06/07/2000

How to Pass on the Family Vacation Home

Summer is nigh and you are planning to spend time at your summer home. It is a special place because of all the memories created there over the years. As you plan for the future and the next generation, you want to make sure the summer home stays in the family! You know that the children and grandchildren have already developed their own love for the place, and couldn’t stand to see it sold. So how do you transfer ownership to the kids for the least amount of estate taxes? One approach is through a qualified personal residence trust commonly known as a "QPRT" (cue-pert).

What is a QPRT?

A QPRT is a legal document -- trust -- that transfers ownership of a qualified residence to someone else -- the children in this example -- while reserving your right to use the home for a period of years. After the period of years, the children, or other beneficiaries, own the residence. The benefit -- you will have greatly reduced the value of the gift of the residence to your kids, thereby preserving more of your estate tax credit. The larger your estate tax credit, the lower the check your children may have to send to "Uncle Sam" for estate taxes.

What is the Estate Tax Credit?

The federal government has given each of us a credit in order to reduce our combined estate and gift tax burden. This year -- 2000 -- the credit is $220,550 which will enable an individual to pass a total estate valued at $675,000 (the "applicable credit amount") estate tax free. The estate tax credit will increase every year till 2006 at which time one will be able to avoid estate and gift taxes on an estate (transfers) valued at $1 million -- the applicable credit amount.

If you were to directly give a personal residence to you heirs you would be reducing your applicable tax credit amount. The lower your credit amount, the more your heirs will have to pay in estate taxes. Thus, you may want to consider a QPRT as a way to gift away a personal residence and preserve more of your estate credit.

How Does a QPRT Work?

Example: Tom Beach, in his 60’s, own a beautiful vacation home (or personal residence) which he wants to leave to his children. The home is worth $300,000. If Tom makes an outright gift of the home to the kids, he will lose almost half

of the $675,000 "applicable estate tax credit amount" mentioned above. So instead of making a direct gift of the vacation home, he chooses to use a QPRT.

In establishing the QPRT, a right to use the home for 15 years is reserved. In doing so, Tom has made a taxable gift to the children of approximately $122,000, not the $300,000 market value. Of his $675,000 estate tax credit amount, Tom has $553,000 remaining ($675,000 - $122,000).

The reduction in the gift amount from $300,000 to only $122,000 is due to the fact that Tom retained a legal right to use the home. Thus, he did not make a gift of the entire home at present. His retained right over the next 15 years has a value which reduces the value of the gift. The greater the number of years of the retained right, the lower the value of the gift to the Beach children.

Choosing the Term of Years

If you have followed the logic so far, you are now asking why didn’t Tom make the retained right a term of years of 30 or even more. Surely a retained right of 30 would reduce the value of the gift to almost nothing and preserve more of Tom’s estate tax credit. Yes, you are right, a larger number of years for the retained right of usage would have accomplished this. However, Tom knew that a QPRT only worked if the donor outlives the term of years. The Beach’s felt strongly that Tom would live another 15 years, but possibly not 30. So in choosing the 15 years, they were picking a number large enough to get a sizable gift reduction, but not so large that Tom would not be able to outlive it.

Living and Not Outliving the Term of Years

What happens if Tom does not outlive the 15 years set up for the QPRT? If he dies before the 15 years are up, the trust is void and the gift deduction is lost. However, this event falls into the category of "nothing ventured nothing gained". If Tom outlives the term of years, his estate gets a nice gift reduction, if he doesn’t, then he hasn’t lost anything in making the effort (except for the cost of setting up the trust.)

If Tom outlives the term, and wants to continue to use the home he/they must pay fair market rent to their children. Failing to do so could result in tax problems. On the plus side, paying rent is a good way for them to transfer additional assets to the kids without the concern to gift taxes. (If the residence passed to a trust in which Tom’s wife is the beneficiary, Tom could use the home as her guest.)

What Did the QPRT Accomplish

In using a QPRT, Tom:

1. Transferred a $300,000 property for only $122,000, thus preserving more of his estate tax credit.
2. Reserved the legal right to continue to use the home thus maintaining control of his life and this home for the next 15 years.
3. Locked in the cost of the transfer at today’s value! In other words, the value of the gift will remain at $122,000 -- even if the value of the home increase!

When you die your heirs receive a step-up in the tax basis of transferred assets. For example, Tom Beach paid $75,000, (his cost basis) for the home now valued at $300,000. If the property transferred at this death, his heirs would have received a step-up in basis. Thus, the children could sell the property and avoid any capital gain because the cost basis would be equal to the fair market value after Tom’s death. However, Tom choose to use the QPRT and in doing so his heirs lost the step-up in basis. Usually, this is not an issue, because someone using a QPRT is doing so to keep the residence/vacation home in the family, not intending to sell it. Furthermore, the capital gain rate is lower than the estate tax rate, so it is wiser to try to avoid estate taxes.

Please send questions or comments to dcoffin46333@wradvisors.com.