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Up the Down Staircase

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These days, it’s difficult to turn on the television, read the newspaper, or surf the Net without encountering doom-and-gloom stories about the current real estate market. The credit crisis, increased foreclosure rates, falling prices, and weakening home sales provide ample fodder for financial news outlets. I certainly don’t know when the real estate market will begin to recover, but I do believe that, as the market falls, the potential to capture future opportunities increases. Advisor may want to prepare their clients’ financial plans to take advantage of those potential opportunities.

From a personal standpoint, as a homeowner in the volatile San Diego real estate market I’ve been wondering how homeowners might take advantage of the significantly reduced housing prices that I have witnessed over the last two to three years. Many would say the answer is obvious–prices are low, so now is the time to buy more. Aside from the fact that not everyone wants to be a real estate investor or a property manager, I do agree that this may be a time for real estate investors to consider acquiring more property. But I also believe that there’s an alternate way to benefit from the market–one that considers the potential estate planning opportunities available from the recent decrease in real estate values.

Gift and Estate Tax Savings

Many of your clients are undoubtedly homeowners. Some clients may own more than one residence–a vacation home, perhaps. As with any market correction, your clients may be expressing concerns over how this recent real estate downturn will affect their financial plans.

For clients who are not on the brink of foreclosure, and for those who did not opt for the interest-only loan, the long-term effects are probably minimal. This is especially true for clients who view their house primarily as a home and not as a tradable commodity. Can these clients do anything to take advantage of depressed housing prices? Possibly, but as with any planning strategy, it depends on the clients’ goals and overall situation.

For some clients, a house is the most valuable asset they own; therefore, it’s a significant factor in determining whether your clients’ estate will be subject to estate taxes when they pass away. A qualified personal residence trust (QPRT) could be a valuable gift and estate tax planning instrument for clients who face the possibility that their estate may be subject to taxation.

To determine whether any of your clients may benefit from a QPRT, you need to understand how it works, what its benefits are, and which are the standard concerns associated with implementing this type of trust.

How It Works

A QPRT is a type of irrevocable grantor-retained income trust into which a homeowner transfers title to a personal residence or vacation home. The homeowner retains the right to live in the residence for a term of years. Assuming that the homeowner survives the completion of the trust term, the residence passes to those named as remainder beneficiaries to the trust. If the original homeowner wants to continue living in the house after the completion of the QPRT term, she must pay rent at fair market value to the remainder beneficiaries who now own the property.

At this point, you may have a hard time identifying any clients who would be willing to give away their residence when they might have to pay rent to continue living in a home that was rightfully theirs prior to the existence of the QPRT. There are potentially valuable benefits to consider, however.

The Benefits It Delivers

The primary benefits of a QPRT lie in the gift and estate tax savings this trust offers. A QPRT is an estate-freeze technique that allows clients to transfer their interest in a principal residence or vacation home out of their estate–thereby reducing the amount ultimately subject to estate taxes.

The transfer of the residence is a taxable gift, but the tax is not based upon the fair market value of the residence upon the transfer. Rather, it is based on a value that is discounted for gift tax purposes, due to the interest (the right to live in the residence) the homeowner retains during the term of the trust. The longer the term of the retained interest, the greater the discount. In other words, the value of the gift is based upon the present value of the remainder interest to be transferred to the trust beneficiaries.

Once the residence is transferred to the QPRT, all future appreciation associated with the residence is removed from the client’s estate. (This assumes that the client survives the term of the trust, which will be discussed in more detail below.) If the original homeowner wishes to continue living in the residence when the QPRT term is complete, he must pay fair market value rent to the remainder beneficiaries who now hold title to the residence.

While some may see this as a negative, the rent payments are actually another estate reduction benefit. Because the payments satisfy a lease, they are not considered a gift; instead, they represent a transfer of value to the beneficiaries without applying gift taxes or exhausting the available annual gift tax exclusion. Just remember that the recipients of the rental payments must declare those payments as income.

Given that a QPRT is not only an effective instrument to reduce gift and estate taxes, but also provides limited asset protection (see “Get Protected” sidebar), you may be asking, “Why not implement a QPRT now?” As with any planning technique, you must weigh the benefits against the possible concerns that the client may have. Below we’ll explore some of the issues to consider when analyzing how a QPRT will fit within the client’s financial and estate plan.

