Interest rates have soared at a speed and magnitude not seen in decades, transforming the planning landscape. As rates have marched higher, so too has the salience of a qualified personal residence trust (QPRT). But while a QPRT can be a valuable wealth transfer tool, it’s important to weigh the income tax impact—and other considerations—before proceeding.
What’s a QPRT?
A QPRT is a way for your client to transfer your property to loved ones without the steep tax hit. That’s because a QPRT enables your client to transfer ownership of their primary residence or vacation home out of their taxable estate at a lower gift tax value.
How does it work? Essentially, your client transfers ownership to an irrevocable trust, but is allowed to keep living in the property during the trust’s term. This means that the value of the taxable gift your client makes is reduced by the value of their retained use (think of it as applying a discount because your client is still enjoying the property).
At the end of the term, the trust terminates, and all remaining property transfers irrevocably to the trust’s remainder beneficiaries free of gift or estate tax. It’s an effective way for your client to transfer property to their loved ones without the exorbitant wealth transfer tax burden.
How Interest Rates Factor In
As far as tax planning strategies go, QPRTs respond quite well to a spike in interest rates, setting them apart. That’s because federal tax laws rely on the Internal Revenue Code Section 7520 rate (120% of the applicable federal mid-term rate) to calculate the value of the grantor’s retained use of the transferred real estate.
The higher the IRC Section 7520 rate, the greater the value assigned to the grantor’s retained interest—which means the lower the value of the trust’s remainder interest. Let’s look at an example to quantify the impact on the calculated gift taxes.
Harper is 65 years old, and her home is currently worth $5 million. She wants to transfer the home to her children through a QPRT with a 10-year term, but she also needs to be mindful of the lifetime applicable exclusion she’s using to do so. If Harper had funded a QPRT towards the end of 2020 when the Section 7520 rate was only 0.4%, the calculated retained interest of the home would have only been $1.1 million, and $3.9 million would be the implied gift counted against her lifetime exclusion.
But if Harper waited for interest rates to climb, funding the trust at a 5% Section 7520 rate, she would capture the higher rate. So the calculated retained interest would grow to half of the value of the home, and the implied gift would total just $2.5 million. That’s almost a 36% decrease in the lifetime applicable exclusion used!
The Trade-Off
While this may sound attractive, there’s a trade-off. Once the term is up, the home no longer belongs to Harper as the grantor. She may continue to live on the property but must pay rent at fair market value to keep the property out of her taxable estate. As a result, she’ll need sufficient liquidity to make the rent payments after the QPRT term. And keep in mind, rent paid to a separate taxpayer—such as her adult children—is considered taxable income to them.2
If your client is considering a QPRT, pay close attention to the trust’s term. As it increases, so does the value of the nontaxable retained interest (because your client is using the property for a longer period)—resulting in a more efficient transfer of wealth. On the other hand, a longer term heightens the mortality risk. If a grantor dies before the end of the trust term, the property will be included in the grantor’s estate for estate tax purposes—thereby unwinding the strategy. Put simply, to transfer real estate at a fraction of its value, the grantor assumes the risk of not surviving the QPRT term.
Let’s revisit Harper. Lengthening the term of her QPRT from 10 years to 20 years decreases the lifetime applicable exclusion she uses to $900,000 (a $1.6 million drop). But she must carefully weigh the benefits of using less of her exclusion against the increased mortality risk—and ultimate inclusion in her taxable estate if she were to pass away during the trust term.
Other Considerations
When exploring a QPRT for your client, be sure to compare the expected estate tax savings to the potential income tax consequences. Transferring appreciated property through a QPRT while your client is still alive could mean forgoing a step-up in cost basis on the property at death.
Plus, depending on where your client lives, a QPRT could also trigger a reassessment of their property’s value for state and local property taxes. In California, for example, a property’s assessed value can only go up by 2% each year unless there’s a change in ownership or new construction. And the transfer of ownership at the end of a QPRT’s term is typically considered a change in ownership. So, your client could end up losing out on the lower property tax value base, which would eat into the tax savings they were hoping for with the QPRT.
Things can get a bit trickier if the property your client is putting into a QPRT still has a mortgage on it. To determine the value of the gift, you must account for how much equity your client has left after netting out what they still owe on the mortgage. And every time your client makes a monthly mortgage payment, that’s considered a new contribution to the trust. That means your client might have to pay gift taxes on those contributions based on the prevailing Section 7520 rate at the time of payment.