In my last two posts, we’ve been looking at James and Susan, married business owners in their late 50’s. James and Susan have a net worth of just under $20 million, and they’ve come to you with some pretty simple estate planning goals: they want to provide first for each other, and then for their two children, Mark, 35, who is married with three children, and Emily, 33, who is a newlywed with no children. Of course, they also want to minimize their overall tax bill as much as possible.
One of the strategies we explored at the Academy Spring Summit that would be particularly useful for a couple such as James and Susan is to establish Qualified Personal Residence Trusts (“QPRTs”) for their primary residence and one secondary residence. If they expect the homes to appreciate significantly, QPRTs may be a great way to move that wealth out of their estates and transfer it to their children in trust.
With a QPRT, an owner gives a residence to the trust while retaining the right to use the property during a term of years. After the term of years, they can retain an option to rent the property from the trust for fair market value rent or the spouse can be given a right to live rent-free. While clients often are not crazy about having to pay rent to live in their own home after the term, this strategy is a great way of removing even more value from their estates.
IRC §2036 provides that if the grantor of the trust dies during the term, the property is included in the grantor’s taxable estate. However, if the grantor survives the term, the property is removed from the taxable estate without further use of applicable exclusion. This can be a powerful way to remove wealth from the grantor’s estate. This is especially powerful when the value of the underlying real estate is depressed in value, as in today’s market.
So, James and Susan can transfer up to two residences into QPRTs and, assuming they outlive the terms designated for the trusts, ownership of the properties will ultimately be transferred to trusts for James and Susan’s children with the following benefits:
- James and Susan can retain the use of the residences
- Because the trusts for the children don’t receive ownership of the properties until the expiration of the specified term of years, the value of the gift to the children is discounted
- Assuming James and Susan survive the term of years specified when the QPRTs are established, the value of the residences are removed from their taxable estates without further use of the applicable estate tax exclusion
Another trick to minimize both the use of applicable exclusion and the mortality risk is doing multiple QPRTs on each residence. For example, James could take his 50% interest in the residence and set up three QPRTs of different terms, let’s say 5-, 10-, and 15-years. Susan could do likewise. If James dies after 8 years and Susan lives 17 years, we would have been successful in removing all of the QPRTs Susan set up and one out of three that James set up. The 10- and 15-year QPRTs which James set up will be included in his estate because he failed to outlive the terms. An additional bonus to fractionalizing the residence with multiple terms is a fractional interest discount. Typically, a fractional interest in real estate would qualify for a valuation deduction of at least 10%. So, 1/4 of a $1 million property would not be worth $250,000, but, rather, would be worth $225,000.
Between the discount inherent in giving only the remainder interest in the QPRT, and the fractional interest discount, this is a very cost-effective way to transfer the asset. Typically, clients may refrain from doing QPRTs because the strategy can use a large amount of applicable exclusion. However, with the new, temporary $5 million applicable exclusion, QPRTs may make more sense than ever.
We also explored other strategies at our conference, including Grantor Retained Annuity Trusts and a sale of the business to the intentionally defective grantor trust.
Stephen C. Hartnett, J.D., LL.M.
Associate Director of Education
American Academy of Estate Planning Attorneys, Inc.
6050 Santo Rd Ste 240
San Diego, CA 92124
- The Magic of Grantor Trusts - September 19, 2023
- IRS Confirms Grantor Trust Status Alone Does Not Cause a Step-Up in Basis - August 15, 2023
- Double Your Gifting with Spousal Gift-Splitting - January 11, 2022