Bardell Real Estate Logo

NEW YORK – Oct. 31, 2008 – Plunging real-estate values have made it an opportune time for older homeowners to give property to their children, while realizing big savings on gift and estate taxes.

They can do this by moving the home out of their estate with a so-called qualified personal residence trust, or QPRT, which allows homeowners to live in a property for many years before passing it on to their heirs. Though the trusts have been around for many years, many estate planners say now could be a good time to set one up since real-estate values have fallen dramatically in many markets.

QPRTs are one of a number of strategies that wealth advisers and estate planners are recommending as clients cope with beaten-down financial markets and a nasty real-estate landscape. The goal: Put beaten-down assets into trusts now and reap benefits from their appreciation outside of your estate. With real-estate values low, executing a QPRT now ensures your estate won’t contain a more-expensive home down the road, which could trigger a costly tax bill for your estate.

Most estate planners say activity on QPRTs remains quiet these days amid uncertainty over the direction of the estate tax and investors’ timidity in parting with assets during a bear market. But these same wealth advisers say conditions could be ripe – now and in the months ahead – for executing these trusts.

By transferring your home into a QPRT (often pronounced CUE-pert) when the value of your home is most likely at a low point, you’re effectively locking in a lower gift-tax amount when you move the home into the trust. And if interest rates move higher in the months ahead, that discount could be even greater because of the special method the Internal Revenue Service uses to compute the home’s gift-tax value.

“We’re probably heading to a time where it might be a perfect storm” of market conditions that make it the time to set up a QPRT, says Janine Racanelli, head of the Advice Lab at J.P. Morgan Chase & Co.

Henry “Terry” Christensen III, a lawyer at McDermott Will & Emery LLP, says his firm executed about 50 percent more QPRTs earlier this year than it did two years ago. Mr. Christensen says that the trusts are especially popular in California and Florida, where home prices have dropped the most.

Here’s how a QPRT works: Say you’re 60 years old and own a $1 million home. You’d like to leave the home to your children, but worry the property could jack up the value of your estate, perhaps pushing it high enough to trigger the estate tax. (The basic federal estate-tax exemption is $2 million per person for 2008, with the top estate-tax rate at 45 percent.)

To move the asset out of your estate, you can put the home into a QPRT for a term of 10 years (terms can be longer or shorter, depending on your situation). For those 10 years, your living arrangements don’t change – you live in the home and pay all the expenses, including property taxes.

Because you’ve given the home to a QPRT, you’ll have to file a gift-tax return that year, but you stand to benefit from a complex IRS formula that actually discounts your gift amount when you move the home into the trust. Assuming that value doesn’t push you over your $1 million lifetime gift-tax exemption, you won’t have to pay taxes at all.

The formula, among other things, considers your age, the IRS’s current applicable federal rate of 3.8 percent, which is the federal interest rate used to set up trusts or loans to relatives, and the 10-year length of the trust. Assuming your home appreciates 4 percent a year, the formula can nearly halve the value of your house for gift-tax purposes.

After 10 years, the home transfers to your beneficiaries, usually your children. At this point, they own the home, and it’s outside your estate and won’t be subjected to estate taxes. In this example, when the QPRT expires, your home is worth nearly $1.5 million. Assuming you live well into your 70s or 80s, it’s likely to be worth even more.

If you wish to remain in the home, you’ll have to pay fair-market rent to your kids, or risk running afoul of the IRS, which could scrutinize your children for allowing rent-free use of the property. When you die, your children keep the house and don’t have to pay inheritance taxes.

In 1986, Tom and Margie Williams of Columbus, Ohio, bought a lakeside cottage on Walloon Lake in Petoskey, Mich., near the northern tip of the state. Over the years, the couple and their three daughters spent summers there and used the spot for Christmas reunions. The home also had some historical value: Built in 1875, it stands in a lakeside community where Ernest Hemingway spent time as a child.

As the Williamses entered their 60s, they sought estate-planning advice, determined to keep a property near and dear to them in the family without burdening their children with a bigger estate-tax bill.

In 1996, the couple turned the $300,000 home over to a QPRT for a 10-year term. At the time, the applicable federal rate was 7.6 percent. The value of the cottage for gift-tax purposes was only about $120,000. The couple were nowhere near exceeding their lifetime $1 million gift-tax exemption, so they didn’t have to pay taxes on the transfer.

In 2006, the home passed to their children, who now collect rent from the couple in exchange for their right to use the home. “I always tell Margie, ‘Check with the landlord,’“ when something goes wrong, says the 73-year-old Mr. Williams.

The Williamses passed more money to their daughters through other maneuvers in the hope that they’ll maintain the home for years to come. “They’ve kept it this long,” says Margie Williams, “and they won’t have to pay the inheritance taxes.”

These trusts have some quirks. If you die before the trust term expires, the home reverts to your estate, nullifying any potential estate-tax savings. Because of this rule, it’s essential to take stock of your age and health when drawing up the trust.

Also remember that a QPRT is an irrevocable trust, meaning you have to give up the home when the term ends. That type of planning can be tricky – it’s sometimes hard to predict what your relationship with your children will be one or two decades down the line, and there’s no guarantee your beneficiaries will let you stay in the house.

Of course, a QPRT makes sense only if you anticipate your assets will exceed the estate-tax exemption when you die. In 2009, that exemption jumps to $3.5 million.

The tax is set to vanish in 2010, and then return in 2011 with a lower $1 million exemption and a 55 percent top rate. But most estate planners are betting Congress will revise the current structure. Both presidential candidates want to keep the estate tax, though with different exemptions and tax rates.

In addition to uncertainty surrounding the estate tax, some estate planners discourage QPRTs at times like these, when interest rates, including the applicable federal rate, are low. That’s because you get a greater discount on your gift-tax value when the rate is higher. But other advisers tell clients not to focus too much on the rate, especially if your home’s value has declined significantly in the past year or two.

“I think the idea that they’re only attractive when interest rates are high is just a myth,” says Natalie Choate, a Boston estate-planning lawyer and author of a widely used book on QPRTs. “If you wait until interest rates are high, it may be too late because of your health or because the house has appreciated dramatically.”

Source: FAR