one other residence that you occupy, including a vacation home or condominium.  If you decide to sell your residence, the trust can purchase a new residence for you.  You can also transfer a one-half interest in your residence to a QPRT, so that each spouse can have his or her own QPRT.  When the fixed term ends, the residence is distributed to your children or remains in further trust for your children.

 Even after the fixed term ends, however, you can continue to use the residence in one of two ways.  First, rather than immediately distributing the residence to your children, the residence may be retained in trust for you and your spouse’s lifetime, thus assuring that the residence is available until the death of the survivor of you and your spouse.  Second, you can enter into a lease with your children which will allow you to live in the residence for as long as is agreed.  In either case, however, you must pay fair market value rent to your children after the fixed term ends in order to keep the residence from being subject to estate tax on your death.  Paying rent to your children is also an effective way to transfer money to your children free of gift tax.

Tax Implications of the QPRT.  Although your transfer of the residence to the trust is a taxable gift, you are allowed to subtract from the fair market value of the residence the value of your right to live rent-free in the residence for the fixed term.  Thus, depending upon the length of the term selected, the amount of the taxable gift will be substantially less than the fair market value of the residence.  If the amount of the gift is less than your available exemption from the gift tax, no federal gift tax will be due as a result of your gift to the trust.  State gift taxes may be due if the state in which the real property is located has a state gift tax. The value of a gift of your residence to a QPRT is a function of (i) your age; (ii) the number of years during which you will retain the right to occupy the property; (iii) the current appraised value of the property; and (iv) the current IRS actuarial tables and interest rates used to calculate future values.  Generally, the QPRT should be planned to last as long as possible so as to make the value of the taxable gift to the children as small as possible—but not so long that you die before the QPRT ends, which would result in the loss of the tax benefit because the property would be included in your taxable estate.

Estate Tax Advantage.  If you survive the fixed term of the QPRT, the value of the residence will not be included in your estate for estate tax purposes.  Even if you do not survive the fixed term, the estate tax consequences will be no worse than they would have been if you had not created the trust in the first place.  In other words, from a tax point of view, there really is no potential downside to a QPRT.

Example.  The tax savings of a QPRT can be seen by the following example:  Assume Mr. Jones, age 60, decides to transfer his residence worth $1,000,000 to a 15-year QPRT.  (According to IRS actuarial tables, Mr. Jones’ life expectancy is 24 years.)  Assume for purposes of this example that the IRS interest used for determining the value of Mr. Jones’ retained use is 3.4% (this rate changes every month).  Based on these assumptions, the value of Mr. Jones’ gift is only $427,980.  Assuming that (i) the property would have been taxed in Mr. Jones’ estate at a 35% estate tax rate, and (ii) Mr. Jones outlives the 15-year term of the trust, the estate tax savings amount to approximately $200,207 (i.e., $572,020 removed from estate times 35% tax rate).  If the property appreciates in value and/or the estate tax rate in effect at Mr. Jones’ death is higher than 35%, the estate tax savings can be even greater. 

Note that if you survive the QPRT term, the residence will not receive a “step‑up” in its income tax cost basis to the estate tax value because the residence will not have been taxed in your estate. Therefore, the capital gains tax “cost” of doing a QPRT must always be weighed against the possible estate tax savings. 

Questions. If you have questions about this Client Memorandum, please contact any member of the Wiggin and Dana Private Client Services Department.