|Qualified Personal Residence Trust (QPRT)
The first tip off that someone is not an asset protection planner is the suggestion that the best way to asset protect a residence is through a QPRT. We are not personally fans of a QPRT for most clients; and as it is discussed below, you will see why. Having said that, a QPRT is one of only a few ways a client who does not have an unlimited homestead exemption or lives in a TE state can protect his/her personal residence.
A QPRT is a trust set up where the personal residence is gifted to the children in an irrevocable manner. Those who like the QPRT tout the fact that the personal residence can be transferred to the heirs via a trust at a low gift tax value and with NO estate-tax consequence. The person gifting the house to a QPRT gets to live in the house rent free to a specified period of years. If the person gifting the house survives to the end of the term, the residence will pass estate-tax free to the heirs.
During the trust term, the owner/spouse in the residence is responsible for maintaining the property and paying taxes and expenses connected with the occupancy. This means that the term holder is treated just like an ordinary owner in a residence. If there is a mortgage on the property, the term holder should continue to make the payments; but a portion of each principal payment may be considered to be an additional gift to the remainder beneficiaries. That would add to the complexity of the calculations for the trust.
Let’s look at an example of how to set up and use a QPRT.
Dr. Smith is age 65, and his spouse is also 65 years old. He does not live in Florida or Texas; and, therefore, the homestead exemption is of little help when it comes to asset protection. Also, assume he does not live in a TE state.
Dr. Smith is an OBGYN and is fearful of losing his house to a patient creditor in a medical malpractice suit. The house is worth $400,000 with no debt on it so he decides to gift it to a QPRT. If we assume the term of occupancy for Dr. Smith in the house is four (4) years, the current value of the gift to the QPRT would be approximately $210,000. Dr. Smith could use some of his estate tax credit to pass the house to the QPRT gift tax free.
The taxable gift upon transfer of an asset to a QPRT is determined by subtracting the value of the client’s right to remain in the home (valued as an income interest) and the value of the possible reversion to the grantor’s estate. No gift tax will ever be paid on any future appreciation on the home.
After the fixed term ends, Dr. Smith 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 Dr. Smith 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.
If Dr. Smith survives the fixed term of the QPRT, the value of the residence will not be included in his estate for 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 not a bad way to remove a residence’s value from one’s estate at a greatly reduced gift tax cost.
Downside to a QPRT
1) If the client dies prior to the end of the term, the asset will be includible in the client’s estate (and this will act for the most part like the QPRT was never put in place). The deceased client’s estate will be given credit for any gift tax previously paid, and the estate tax calculation will take into consideration the entire lifetime exemption.
2) If the client outlives the term of years, typically he/she will lose control of the property and could be thrown out of the house if there was a falling out of with the beneficiaries of the QPRT.
3) If the client has a provision in the trust to live in it past the term of years, the client will end up paying rent to the beneficiaries of the trust at the fair market rate. This rent is not deductible to the renter and will be income to the beneficiaries.
Conclusion on the QPRT
The QPRT can work as an asset protection tool, but younger clients will be hesitant to use this concept due to the difficulty in picking a term of years on a property that will most likely be sold prior to an ultimate transfer to the heirs. If the client lives through the term of years of the QPRT, he/she runs the risk of being thrown out of their own residence by the beneficiaries or paying non-deductible rent payments which will be taxable to the beneficiaries.
As an asset protection tool, the QPRT has marginal value; however, the QPRT is not a bad estate planning tool for clients over the age of 60 to gift away a large asset at a significant discount where if the client (grantor) lives through the term of years of the QPRT, the asset will pass income and estate tax free to the beneficiaries (even if the asset significantly appreciates in value).