The past two years sent wealth managers on a volatile ride, as all manner of client wealth was decimated in some fashion. Equity markets have since made an enviable comeback, with government-sponsored stimulus and loose monetary policy leading to an optimistic bid-up of shares. But, as summer 2010 comes to a close, there continues to be plenty of concern regarding economic growth and the sustainability of the resurgence. And to be convinced that the few positive indicators represent a recovery, you would have to be wearing your rosiest-colored glasses.

One sector of the economy at the forefront of the downfall was real estate. Viewed by many economists as the primary reason for the credit crisis, it is now seen by others as the glimmer of hope in the move toward recovery. The recent annual increase of 3.6% in the S&P/Case-Schiller Home Price Index, for example, has given optimists a reason to cheer (though many observers have dismissed the number as a product of the government’s recently expired tax-credit program).

Where the real estate market will go from here is difficult, if not impossible, to predict. Still, some markets around the U.S. have indeed seen considerable price increases when compared with those of the same period last year. If we are in fact experiencing a price rebound, how can clients who own real estate take advantage of that good news from the wealth transfer perspective? 

What is a qualified personal residence trust (QPRT)?

A QPRT is an irrevocable trust funded by a homeowner’s interest in the residence. The homeowner transfers title of the home to the trustee of the QPRT while retaining the right to reside in the house throughout the trust’s term of years. At the end of the trust term, the house passes to the QPRT beneficiaries (commonly the homeowner’s children).

Tax advantages

Implementation of a QPRT may provide a homeowner with significant wealth transfer tax savings because the initial title transfer is considered a gift to the beneficiaries of the irrevocable trust. Although all of the interest in the home is transferred to the QPRT, the value of the gift is reduced because of the homeowner’s retained interest to live in the home during the trust term. The longer the homeowner retains a right to live in the home (i.e., the term of the QPRT), the bigger the reduction of the gift tax valuation at transfer.

Further, any appreciation in the home’s value from the date of transfer to the QPRT is removed from the homeowner’s taxable estate. It should be noted, however, that, if the homeowner fails to survive the term of the QPRT, the home will be included in the homeowner’s taxable estate—as if the QPRT had never been implemented. This possibility is a significant consideration when determining the length of the trust term.

If the homeowner survives the QPRT term, the trust beneficiaries become owners of the home. The original homeowner no longer retains the right to live in the home rent-free. If the original homeowner wishes to remain in the home, he or she must sign a formal lease and pay fair market value rent to the QPRT beneficiaries. For many higher-net-worth clients, the payment of rent is viewed as a means to transfer wealth to their children—free of wealth transfer taxes. The payments are income taxable to the children.

An example of a QPRT

To understand the benefits of a QPRT, it is helpful to consider an example.

Let us assume that a 60-year-old man transfers his primary residence, valued at $1 million, to a 10-year QPRT. Although the home is currently valued at $1 million, the 10-year retained interest of the homeowner reduces the transfer value of the home for gift tax purposes to $645,370. This figure represents the current value of the remainder interest. When the homeowner reaches age 70, the remainder interest in the home will pass to the QPRT beneficiaries. To continue living in the home, the 70-year-old man would have to enter into a lease with the QPRT beneficiaries, which calls for payment of fair market value rent.

One factor in determining the amount of the taxable gift upon transfer of the home to the trust is the Applicable Federal Rate (Section 7520) for the year in which the QPRT is established. In the example above, the assumed AFR is 2.60 percent, which is historically very low. If we had assumed an AFR of 3 percent and applied it to the same scenario, we would have created a taxable gift of only $620,740.

Why consider the QPRT now?

If the AFR is historically low in late summer 2010—thus creating a higher taxable gift than if we were in a period of higher AFRs—why consider a QPRT now? Like many wealth transfer strategies, it is impossible to determine the success or effectiveness of the QPRT until completion of the trust term. But the accelerated depreciation of real estate values over recent years has increased the likelihood of successfully implementing a QPRT, at least when compared with using the same strategy and subject property just two years ago.

Clients who own real estate situated in highly desirable areas, such as coastal properties, and who continue to seek tax-efficient wealth transfer strategies may find a QPRT to be an excellent way to transfer real estate within the family, at a reduced wealth transfer tax cost. Because there are several considerations to take into account when designing a QPRT, it is of the utmost importance for clients to obtain a qualified attorney, familiar with drafting and implementing complex estate planning vehicles, to undertake the assignment.