Yesterday I was talking to a client about how the tax law rules have changed since the last time we got
together to review her estate plan. She mentioned how good it would be for her heirs now that the
effective “estate tax exemption” is over $12 million, which she claimed is approximately what her current
investments are worth. I had known this client for several years so I knew from all of our prior meetings
that she must have been underestimating the value of something. I asked if she was including the value
of her personal residence in that estimate and she said, “Oh, yes, but that’s not worth that much.” After
some digging, I knew she was underestimating the value of her house by at least several hundred thousand dollars! Not only that, but she wasn’t even including it in her approximate estimate of her net worth for estate tax purposes!
It is my experience that the attitude this client had toward the value of her home when discussing her
estate’s potential estate tax situation is actually quite common. There are a lot of folks who
underestimate the value of their home, which sometimes ends up being their most valuable asset.
Fortunately, there is a very good strategy for completely excluding the value of a client’s personal
residence from their estate for estate tax purposes. That strategy involves the use of a specialty trust
called a Qualified Personal Residence Trust, or “QPRT.”
Like a Family Limited Partnership or Irrevocable Generation Skipping Trust, a QPRT is a proven effective
strategy used to reduce your taxable estate. The QPRT, however, while part of the overall strategy and
estate plan, is unrelated to the other estate planning vehicles. The goal of the QPRT is to remove your
personal residence from your taxable estate at a discounted value. This is accomplished by transferring
your house to a separate irrevocable trust, which is designed to last a set term of years. At the end of the
term, the trust terminates, the house is transferred to your children, but you have the right to rent the
house from your children for a fair market rent.
In addition to the goal of removing the house from the taxable estate, a significant side benefit of the
QPRT is the ability to do so at a considerable discount. This is accomplished by making the gift to your
children of not just an outright current interest in the home at the time of the gift, but a gift of the future
right to own the home at the end of the term of years set in the trust. For example, assuming your house
appraises for $2,500,000, if we create a 15-year QPRT, using current interest rates and IRS actuarial tables, we might be able to report to the IRS on a gift tax return a gift of an amount as low as $1,000,000. If you live to the end of the 15-year term, the house is completely out of your estate from an estate tax
standpoint, and it only cost us $1,000,000 of your gift tax exemption, as opposed to the full $2,500,000.
With the depressed real estate market, if the appraisal comes in at less than $2,500,000, we get even
more bang for our buck because the QPRT transfers all asset appreciation out of your estate completely
tax-free.
A common concern with our clients in creating a QPRT is the fact that the house will belong to the kids at
the end of the term, and that, if you want to continue living in the house, you will have to pay fair market
rent to your kids. This shouldn’t be a concern, however, because this is just another way to reduce your
taxable estate and transfer funds to your children. Once you get to the point where you will be renting
from your children, you can adjust your gifting habits accordingly.
The QPRT is an “all-or-nothing” strategy. This means that, if you survive the set term of years of the QPRT, you get the full estate tax advantages discussed above. However, if you pass away before the term of years expires, the house is included in your estate, and you receive no estate tax benefits. Thus, when drafting a QPRT, we try to make a very educated guess regarding your life expectancy. The longer the term of years we set in the QPRT, the greater the estate tax savings, but also the greater the risk that you do not survive the term. As you can see, there are important technical details that you should discuss with an experienced Arizona estate planning attorney.
