Interest rates have now soared at a speed and magnitude not seen in decades, transforming the planning landscape. As interest 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 may sound like a trendy new workout routine, but it’s actually a way to transfer your property to loved ones without the steep tax hit. That’s because a Qualified Personal Residence Trust enables you to transfer ownership of your primary residence or vacation home out of your taxable estate at a lower gift tax value.
How does it work? Essentially, you transfer ownership to an irrevocable trust, but are allowed to keep living in the property during the trust’s term. This means that the value of the taxable gift you make is reduced by the value of your retained use (think of it as applying a discount because you’re 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 (Display). It’s an effective way to transfer your property to your 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. This is because federal tax laws rely on something called the 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 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. While it may sound complicated, it often becomes clearer when you see it in action. 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 exclusion1 she’s using to do so. We first analyzed a Qualified Personal Residence Trust for Harper towards the end of 2020 when the section 7520 rate was only 0.4%. If she had funded a QPRT then, 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 Harper waited for interest rates to climb, funding the trust at a 5.0% section 7520 rate. By capturing the higher rate, the calculated retained interest grew to half of the value of the home, and the implied gift now totaled just $2.5 million (Display). That’s almost a 36% decrease in the lifetime applicable exclusion used!
The Other Side of the Coin
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 you’re considering a Qualified Personal Residence Trust, pay close attention to the trust’s term. As it increases, so does the value of the nontaxable retained interest (because you’re 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.3 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 (Display).
When exploring a Qualified Personal Residence Trust, be sure to compare the expected estate tax savings to the potential income tax consequences. Transferring appreciated property through a QPRT while you’re still alive could mean forgoing a step-up in cost basis on the property at death.
Plus, depending on where you live, a QPRT could also trigger a reassessment of your 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, you could end up losing out on the lower property tax value base, which would eat into the tax savings you were hoping for with the QPRT.
Things can get a bit trickier if the property you’re putting into a QPRT still has a mortgage on it. To determine the value of the gift, you must account for how much equity you have left after netting out what you still owe on the mortgage. And every time you make a monthly mortgage payment, that’s considered a new contribution to the trust. That means you might have to pay gift taxes on those contributions based on the prevailing section 7520 rate at the time of payment.
Make an Informed Decision
Qualified Personal Residence Trusts can be an attractive way to transfer your primary residence or vacation home to your beneficiaries while minimizing wealth transfer taxes, especially when interest rates are high or on the rise. However, it’s crucial to weigh the pros and cons of a QPRT before making any decisions. To help you figure out if a QPRT is right for you, speak to your Bernstein financial advisor or estate planning attorney.
- Jacob Sheldon, CFA
- Senior Analyst—Investment & Wealth Strategies
1 As of January 1, 2023, each US citizen and permanent resident may give away during life and/or at death up to $12.92 million free of federal gift and estate tax. Barring congressional action, however, this amount will drop to a forecasted exclusion of $6.9 million on January 1, 2026, leaving only those individuals who made a gift in excess of $6.9 million prior to 2026 with the benefit of some or all of the excess exclusion.
2 A workaround to avoid the income tax liability for beneficiaries could be to establish a grantor trust as the beneficiary of the QPRT.
3 A QPRT can hold limited amounts of cash for expenses or improvements to the residence and allow the residence to be sold (but not to the grantor or the grantor’s spouse). For income tax purposes, a QPRT is taxed as a grantor trust, which means all income, deductions, and credits are treated as if there was no trust, and these items were attributable directly to the trust’s grantor. Since the grantor is treated as the owner of the home for income tax purposes, the grantor should be able to exclude up to $250,000 (or $500,000 if filing jointly) of capital gains from the sale of a primary residence. However, if the residence is sold, or if the QPRT ceases to qualify as a QPRT for any other reason, either all the trust property must be returned to the grantor or the QPRT must begin paying a “qualified annuity” to the grantor (much like a grantor-retained annuity trust, or GRAT).