By Hayley Cuccinello
May 8, 2023
Higher interest rates come with a silver lining for rich taxpayers who want to give their home to their children while they are still around to see them enjoy it.
- Rich Americans can give homes to their kids before death and save on taxes with irrevocable trusts.
- They can stay in the home during the trust, and any appreciation is exempt from gift and estate tax.
- The tax savings are bigger with interest rate hikes, but heirs who want to sell should be wary.
With a qualified personal residence trust, or QPRT, an individual puts a primary residence or a vacation home in a trust and retains ownership of the property for however many years they choose. The grantor – the person who funds the trust – can live in the home until the trust expires and the property transfers to a designated beneficiary, who is usually an adult child.
The estate of the original homeowner gets two big tax savings when the transfer happens. First, it only has to pay gift tax on the value of the property when the trust was established, even if the trust has lasted many years and the home has appreciated by millions of dollars in value. Second, since the property is no longer part of the grantor and the grantor spouse's taxable estate, it doesn't have to pay estate tax on the value of the home as it would have if the property had been had bequeathed.
QPRTs have become more popular in the past year because high interest rates confer another benefit, according to Jennifer Galvagna, who leads trust, estate, and tax solutions at Bank of America Private Bank.
The amount subject to gift tax is the original fair market value of the house minus the value of the grantor's right to live on the property during the QPRT's term. The discount is larger when interest rates rise as the IRS uses a higher rate to calculate the value of the grantor's retained right. This rate, called the 7520 rate, is currently 4.40%, up from 1.2% year-over-year.
"We are hearing more and more about people thinking about QPRTs when they haven't in a number of years because the environment is starting to change," Galvagna told Insider.
QPRTs are most relevant to the high-net-worth crowd as the federal lifetime estate and gift tax exemption is $12.92 million ($25.84 million for a married couple). The federal estate tax exemption, however, will be cut in half at the end of 2025, barring further legislation.
These trusts have a few strings attached, but QPRTs are a fairly simple way for the rich to save on taxes and keep homes in the family.
This is how QPRTs work
There are no restrictions on how long a QPRT can last, but the tax savings kick in only if the grantor outlives the trust, so life expectancy should be taken into account. The ideal client is in their forties or fifties as they have better odds of surviving a 10 to 20-year term, and longer trusts mean more property appreciation is excluded from their estate.
The value of the discount is calculated by the IRS using the 7520 rate and several other factors such as the grantor's age and the length of the term.
Another benefit is that after the trust expires, the grantor can still live in the home if they pay a fair-market rent to the new owner. This rent allows parents to transfer more wealth to their heirs free of gift tax. The payments can help the beneficiaries with such expenses as real estate taxes and home improvements.
Here is an example of how a QPRT works, provided by Galvagna:
Consider a grantor who wants to give her adult child a property worth $1 million. The grantor is 50 years old and in good health so she chooses a 15-year term. The 7520 rate is 5% when she funds the trust, so her retained interest is valued at $577,400.
She outlives the 15-year trust and now the property is worth $1,800,944, assuming a 4% growth rate after taxes. However, none of this growth is taxed. The taxable gift – the remainder interest – is only $422,600, the difference between the initial value of the property and the retained interest.
In short, the grantor was able to give a property worth $1.8 million, but only pay gift tax on $422,600.
She was able to live on the property for 15 years, and can pay fair-market rent to her child in order to live on the property after the term ends. The rental payments are not subject to gift tax.
There are a few strings attached, however
The IRS has several requirements for QPRTs, including:
- Taxpayers are limited to transferring two properties: their primary residence and a secondary residence or vacation home.
- QPRTs are irrevocable, so the grantor cannot withdraw assets from it.
- If the grantor stops using the property as a personal residence, the trust will no longer qualify as a QPRT, and all assets have to be distributed to the grantor or the trust has to be converted to a grantor retained annuity trust or GRAT.
- While minor repairs and improvements don't increase the value of the gift, capital improvements do, such as building a new deck or installing central air.
- A grantor can use mortgaged properties for QPRTs, but mortgage payments are considered gifts to the trust, which adds complications like additional gift tax returns. QPRTs work best for homes that are owned free and clear.
The most significant caveat is that QPRTs can cost more in taxes if the would-be beneficiary plans to sell the home, according to Galvagna. If the beneficiary receives the property via a QPRT and sells it, they have to pay capital gains tax on the property's increase in value since it was purchased. If they inherit it upon their parents' death before selling it, they only have to pay capital gains tax on the increase in value since it was bequeathed, thanks to the IRS's step-up in basis rule.
Galvagna talks to clients about the family's plans for the home, and generally advises against QPRTs if the beneficiaries plan to sell the home.
"It's a great strategy for families that are looking to keep property within the family," she said. "Maybe it has sentimental value."
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