Like many of you, summer is my favorite time of the year. In my adopted home of New England, nothing is more glorious than a warm summer day on Cape Cod. Beautiful sandy beaches, clam bakes, and a cool breeze blowing in from the Atlantic Ocean create the backdrop for a leisurely holiday that allows a visitor to forget nearly all the stress of his or her usual day-to-day life.
One evening, while my son and I were walking along the beach just before sunset, I came upon a gentleman digging clams. Among the things that I learned while talking to him was that he owned the stunning antique home not far from where we were talking. He told me that his home had once been a lighthouse and that he had purchased it as a vacation home over 40 years ago when his children were still in school. He smiled as he told me that some of his best memories are of his children, and later his grandchildren, playing on this very beach. Before I left, he also gave me his “secret” recipe for stuffed clams. For those of you not from New England, take my word for it–there is nothing better than sitting at a picnic table on a cool summer evening eating stuffed clams, chowder, and fresh lobster. To say the least, Im grateful to this gentleman for sharing his familys stuffed clam recipe with me.
After I finished talking to this gentleman, I continued my walk along the beach. And, for one of the few times during my vacation, I suddenly remembered that I am an estate-planning attorney. And, as such, I couldnt help wondering to myself if this charming man had taken the necessary steps to ensure that his vacation home remains in his family after his death. If I were his child or grandchild, I wouldnt be able to stand the thought of selling this family treasure.
The more I thought about him and his beautiful vacation home, I realized that his problem is not isolated. In fact, his problem is very common. As I stood on the beach and looked up at the majestic summer homes that look down upon ocean, I couldnt help wondering–have the people who own these fabulous pieces of property taken the proper steps to ensure that their children and grandchildren will always be able to enjoy these views?
And, more importantly, this isnt just a New England matter. Think about your favorite vacation spot. Have the people who own vacation homes in those locations done the proper planning to ensure that their homes remain in their families?
Based upon my experiences, the answer is often no. And, unlike many estate-planning problems facing your wealthy clients, preservation of a familys vacation home is not a complicated matter. In this article, Ill discuss just how easy it can be to protect a familys vacation home through the use of a qualified personal residence trust. A QPRT is one of the most effective estate planning tools available. Yet, despite the simplicity and effectiveness of QPRTs, they are too infrequently used.
What is a QPRT? It is an irrevocable trust in which the grantor (i.e., the creator of the trust) retains an interest in the personal residence for a period of years. At the end of the retained interest, the personal residence passes to the beneficiaries named in the trust. These beneficiaries are ordinarily the children of the grantor.
What is the benefit of a QPRT? By transferring a personal residence to a QPRT, the owner of the residence can get the property out of his or her estate for federal estate tax purposes. However, because the property does not transfer to the trust beneficiaries until the end of the retained period, the value of the gift may be significantly less than the entire fair market value of the property.
Sure, it sounds complicated. But it really isnt. The best way to understand how a QPRT works is to look at an example. Lets take the gentleman that I talked to on Cape Cod. While I dont really know much about this man, lets pretend that we know a few more facts than I really know.
The gentlemans name is Zachary Alexander. He is 75 years old and widowed. Prior to retirement, he was a successful businessman and he has been very savvy with his investments since retirement. Currently, his net worth is $10 million. His assets include his primary residence in Newton, Mass., and his vacation home overlooking the ocean in Wellfleet, Mass. His home in Newton was recently valued at $1.5 million. His vacation home has a value of about $1 million.
The rest of his estate consists primarily of illiquid stock in the family-owned business. As part of Mr. Alexanders estate plan, he could create (as can any individual) two QPRTs–one for his primary residence and one for his vacation home.
Without any additional planning, Ill demonstrate how the creation of two QPRTs will significantly reduce Mr. Alexanders estate tax exposure and reduce the risk that his family may need to sell the vacation home to pay estate taxes. Of course, creation of the QPRTs would really be only part of a comprehensive estate plan for Mr. Alexander, but for the sake of simplicity this article will focus on the QPRT created to hold the vacation home.
