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Living in beautiful San Diego, it should not come as a surprise that there are homes in neighborhoods like Del Mar and Rancho Santa Fe that are valued anywhere from $1 million to upwards of $20 million. If you own a gorgeous residence by the beach with that perfect ocean view, you should consider using qualified personal residence trusts to reduce your taxable estate. It is never too early to plan for the future, especially when the 40% estate tax is looming.

In a nutshell, a qualified personal residence trust (QPRT) is a tool that allows you to remove the value of your primary or secondary (vacation) home, and all future appreciation, from your taxable estate by making a gift that is only a fraction of the home’s value. You create the trust for a term of years and designate beneficiaries, which would be you/your spouse for this initial term and then someone else thereafter. After the term of the trust expires, the residence is then gifted to the trust. By placing your home in this type of irrevocable trust, you and your spouse can continue to live in your primary residence rent-free while maintaining the ability take all the applicable income tax deductions during the initial term (i.e. property taxes, home mortgage interest, etc.).

It should be noted that for the QPRT strategy to be effective for estate tax purposes, you/your spouse must outlive the initial term of the trust. However, if one spouse dies before the end of the trust term, the residence is once again includable in his/her estate. This would have happened from the get go and so you break even. There is little risk associated with this estate planning technique.

At the end of the trust’s initial term, you lose your interest in the trust (i.e. your personal residence). However, you can stay on as the trustee and continue to live in the home by paying rent at a fair market price. This rent income to the trust can be used to pay the costs of keeping up the home. This strategy does however allow you to give more to your heirs free of gift tax consequences.

Let us look at an example to illustrate the benefits of creating a qualified personal residence trust. Let’s say you and your spouse both create QPRTs and place 50% of the home valued at $1,000,000 in each, $500,000. You are both 55 years old and set the trust to have an initial term of 20 years. Let’s also assume you both live to age 80 and the house appreciates at 5% annually.

Example You Your Spouse Total
Current FMV  $500,000  $500,000  $1,000,000
Less Minority Interest Discount ($100,000) ($100,000) ($200,000)
Value of Property placed into QPRT  $400,000  $400,000  $800,000
Immediate Gift to Heir (3% Interest Rate)  $156,761  $156,761  $313,522
FMV of Home 20 Years Later  $1,693,177 $1,693,177  $3,386,354

Even though we cannot predict what gift and estate taxes will look like 20 years from now, it is clear that incurring a $313,522 taxable gift is likely to reduce a taxable estate by $3,386,354.

One thing to keep in mind, however, is that if the beneficiaries decide to sell the residence after the end of the term of the trust, they may incur a significant income tax liability. The property does not receive a step up in basis after the grantor passes away the way it would if the property were not placed in a QPRT. Thus, it is important to consider not only the estate tax benefits, but the income tax consequences of losing the basis step-up as well.

QPRTs may work out great in some situations, but are definitely not for everyone. There are other negative consequences that may arise when entering into a QPRT, so it is important to understand how they may or may not fit into your estate plan. If you have any questions or are interested in understanding how qualified personal residence trusts may benefit your particular situation, please do not hesitate to contact us at (858) 558-9200.

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