If you think you may face a gift tax issue, you may want a qualified personal residence trust—a type of irrevocable trust that can remove a house from an estate to reduce gift taxes when transferring it. Here's how it works: The taxable portion of your house is considered a future interest gift, but you can minimize it by using the estate and gift exemption.
You, your spouse and any dependents can continue to live in the residence without any changes while it's inside the trust. You live rent free and continue to pay any normal operating expenses so you can claim all appropriate income tax deductions.
But you only have a right to the residence for the trust-stated term, so your home isn’t as marketable as when you own your house outright. This of course increases the inconvenience to any creditors who can’t force you to sell your home. The longer the QPRT’s term, the larger your retained interest and the smaller the amount of gift tax exemption used.
Once the term of the QPRT expires, you can still occupy your house, but you give up ownership to your beneficiaries. Then you pay a fair-market rent to keep living in your home, but that rent passes to the next generation without any gift tax implications.
You’ll appreciate the financial perks—a QPRT removes all future appreciation from your taxable estate while using little of your lifetime gift tax exemption. You’ll also be hedging against possible decreases in the shared lifetime gift tax and estate tax exemption. You’ll lock in the value of your residence for gift and estate tax purposes. You won’t have to worry about how much your house appreciates in value.
However, it's not without risk: The QPRT transaction will be completely undone if you die before the trust period ends. The value of your home will be reassessed and included in your taxable estate at its full fair market value as of the date of your death.
When would you want to employ a QPRT?
Let’s look at an example: You want to pass your house to your child, but right now, you don’t want to move out. You can reduce the tax impact on your estate with a QPRT for 10 years. Then, in 10 years, the house increases in value and the gains will be tax free so you as the parent only have to pay gift tax on the initial value of the house in the trust, not on the increased value.
Among the factors that make QPRTs less attractive are the provisions pertaining to the adjoining land, outliving the trust and selling the home before the term’s end. An heir who sells the home after the retained income period ends will owe capital gains taxes based on the difference between its value at the time the gift was made and the price of the sale. That’s why it’s better to use QPRTs with heirs who plan to keep the house in the family for generations.
Not everyone will need a QPRT, but for most people, their primary residence is the single most valuable asset they will leave their heirs. Talk with a financial professional to find out whether a QPRT or another technique is best suited for handing the family home to the next generation.
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