The Qualified Personal Residence Trust ("QPRT") is special kind of irrevocable Trust which can be used to transfer a person's residence to his children (or any other beneficiaries) at a significantly reduced gift tax cost and with no estate tax, yet allow him to continue to live in the residence for as long as he wishes. Here's how the QPRT works. Assume both Dad and Mom are alive. Dad will execute a separate QPRT for his one-half interest in a community property state. Mom will also execute a separate QPRT for her one-half interest. The following illustration also works for a widowed or otherwise unmarried Dad who owns the entire residence.
During Dad's lifetime, he transfers his residence (share of) to the Trustee of the QPRT. He can be the Trustee of the QPRT. The Trustee must allow Dad to continue to use the residence rent-free for a fixed number of years specified in the Trust instrument (the "fixed term"), which should be a term Dad will likely survive. During the fixed term, he will continue to pay mortgage expenses, real estate taxes, insurance, and expenses for maintenance and repairs, and will continue to deduct mortgage interest and real estate taxes on his individual income tax return. When the fixed term ends, the residence will be distributed to his children, or will remain in further trust for them.
Even after the fixed term ends, Dad can continue to use the residence in one of two ways. First, the residence can be retained in trust for his spouse's lifetime, thus assuring that the entire residence is available to her, before it will be distributed to the children upon the spouse's death. Second, he can enter into a lease with his children which will allow him to live in the residence for as long as he wishes. If Dad does so, however, he must pay fair market value rent to his children after the fixed term ends in order to keep the residence from being subject to estate tax on his death. Although Dad's transfer of the residence to the QPRT is a taxable gift, he is allowed to subtract, from the fair market value of the residence, the value of his right to live rent-free in the residence for the fixed term. Thus, the amount of the taxable gift will usually be substantially less than the fair market value of the residence. The technical name of the interest gifted is the "remainder interest." If the gift of the remainder interest is less than Dad's available applicable exclusion amount (the "AEA") from federal gift tax ($1,000,000), no gift tax will be due as a result of his gift to the QPRT.If Dad survives the fixed term of the QPRT, the value of the residence will not be included in his estate for federal estate tax purposes. Even if he does not survive the fixed term, the estate tax consequences will be no worse than they would have been if he had not created the QPRT in the first place. In other words, from an estate tax point of view, there's no potential downside to a QPRT. A QPRT is an extremely effective way to remove a residence's value from one's estate at a greatly reduced gift tax cost.
If a single Dad who is 75 years old creates a 2-year term QPRT in March of 2006 with a residence valued at $1,000,000, the amount of gift (determined under the IRC §7520 tables for a remainder interest) will be $827,710. This amount is less than the current AEA of $1,000,000, and therefore no gift tax will be owed. Essentially, if Dad survives the 2-year term, $172,290 of estate value, plus any appreciation on the residence from the start of the QPRT, will be removed from his taxable estate.
If a 4-year term QPRT is created, the amount of gift will be $674,560. Removed from the estate will be $325,440 of value. If an 8-year QPRT is created, the gift will be $418,990. Removed from the estate will be $581,010 of value.
The longer the term or the older the age of Dad, the less will be the amount of remainder interest gift value. However, a longer QPRT term or an older age will increase the risk that Dad will not survive the QPRT term.
