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Lower estate taxes by "freezing" your home's value with a Qualified Personal Residence Trust
For many people, a residence comprises a significant portion of their estate. When they pass, that residence will incur some of the largest taxes levied post-death. If you would like to free yourself and your children from these taxes, a Qualified Personal Residence Trust (QPRT) can help. If established properly, this trust will help you “freeze” the value of your residence and reduce the gift tax incurred when transferring your assets to your children. This is especially useful if your home is likely to appreciate in value.
How does a QPRT work?
If you would like to set up a QPRT, first, you, as the trust grantor, need to set a specific amount of time you want the QPRT to last. This period is also known as the retained income period. Then, you will designate the beneficiaries, which are the people who will receive the property once the trust is expired. These are usually your children or spouse.
You will then transfer a principal residence, a vacation home or secondary residence, or a fractional interest in either. By doing so, you are making your home a “gift” for your beneficiaries to receive. Anything you decide to include will be placed in the trust at its current fair market value, and only a portion of that value is taxed. Note that if the value of your home is over $11.7 million—which is the lifetime gift tax exemption limit in 2021—your property will be subject to gift taxes.
During the term of the QPRT, you will be able to use your estate the same way you did before you established the trust. You will not have to pay rent to live in the property, but you will still have to pay recurring expenses such as real estate taxes.
At the end of the term, the property will be passed to your beneficiaries. When this occurs, you will have to lease the residence back from the beneficiaries at fair market rent in order to keep living in your home. You cannot buy the house back, because legislation enacted in 1997 prohibits you from doing so.
If you die before the term ends, however, the property will be included in your estate and become subject to estate taxes. But this does not mean that you should make the trust last for a very short time, as longer-term trusts benefit from smaller remainder interest given to the beneficiaries. A remainder interest is essentially the interest that is left after another interest in the property ends, and a smaller remainder interest essentially means a smaller gift tax.
As you can see, there are big benefits you can reap from creating the trust, but they are accompanied by great risks. Because a QPRT is irrevocable (meaning that you cannot change its terms once you establish it), you need to be mindful of the advantages and disadvantages the trust contains.
The advantages of a QPRT
The biggest benefit of establishing the trust is that you are able to transfer your residence to your heirs in a way that significantly reduces taxation of the transfer. Furthermore, the value of your residence will be locked in, and you will not have to worry about how appreciation will lead to higher taxes.
Even after transferring the property into the trust, you can continue to live in your home and maintain full control of it during a set period. You also have the ability to specify this amount of time while establishing the trust.
Paying rent after the set period will reduce your taxable estate. As mentioned before, once your retained income period is over, you will either have to move out of the house or lease it back from the beneficiaries at fair market rent. Though this may seem like a disadvantage, it actually helps you reduce your estate without using up your gift tax exemption limit.
It is hard to sell a residence that was once placed in the trust, so establishing the trust is ideal if you would like to let your home remain in the family for generations.
The disadvantages of a QPRT
If you die before the retained income period is over, the current value of the residence will be included in your taxable estate. This completely undoes the transaction in the QPRT. However, if you would like to alleviate some concern about this happening, you could create several trusts with different expiration periods, and place different homes or even fractions of a home into these trusts. Say you have two trusts, each of them ending five years and 10 years from now. Even if you pass away seven years from now, you will at least be able to reap the benefits from one of your trusts.
Selling the home could be difficult if you would like to after it was placed in the trust. You are required to either invest the sale proceeds in a new home or receive the sale proceeds in the form of an annuity. If your beneficiary decides to sell the home, they will owe capital gains taxes. This tax is based on the difference between the value of the time the property was placed into the trust and the price it will sell for.
Homestead status, which protects the property from creditors and property tax, might be lost in certain states if none of your beneficiaries make the home their primary residence.
Keep these pros and cons in mind when thinking about the Qualified Personal Residence Trust. Whether or not you decide to create the trust, remember that you have the option to consult our concierge service if you have any questions or require additional assistance. Tthe concierge service can help with referrals to trusted professionals, offering case-specific advice, recommendations, and coordination for you. For more about our concierge service or to schedule a free consultation, click here.