At the end of the 20th century, real estate values were growing at phenomenal rates with no end in sight. By the end of 1999, the S&P 500 featured an astounding five-year average annual return of 28.56%. For the 2000 calendar year, though, the federal estate tax exemption was a relatively low $675,000. The combination of these three factors led many searching for effective means of transferring their appreciating assets out of their taxable estates. For many, the Qualified Personal Residence Trust (QPRT) represented an ideal way for individuals to remain in their houses while transferring out the future appreciation in the home at a relatively low gift-tax cost.
Unfortunately, each of these three factors that led many to choose the QPRT took a drastically different path after the turn of the century. Since 2000, real estate values rose dramatically and then dropped just as dramatically. According to the Case-Shiller index, residential home prices have risen by approximately a mere 2% per year from 2000 to 2012. The S&P 500, meanwhile, has had a similar drop-off: the 15-year average annual return ending in 2012 was just under 4.5%. Although the S&P 500 has recovered somewhat, the long-term growth numbers remain low. The factors that created such a sense of urgency in 2000 have severely disappointed most investors.
Of course, these growth factors alone were not enough to inspire many families to seek estate planning opportunities such as the QPRT. With five years of significant growth behind them, and potential greater gains on the horizon, many families panicked at the thought of their estates being taxed by the federal government at 55% on assets exceeding $675,000. Thus, the perfect storm of rapid growth in combination with the relatively low estate tax exemption caused a run on advanced estate planning techniques such as the QPRT.
Since 2000, though, the federal estate tax exemption has risen dramatically from $675,000 to the current level of $5.25 million. As you can see, the diminished growth in the real estate and stock markets along with the increasing estate tax exemption have taken away many of the positives associated with QPRTs. Assuming that the individual(s) transferring their residence into a QPRT survive the QPRT term, though, it would seem that the QPRT is a no-lose proposition. After all, the total value of the residence has been removed from their taxable estates, and the family did, in fact, want the residence to end up in the hands of the next generation.
The realities of life in 2013, though, complicate this analysis. Consider one of the most significant downsides of a QPRT: once the residence passes to the next generation, if the donors wish to remain in the residence, they must pay a market-value rent to the “new” owners. Failure to do so may cause inclusion of the residence in the estate of the surviving donor as a retained interest, which is precisely what the family intended to avoid. Naturally, this was explained to the donors in 2000 when they initiated the QPRT. But at the time, everything was looking up and the possibility of paying rent to your children in 2013 seemed distant and simple.
As many QPRTs initiated in and around 2000 begin to reach their termination dates, there are quite a few families concerned about the problems associated with the conclusion of the QPRT. With stagnant or no growth in their other asset portfolios, rising costs of living, and a lack of optimism regarding future growth, many of these future tenants are rightly concerned about their ability to afford the market-value rents that loom in the near future. Estate planners are now tasked with finding a way to resolve the problems created by a technique that was spot-on correct in 2000.
One of the options to consider is the Reverse QPRT. A brief illustration is in order. James and Jane Smith transferred their home into a QPRT in 2000. The QPRT is slated to terminate in 2013, and the home is to be distributed to James Jr. outright. A local real estate agent has determined the fair-market value rent to be $20,000 per month, and the Smiths are concerned that their retirement income is insufficient to sustain this expenditure over a long period of time.
Under a Reverse QPRT, James Jr. now transfers the residence into a QPRT, giving his parents the right to continue living in the residence rent-free for a certain period of time – say, five years. The specific term is a factor to be determined for each particular family’s situation. James Jr., of course, is making a gift to his parents and must value that gift and presumably report it on a federal gift tax return. At the conclusion of the Reverse QPRT, title to the residence reverts to James Jr. If his parents are still living, additional planning must be done.
Naturally, the Reverse QPRT relies on cooperation from the next generation. The children must be willing to use some of their own lifetime estate and gift tax exemptions to benefit their parents. There are also several technical considerations to heed. A lack of attention to certain issues may cause unintentional inclusion of the property in the parents’ estates. This technique, though, which has been blessed in a series of Private Letter Rulings, has the ability to address most of the problems confronted by families whose QPRTs haven’t quite progressed according to plan.