Save Estate Taxes with a Qualified Personal Residence Trust

Some high-net-worth physicians may end up with what I call an “estate tax problem,” although the percentage of physicians likely to have this issue is dramatically lower than it used to be. The reason for this is the relatively high current estate tax exemption amount. As recently as 2003, the amount of your estate that is exempt from federal estate taxes upon your death was a mere $1 million. However, that amount was rapidly raised over the next few years to $5 million starting in 2010. Beginning in 2012, the exemption was indexed to inflation. In 2014, the current federal estate tax exemption is $5.34 million. If you are married, that amount is effectively doubled to $10.68 million. This increase has dramatically decreased the percentage of physicians whose estate will owe federal estate taxes upon their death. However, there are some physicians for whom this is still an issue. More importantly, there are a number of states (16) whose estate tax exemption limits are much lower than the federal limits. States with a particularly low estate tax exemption include New Jersey ($675,000,) Rhode Island ($921,655,) the District of Columbia ($1 million), Maryland ($1 million,) Massachusetts ($1 million), and Oregon ($1 million.) To make matters even more complicated, 5 states also have an inheritance tax, which rather than taxing the estate, taxes those who actually inherit it. Two states, New Jersey and Maryland, have both.

The general solution to avoiding estate and inheritance taxes is to give items away prior to death in order to get them out of your estate. There are rules about this, of course, such as the gift tax. The gift tax is not really a tax at all, but gifts above a certain amount each year ($14,000 per giver per recipient in 2014) are subtracted from the estate tax exemption.

One of the largest parts of the estate of many wealthy people is their first or second residence. In order to reduce the estate tax bite, they often choose to give their primary residence (and/or one vacation home) away prior to death. This is done using a Qualified Personal Residence Trust (QPRT). These trusts are “split-interest” trusts, meaning the trust gets part of the interest, and the grantor (the original owner of the home), receives the remainder of the interest. A term is set during which the grantor can live in the home rent free. After the trust term expires, the residence is transferred to the trust beneficiaries. The trust usually states that the grantor may then continue to live in the home as long as he wishes, but after the trust expires he must pay fair market value rent to the beneficiaries. Because of this interest retained by the grantor, the IRS valuation of the gift is less than the true value of the home. As the home appreciates with inflation, that value also is not included in the estate. In essence, the grantor has taken an asset worth $1 Million and transferred it out of his estate at the cost of perhaps only $400,000 of his estate tax exemption. By the time he dies, the home may be worth $2 Million. If he had not used the QPRT, he would now owe 40% of the value of his estate above the exemption. If he has $5.34 Million in addition to the home, the QPRT would have allowed the estate to pay just $160,000 instead of $800,000 in estate taxes. In addition, after the term of the trust is up, rent is paid to the heirs estate tax free (but not income tax free), further reducing the estate.

The actuarial calculation of the IRS valuation of the gift is complicated and depends on the term of the trust and current interest rates. The longer the term the better, but if the grantor does not survive the term, the residence is placed back into the estate for estate tax purposes and it is as if the QPRT were never created. Thus the younger the grantor is, the longer the term that can be safely used. Some estate attorneys recommend you choose a term that is less than ¾ of your life expectancy. It is also more favorable to form a QPRT when interest rates are high. The formula uses the IRS 7520 rate, currently just 2.2%, which is unfortunately a historically low level.

There are a few downsides to using a QPRT. First is the expense and hassle of setting it up and maintaining it. Second, after the trust expires, the payment of rent is mandatory. If you have a true estate tax problem, the amount of rent should not be an issue, but family dynamics may make this undesirable. The rent, of course, is also taxable income to the beneficiaries. Third, the heirs will not benefit from the step-up in basis at death. Normally, if you die and leave your house to your heirs and the heirs sell it immediately, they will not owe any income tax on the proceeds. If a QPRT is used instead, and the house is sold, the heirs will receive the grantor’s basis instead, and likely owe substantial capital gains taxes upon sale of the home. So for someone who actually does not have a true estate tax problem, you can actually increase the overall amount of taxes paid by mistakenly using a QPRT.

The decision to establish a QPRT involves weighing the benefits of reducing estate taxes against the tax and non-tax consequences of relinquishing ownership prior to death. Most physicians will not and should not even consider using a QPRT. However, high-net-worth physicians, especially in certain states, with favorable family dynamics, may substantially reduce their estate tax bill by utilizing this unique trust. If you think you may be among the doctors who will benefit from a QPRT, consult with an experienced estate planning attorney in your state.

Dr. Dahle is not an accountant, attorney, insurance agent, or financial advisor. He blogs as The White Coat Investor and is the author of the best-selling The White Coat Investor: A Doctor’s Guide to Personal Finance and Investing.