There are asset protection trusts that can be used to reduce the burden if you are exposed to the federal estate tax, and one of them is the qualified personal residence trust (QPRT). Before we look at the value of QPRTs for people who are looking for tax efficiency, we should explain some things about the tax itself.
Every estate is not subject to the estate tax, because you can transfer a certain amount before the tax would become applicable. This figure is called the estate tax credit or exclusion.
For the 2011 calendar year, a $5 million exclusion was established after a new tax law was passed to replace the Bush era parameters. This base figure was retained, but there were annual adjustments to account for inflation through 2017. During that year, the exclusion was $5.49 million.
A fresh piece of tax legislation was signed into law for 2018, and this included a very favorable change to the estate tax exclusion. It was increased to $11.18 million per person, so a married couple would have a total exclusion of $22.36 million at that time. There have been inflation adjustments applied since then, so in 2020, the exclusion sits at $11.58 million.
You should be aware of the fact that the exclusion is portable between spouses. The best way to explain portability is through a simple example.
Let’s say that you are married. You and your spouse enjoy successful careers, and you make sound investments. You both inherit some assets along the way, so between the two of you, there is some considerable wealth.
If you die before your spouse, he or she would have an exclusion, but what about yours? This is what portability is all about. Under these hypothetical circumstances, the surviving spouse would be able to use two exclusions, because the exclusion is in fact portable.
We have an unlimited marital estate tax deduction in the United States. If you are married to an American citizen, you can transfer unlimited property to your spouse free of the estate tax. Transfers to anyone else are potentially taxable.
Any logical person would consider lifetime gift giving as a way to get around the estate tax. This was possible right after the estate tax was established in 1916, but a gift tax was enacted in 1924 to close this loophole. It was repealed in 1926, but it returned for good in 1932.
During the 1970s, the federal government unified the estate tax and the gift tax. As a result, the $11.58 million exclusion is a unified exemption that applies to large lifetime gifts along with the value of your estate.
Tax Efficient Home Transfers
Now that you know the lay of the land when it comes to the federal estate tax, we can look at the value of qualified personal residence trusts.
Your home is probably one of your most valuable assets, so you could gain a great deal of tax efficiency if you could transfer it to a beneficiary at a tax discount. This can potentially be done if you convey the home into a qualified personal residence trust.
This can sound disconcerting, because you need a place to live, but nothing changes at first when you convey the home into the trust. You establish a period of time that is called the retained income period. During this interim, you remain in the home as usual, so your life is not disrupted.
When you place your home into the QPRT, you are removing its value from your estate for estate tax purposes.
In the trust declaration, you name a beneficiary who will assume ownership of the home after the expiration of the term. This transfer would constitute a taxable gift in the eyes of the Internal Revenue Service, so the gift tax would be applicable.
At this point you are probably scratching your head. If the transfer is still going to be subject to taxation, what’s the point?
That is a logical question, but there is also a logical answer. Suppose you are going to try to sell your home on the open market with the stipulation that the buyer could not occupy the home for 10 years. No buyer would pay full fair market value under those circumstances.
You are going to be remaining in the home during the retained income period, so the beneficiary cannot occupy the home during that interim. The Internal Revenue Service takes this into account when the taxable value of the home is being established. It will be considerably less than the actual market value of the home. As a result, the beneficiary will ultimately assume ownership of the home at a tax discount.
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