From the October 2006 issue of Wealth Manager Web • Subscribe!

Gimme Shelter

Manhattan attorney Laura M. Twomey set up a qualified personal residence trust (QPRT) for a client couple with better than anticipated results. The couple's then $1 million home is now worth $3 million. "Not only did they get $1 million out of the estate, but an additional $2 million as well," says Twomey, a trusts and estates partner in the tax department of Fulbright & Jaworski LLP.

Because of low interest rates, QPRTs were infrequently utilized during the last five years, says David Kohn, a senior manager in the personal wealth advisory group at Eisner LLP, also in New York. With higher interest rates, however, QPRTs are resurging in popularity. But while using QPRTs to shelter assets from gift and estate taxes may look like a no-brainer, nothing in the area of trusts is ever that simple.

Essentially, QPRTs allow clients to transfer real estate to heirs as though it were worth less than full fair market value--that is, it leverages the gift and use of the unified credit. This is where interest rates come into play. The higher the Applicable Federal Rate (AFR)--an interest rate published monthly by the IRS--on the date the trust is set up, the greater the value of the interests retained by the person creating the trust and the lower the overall value of the gift to heirs. In August 2006, for example, the AFR rate used to value QPRTs was 6.20 percent, up from 3.20 percent in August 2003.

When establishing a QPRT, the grantor drops a personal residence into the trust for a term of years. If the grantor outlives the term, the residence is transferred to the heirs. QPRTs can only be used to transfer a residence of the grantor--not rental income real estate. Second homes can also be used in QPRTs, although the home must be a personal residence that is not more than incidentally rented out.

"The current thinking is that because of recent interest-rate changes, QPRTs are more attractive than ever," says Gideon Rothschild, a partner who co-chairs the trusts and estates and wealth preservation group at the New York law firm of Moses & Singer LLP.

And in Westport, Conn., Richard Freeman, a principal in Round Table Services LLC, says that his firm is reopening plans to review whether QPRTs are now advantageous.

The devil is in the details. Valuing a residence for the purposes of calculating gift taxes is a two-step process, says Rothschild. Assume a 55 year old transfers a $1 million residence to a QPRT for a 15-year term and retains the right to reversion should he die before expiration of the term. First, under current IRS tables with the AFR at around 6 percent, the present value of the grantor's retained interest is approximately 54 percent or $540,000. Second, the value of the reversionary interest is an additional $126,000 or 12.6 percent. Thus, the total value for the retained interest is 66.6 percent, and the gifted portion represents only 34 percent of the value of the $1 million home or $340,000. So, on transfer to the trust, the gift to heirs is valued today at $340,000. Therefore an asset worth $1 million is transferred to heirs for $340,000 worth of gift tax exemption. If the QPRT is successful, and the grantor outlives the term of the trust, $660,000 in assets are transferred free of gift and estate taxes. Furthermore, the value of all appreciation on the residence during the term of the trust is also removed from the grantor's estate.

The longer the term of the trust, the bigger the discount, increasing the value of the grantor's retained interest while reducing the valuation of the gift. But as a practical matter, says Rothschild, you would not set up a QPRT with a 15-year term for an 80-year-old client. However, older people can use shorter terms and still realize significant discounts because of the reversion factor. If an 80-year-old homeowner transfers a $1 million residence to a QPRT with a three-year term, the value of the gift under IRS tables is $667,000.

In addition to real estate transfer taxes, advisors need to take into account local estate, gift and transfer taxes before considering a QPRT for their clients. In some states the gift tax thresholds fall below those for Federal gift taxes. Twomey has clients in Connecticut who paid state gift taxes in setting up a QPRT, although no Federal taxes were owed. "You have to check all taxes to make sure that taxes don't negatively impact the plan," Twomey warns.

Capital gains are also an issue, since heirs receive a carry-over basis. If the grantor's estate is not large enough to engender estate taxes, it's certainly a drawback if heirs have to pay capital gains taxes on the home's sale. Had the residence been in the estate, however, the heirs would have received it free of estate taxes, and in addition, benefited from a step-up in basis so that no capital gains tax would be owed on the sale. This is a particularly vexing problem at present because Congress has left the future of the estate tax murky with no certainty as to what will occur after current law expires in 2010. (In fact, a Republican House bill which included major estate tax reductions was rejected by the Senate on August 3.) "While it is possible that in the future we'll have a higher unified credit and lower estate tax rates, it is always wise for clients to plan with the tax laws we have," Twomey advises.

When the term of the trust ends, if parents want to remain in the residence, they can negotiate an "arm's length" rent. This provides further estate-tax planning advantages because the rental payments are removed from the client's estate and are not subject to gift taxes.

Of course, having to pay rent to heirs can be a touchy subject, although this is of less concern when the residence is a vacation home, Kohn points out. Unfortunately you cannot set up the trust for the grantor's life, Kohn adds, so there are concerns about being beholden to children.

