A qualified personal residence trust allows a person to make the most of his or her gift tax exemption. IRS regulations offer a guide to accomplishing a successful transfer that can reduce substantial future gift and estate taxes. Anyone with a significant estate who expects to be subject to prospective transfer taxes is wise to consider a qualified personal residence trust.
The federal interest rate under section 752 of the Internal Revenue Code dictates the auspicious tax outcome of appreciating the gift of a residence. The higher the federal rate, the lower is the gift value and the lower the prospective gift tax. A low federal interest rate usually means lower estate tax savings.
A qualified personal residence trust involves a lifetime transfer of a personal residence (first or second home) in exchange for continued rent-free use of the residence for the trust term. If the settlor survives the trust term, the residence either delivers entirely to the trust beneficiaries or remains in trust for their benefit. A successful qualified personal residence trust allows the settlors to alleviate the gift or estate tax cost of transferring a residence by taking advantage of the gift tax exemption. Since this method is explicitly allowed under tax regulations, there is minimal tax risk.
If the settlor does not survive the term of the personal residence trust, the full value of the residence will be included in their taxable estate.
If the settlor does not outlive the trust term, the fair market value of the home is brought back into his or her estate, while the earlier taxable gift is removed. If the settlor survives the trust term, he or she may be allowed to lease the residence back from the beneficiaries, who are generally family members. Lease payments constitute another method of benefiting heirs without any further gift or estate tax consequences. If the residence transferred to the trust is subject to a mortgage, accounting the monthly mortgage payments and minimizing the income tax consequences carries an added complexity.
A qualified personal residence trust requires only a principal residence or other personal residence, such as a second home, that is eligible for tax treatment. A single person cannot have more than two qualified personal residence trusts. Neither the settlor nor a spouse is allowed to repurchase the residence from the qualified personal residence trust during the trust term or thereafter. If the residence is sold during the trust term, the sale proceeds must be either re-invested into a new residence within two years, or the trust will have to cease, and assets will be distributed to the settlor or convert to the settlor.
If the property stops being used as a personal residence, the trust is no longer a qualified personal residence trust, and the trustee must dispense the assets to the grantor or convert the trust into a grantor-retained annuity trust. This type of trust provides for the payment of an annuity for a fixed term, with the balance passing to the remainder beneficiaries at the end of the term.
Creating a qualified personal residence trust requires balancing the potential estate tax savings against the consequences of relinquishing ownership to the next generation. An experienced professional is recommended to help give adequate consideration to both tax and nontax consequences.