Sharing The Wealth

For most wealthy clients, a residence not only defines who they are and what they like, but it is also a significant repository of wealth. Many want to preserve a special place for the next generation to use and enjoy. A co-op apartment on Central Park, a beachfront Nantucket home, a slope-side chalet in Aspen, a ranch in Wyoming or a house in Palm Beach all speak volumes about the individuals who own them. Many properties are unique or special. This scarcity value often helps these types of property to appreciate at higher rates than typical residential real estate. Knowing how to take advantage of these properties can create avenues to pass wealth to the next generation in a tax-efficient manner. Two such techniques are the qualified personal residence trust (or the "QPRT," as its commonly called) and the sale of a remainder interest in a personal residence. The QPRT can work nicely with properties valued in the low millions. For "trophy" properties, the sale of a remainder interest may be a better option. Obviously, there is no "one-size-fits-all" technique, and there are many variables that must be considered when planning with a luxury residence. This article will discuss these two planning options and their relative pros and cons.

The QPRT

A QPRT is an estate-planning vehicle authorized under the Internal Revenue Code. It allows an individual to transfer his future ownership in a personal residence to the next generation at a significantly reduced gift tax cost while he continues to enjoy the use of the property for a set period of years.

The Basics

The owner of the property (the grantor) deeds his or her home, be it a primary residence, a vacation home, a condominium or a cooperative (but not a time-share) to an irrevocable qualified personal residence trust. Under the provisions of the trust, the grantor retains the right to live in the house for a specified period of years (also known as the "QPRT term.") During this term, the grantor, as trustee, may have control over the home and can even sell it, though the proceeds of the sale would remain in trust and generally would need to be used to purchase a replacement home. If some or all of the proceeds from the sale of the house are not used to purchase a new residence, then the proceeds are paid out to the grantor as an annuity over the remainder of the QPRT term. In essence, this undoes the planning accomplished by the QPRT, as the money paid out to the grantor from the QPRT will be included in the grantor's estate.

Additionally, during the QPRT term, the trust is disregarded for income tax purposes, allowing the grantor to take full advantage of all deductions (such as real estate taxes) associated with the home and any capital gains exclusions available for the sale of a primary residence. If the grantor outlives the QPRT term, the home, including all future appreciation, is excluded from the grantor's estate.

At the end of the QPRT term, the ownership of the home passes automatically to the remainder beneficiaries of the QPRT, typically to the children of the grantor or a continuing trust for their benefit. Also at the end of the term, the grantor may agree to rent the property from the new owners at fair market value and continue to live in the home. While at first glance payment of rent to live in your own home may seem undesirable, the rental payments allow the grantor to pass additional wealth to his or her children in a gift-tax-free manner. If the residence continues in a trust for the grantor's children, and the continuation trust is a "grantor trust" as to the grantor, the rental payments will be both income-tax free and gift-tax free.

The Gamble: Will The Grantor Outlive The QPRT Term?

The estate and gift taxes saved in such a transaction are the result of a gamble that the grantor enters into when creating the QPRT-the gamble that he will survive the selected QPRT term. How long should the grantor retain the use of the property? A longer term will result in a smaller taxable gift, but with a longer term comes greater risk. If the grantor dies before the end of the QPRT term, the residence reverts back to the grantor's estate and the full fair market value of the home at the time of his death will go into his taxable estate. In such event, the purpose of the trust is defeated and the estate tax result would be the same as if the grantor had never done the planning in the first place. The grantor would be in virtually the same position as if no planning had been undertaken, except that he would be burdened with relatively modest legal costs to set up and administer the QPRT and he would also have to consider the opportunity cost of not having pursued another estate planning technique. These risks and costs, however, can be ameliorated with a life insurance program designed to complement the QPRT.

On the other hand, if the grantor outlives the QPRT term, the property will not be included in the grantor's estate, and therefore will pass to the grantor's children or trusts for their benefit without further gift or estate taxes. In this case, the only cost of moving this sizable asset out of the grantor's estate would be to use up the grantor's lifetime gift-tax exemption, which is currently set at $1 million, or, if the gift exceeds this amount, the payment of the resulting gift tax.