On May 3, 2023, the Federal Reserve raised interest rates, this time to a range between 5% and 5.25%. It marked the tenth increase since March 2022. As rates continue to rise, estate planning strategies must shift to take advantage of these new economic conditions. One such tactic is the Qualified Personal Residence Trust (QPRT). A QPRT is an irrevocable trust designed to hold a primary or secondary residence, which can provide significant tax savings and asset protection for high-net-worth individuals. In this article, we will explore how QPRTs function and why they are particularly beneficial in a high interest rate environment.
A QPRT allows the grantor (the person creating the trust) to transfer ownership of their residence to the trust while retaining the right to live in the property for a predetermined number of years. At the end of this term, the residence is passed on to the trust beneficiaries, usually the grantor’s children or other family members. The primary advantage of a QPRT is the reduction of the grantor’s taxable estate, as the value of the residence is removed from their taxable estate upon the trust’s creation.
The effectiveness of a QPRT is enhanced in a high interest rate environment because the value of the taxable gift made upon the creation of the trust is lower. This value is calculated using the applicable federal rate (AFR) in conjunction with the term of the trust and the value of the residence. A higher AFR results in a lower taxable gift, providing a greater tax advantage for the grantor. Additionally, as the property’s value is locked in at the time the QPRT is established, any appreciation on the residence’s value during the trust term will not be subject to estate or gift tax.
Assume, for example, that a 60-year-old grantor owns a residence worth $1,000,000 and wishes to establish a QPRT with a 10-year term. For simplicity, also assume the AFR for the month of the trust’s creation is 5%. To determine the taxable gift upon the creation of the QPRT, we must first calculate the present value of the grantor’s retained interest in the property (i.e., the right to live in the property for 10 years). This is calculated using the AFR and the term of the trust.
Using an IRS-approved calculation, we find that the present value of the retained interest is $610,970. The taxable gift is then calculated by subtracting the value of the retained interest from the value of the residence:
$1,000,000 (residence value) – $610,970 (retained interest) = $389,030 (taxable gift)
With the QPRT in place, the grantor would only be liable for gift tax on $389,030, as opposed to the full $1,000,000 value of the residence. Furthermore, any appreciation in the property’s value over the 10-year term will not be subject to gift or estate tax (currently assessed at a rate of 40%).
If, for example, the property appreciates to $1,500,000 at the end of the 10-year term and the grantor has survived, the $500,000 appreciation will pass to the beneficiaries free of gift or estate tax. Additionally, the property will receive a “step-up” in basis, reducing the capital gains tax implications for the beneficiaries upon the sale of the property.
This above example demonstrates how a QPRT can provide substantial tax savings, particularly in a high interest rate environment. The higher the AFR, the lower the taxable gift and the greater the potential tax advantage for the grantor.
If you are interested in exploring the benefits of a QPRT or other estate planning strategies tailored to your unique circumstances, please do not hesitate to contact our firm. Our experienced attorneys are here to help you navigate the complexities of estate planning in a dynamic economic landscape.