Issues to Consider

When a homeowner transfers a residence to a QPRT, the trust provisions provide that the homeowner will have the retained right to live in the residence for a specific term of years. If the homeowner passes away prior to the completion of the trust term, the home will revert to the deceased homeowner’s estate. The net effect will be as if the homeowner had never attempted to implement the QPRT and had retained a full interest in the residence until death.

This is a crucial element of QPRT design. In an attempt to create a larger discount for gift tax purposes, a homeowner may be overconfident in choosing the QPRT term. Clearly, the QPRT term should reflect consideration of actuarial tables and personal and family health history.

It is important to remember that the transfer to the QPRT is an immediate gift tax event, even though the interest that creates the event is that of a future interest to the beneficiaries. Because it represents a future interest, no portion of the gift is eligible for the annual gift tax exclusion. The gift results in either the payment of gift taxes or a reduction of the client’s $1 million lifetime gift tax exemption.

The QPRT does allow for gift tax savings, however, because of the discount applied when determining the valuation of the transfer. The value of the gift depends on several factors, including:

  • The current fair market value of the residence
  • The homeowner’s age
  • The length of the QPRT term
  • The ?7520, or discount, rate

Without delving into the nuances of how to perform the calculations, advisors should understand that, as the discount rate fluctuates, so does the value of the gift. As the discount rate decreases, the present value of the remainder interest (the taxable gift) increases and vice versa. I mention this because the current discount rate is at its lowest (3.60% as I write this article in early March 2008) since August 2003. While this may result in a higher taxable gift at the time of calculation, I believe that the recent slide in real estate values more than offsets this factor.

Another issue to consider is the loss of a step-up in tax basis upon the homeowner’s death. Because the transfer is a gift, the residence is not included in the original homeowner’s estate upon his death, so the beneficiaries do not receive a step-up in tax basis, which is otherwise typical with most capital assets received through an inheritance.

The last consideration to discuss is the homeowner’s requirement to pay rent if she wants to continue living in the residence after the QPRT term. Certainly, some clients will balk at the thought of having to pay rent to live in a residence that they already own(ed). But as I mentioned above, for the right client, this actually represents a chance to enhance the estate plan. For clients with a sizable estate, knowing that the rent payments will further reduce the estate may be a welcome side effect of QPRT planning. For clients with smaller estates or illiquid assets, however, the thought of paying rent to their children could be less than appealing.

Why Consider It Now?

The QPRT has been written about extensively in law books and planning journals. Why should it be a planning consideration now?

Previously, I mentioned the inescapable news reports we see each day that tell of the nationwide decrease in real estate values over the past few years. I have personally watched as sellers in my neighborhood continuously reduced their asking prices in the hope of attracting buyers. A significant factor in determining the taxable gift of implementing a QPRT is the fair market value of the residence.

If your client needs to reduce his taxable estate and would like to pass along a primary residence or a vacation home to his children, then consider having a conversation about the uses of a QPRT. Most of your clients understand that the real estate market has been suffering through a period of decreasing values. Implementing a QPRT as part of the client’s overall estate plan can produce very effective results.

No one can say when the real estate market will turn around, but the risks of a newly implemented QPRT not achieving its goals are diminishing as home prices search for a bottom. The prospects of an ideally successful QPRT are much better in 2008 or 2009 than they were in 2005.

The principle behind the QPRT is to remove property from the taxable estate that will continue to appreciate. Obviously, a residence that continues to depreciate after the transfer to a QPRT could result in wasted time, fees, taxes paid, and/or lifetime gift tax exemption. These risks, however, are more pronounced in short-term QPRT arrangements where the property has less chance of recovering its value prior to the expiration of the trust term.

Cutting Costs, and More

As investors search for value in depressed asset prices, advisors can also take advantage of asset value fluctuation with clients who have certain needs. The QPRT is a valuable estate planning tool that can reduce the cost of wealth transfer and provide additional planning benefits. Because it is impossible to know exactly when real estate prices will bottom out, clients willing to implement mid- to long-term QPRT arrangements may find that the trust becomes an integral part of their tax-efficient estate plan.

Given the sophisticated nature of the QPRT, be sure to consult with a qualified estate planning attorney and tax professional before implementing any plan.

Gavin Morrissey, JD, is the director of advanced planning at Commonwealth Financial Network in Waltham, Massachusetts. He can be reached at [email protected].


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