One way to avoid paying rent to heirs is to set up a trust that entitles the grantor's spouse to live in the home rent free for his/her life, and upon the spouse's death, the home passes to the children, says Twomey. For example, the husband sets up a QPRT trust for his own benefit for 10 years. At the end of the 10-year term, the spouse becomes the beneficiary of the home through a second trust for the duration of her life. On the wife's death, the house goes to the children. With this scenario, says Twomey, the only way the client would have to pay rent is if the wife dies first.

If clients want to relocate, QPRTs can sell the residence and reinvest in another residence within two years. If the new residence costs the same amount as the first, the QPRT can continue. More commonly, the grantor moves to a less costly residence following the home sale. For example, says Rothschild, the grantor might move from a $3 million New York apartment to a $500,000 Florida condo. The $2.5 million difference minus the taxes on the sale will be converted to a grantor retained annuity trust (GRAT) for the remainder of the trust's term, he says, pursuant to which the grantor receives an annual annuity payment for the remainder of the term. At an annual payout equal to 6 percent, the grantor receives an annuity of approximately $150,000 for the remainder of the term. Finally, if the grantor chooses not to purchase a new home, the sale proceeds must be converted into a GRAT requiring payment of a fixed amount to the grantor for the remainder of the term.

If the grantor does not outlive the term of the trust, trust assets revert back to the estate. It's a gamble, but a gamble worth taking, says Twomey. Even if the grantor dies before the end of the term, the result is the same as if nothing was done at all. The residence reverts to the estate where it becomes subject to estate taxes, and any gift tax credit used or paid is restored as well, Rothschild says.

There are three situations in which Freeman thinks QPRTs are particularly appropriate: The first applies to the "family compound client," where it is important to keep a vacation home in the family. "Here, it's usually more of an emotional issue than a financial one," says Freeman. Second, a QPRT is useful for clients who need tax planning and own no viable assets other than the residence. In that case, "it's the only tool in the toolbox," Freeman says. The third situation uses the QPRT as the "icing on the cake": The clients are so wealthy, and their estate planning so effective, that even if the QPRT does not work, it's not a tragedy. A residence is one of the easiest assets to give away because it's not an asset on which owners generate income, says Rothschild. Clients may have to pay rent to heirs, but if there are sufficient assets, that should not be a problem.

There are clients, however, for whom QPRTs are not appropriate. A QPRT is not a good planning strategy for anyone who must maintain a mortgage, says Twomey, because mortgage payments are then considered gifts to heirs. QPRTs are also inappropriate for clients who will not otherwise have sufficient assets for retirement. QPRTs are not for clients who need to survive on the equity in their homes, Rothschild agrees.

Freeman knows of a couple in their 50s who had a 25-year term QPRT set up for them by a previous advisor when the unified credit was $600,000. At the time, he says the client was 47, still working and had a net worth of $4 million to $5 million. Not only did subsequent tax legislation move in the direction of the clients' not needing the QPRT to avoid estate taxes, but even worse, says Freeman, the husband was forced into early retirement, and the couple is currently living off their assets and struggling financially. Today, Freeman says a QPRT would never have been recommended for this client, but they have it and it's irrevocable. 'Things change," Freeman says, "and often, the end is not always as nice and neat and clean as initially thought."

There are other risks, too. If the trust term ends, and a child divorces or is sued, a judgment could force the sale of the home. However, there are ways to draft the trust document to ensure children or their spouses do not force parents out of the home--generally by leaving the home in a trust for the children's benefit. There is also the risk that the property's value will decline, says Sharon Klein, senior vice president and Trust Counsel at New York-based Fiduciary Trust Company International. Should that happen, and the grantor outlives the trust term, the adjusted taxable gift will remain at the original discounted value of the residence, Klein says, although, she adds, there are ways to draft the trust instrument so that if the value declines below the amount of the taxable gift on creation, the property is, instead, included in the grantor's estate

Sometimes, family dynamics change. Rothschild has a client with a home in New York City and a house in East Hampton, Long Island. A QPRT was created for the couple 15 years ago when the estate tax exemption was $1.2 million ($600,000 per person). Now the exemption is $4 million ($2 million per person), but the house is worth $4 million. The QPRT worked, says Rothschild, but the problem is that the clients can't afford to pay the fair market rents. Furthermore, he adds, the client doesn't now get along with his children. "But he has to live with his decision," Rothschild says, "because the trust is irrevocable."

How to Avoid QPRTs

There may be ways to achieve the same effect without these trusts--or getting out of a QPRT if necessary.

Life Insurance: Freeman suggests an analysis to determine whether life insurance can deliver more assets to heirs free of taxes than a QPRT might. "Life insurance may be a better option for leveraging a dollar of assets in the estate to multiple dollars outside the estate," Freeman says.

A Potential "Out": While QPRTs are technically irrevocable, Rothschild sees this potential "out." "Don't pay rent once the trust term ends," he says. The IRS position, he explains, is that if fair market rent is not paid, the residence must be included in the estate. However, the IRS has not definitely ruled that this would indeed happen, he cautions, adding that the trustee could be sued by the heirs for not forcing the payment of rent. --ERD

Elayne Roberson Demby, JD, has covered executive compensation, employee benefits, and financial issues for more than 10 years.

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