Mr. Alexander creates an irrevocable trust (i.e., the “QPRT”) that will allow him to retain an interest in the property for 10 years. At the end of that time, the vacation home will pass in trust for the benefit of Mr. Alexanders two children, Nathan and Stacey. By putting the property into trust for the benefit of his two children, this should enable the property to remain in his family for years after Mr. Alexanders death.
Because Mr. Alexander will retain an unlimited right to the property for 10 years (including a reversionary interest retained by his estate in the event that he dies prior to the end of the 10-year term), the value of the remainder interest passing to the trust for the children is only $287,990 (instead of the current fair market value of $1 million).
Mr. Alexander can avoid gift tax when he creates his QPRT by simply allocating a portion of his lifetime gift tax exemption (currently $675,000 per person and increasing to $1,000,000 per person in 2002). Although the property must pass to the childrens trust at the end of the 10-year retained period, the QPRT specifically allows Mr. Alexander to rent the vacation home after the end of his 10-year retained interest for fair-market value.
From an estate-planning standpoint, renting the property from the childrens trust is another positive because it will allow Mr. Alexander to further reduce his estate without estate or gift tax limitations and consequences.
Usually estate planning isnt a topic that excites people. But in this case, Mr. Alexander is very happy about this piece of his estate plan because he can continue to enjoy his property, with its scenic views and abundant clams, for the remainder of his life. And, he has the added satisfaction of knowing that his children will enjoy the property for the remainder of their lives.
Why did Mr. Alexander select a trust with a 10-year retained interest? This is one of the more tricky aspects of QPRT planning. The reality of QPRT planning is that a longer retained period creates a lower gift value and, as a result, a better economic benefit. However, that is only true if you have selected a term that you actually survive. If a grantor does not survive the QPRT term, no benefit is obtained from the transaction as the property is brought back into the estate and subjected to estate taxes as if the QPRT was never created.
So, when creating a QPRT, it is advisable to select a term that the grantor should comfortably survive. Because Mr. Alexander is a healthy and energetic 75-year-old, he is confident he will outlive his life expectancy of 11 years. But, if Mr. Alexander passed away before the termination of the trust (lets assume death in June of 2011), the value of the vacation home will be approximately $1.6 million with only 5% annual appreciation. Assuming that Mr. Alexander is in the maximum estate tax rate (returning to 55% after a one-year repeal in 2010) in 2011, the estate taxes attributable to this vacation home will be approximately $880,000 under current tax law.
It is the potential tax liability caused by the possibility that Mr. Alexander may not survive the term of the QPRT that makes life insurance an important part of QPRT planning.
So, to help ensure that the vacation home remains in his family, Mr. Alexander will also purchase a $1 million life insurance contract inside an irrevocable trust in conjunction with creation of the QPRT.
As you can see, the estate- and gift-tax savings available with a QPRT can be substantial. When I first entered private law practice, the top estate planning partner in my firm once described a QPRT to a client as a “birds nest on the ground.” This was his way of telling his client that a QPRT was a simple way to avoid hundreds of thousands, if not millions, of tax dollars.
While my career has taken me from Texas to New England, this “down-home” description of the simplicity and power of a QPRT has stuck with me. It is my personal belief that every individual with a taxable estate should consider creating a QPRT for both his or her primary residence and vacation home.
Through the use of QPRTs, a family can avoid selling a home or a vacation property. But, more importantly, a QPRT can help a family preserve its memories and its roots.
is senior counsel, director of advanced markets and small-business insurance, Manulife Financial, Boston. He can be reached via e-mail at Randy_Zipse@manulife.com.
Reproduced from National Underwriter Life & Health/Financial Services Edition, September 3, 2001. Copyright 2001 by The National Underwriter Company in the serial publication. All rights reserved.Copyright in this article as an independent work may be held by the author.