For people who have an estate tax problem and a large portion of their estate is their personal residence, a Qualified Personal Residence Trust (“QPRT”) should be considered. The concept of the QPRT was created by the IRS as part of the valuation regulations issued twenty years ago and in the hands of an accomplished estate planning attorney is a highly effective means by which the value of the taxpayer’s residence can be artificially reduced. This is achieved by the use of a combination of valuation discounting techniques and actuarial values.
First, let’s start with a brief word about valuation discounting. In the real, 100% of ownership of something is worth more than the combined value of all fractional shares of the same asset. Huh? Okay, for instance if four people each own 25% of a closely held corporation and thus none of them have control, and assuming together they could sell all of the business for $1,000,000, if one of them wanted to sell their 25% interest, they probably could not sell that interest for $250,000. That is because whoever the buyer is would know that purchasing a 25% interest would not give them any control over the business; the other three owners could effectively join together and with their combined voting power effectively freeze the buyer out. This is a risky proposition. So anyone interested in buying this 25% interest is not likely to do so unless they can get a bargain price, say for example, $125,000. The difference between the “bargain price” ($125,000) and the pro rata value of the interest being sold ($1M * 25% = $250,000) is a discount. This discount is commonly referred to as a valuation discount or more specifically a fractional interest valuation discount.
This same phenomenon appears in many circumstances and certainly applies to fractional interests of real property. For instance, if a $1M home is owned by four people, each of whom own 25%, together they might be able to sell the home for $1M, but if any one of them individually tries to sell only their separate 25% interest, they are very likely to find that there are no buyers unless the seller is also willing to sell at a bargain price. This same phenomenon also creates an opportunity to reduce estate taxes by deliberately creating fractional interest valuation discounts. For instance is a taxpayer has three children and gifts 25% of the taxpayer’s residence to each of those children, although the pro rata value of each 25% interest might be $250,000, the individual 25% might be worth only $125,000. Fractional interest valuation discounts can vary greatly depending on market conditions, but often fall between 30% and 50%.
Next, let’s discuss actuarial values in the context of ownership of your home. If you own real property that means that you have a legal right to exclusive possession, starting right now, and continuing off into perpetuity. But you won’t live “into perpetuity,” you may only have a need for use of your residence for the next seven years at the most. Thus the value of the right to use the home over the next seven years has a far greater value than the right to use the home for seven years starting in the year 2101. As an example, based upon the IRS actuarial tables, the value of the right to exclusive use of a $1M residence for seven years to a 75 year old male is $439,720. And if the value to him of the right to exclusively occupy the residence is $439,720, then the value of all other rights to the residence must be the difference, $560,280, because the two amounts have to add up to the total value of $1M.
Let’s take the next step. Pretend this taxpayer transfers his residence into a special trust (just for fun we’ll call it a QPRT) and retains the right to exclusively occupy the home for seven years, but the trust provides that at the end of the seven years, full title of the residence will pass to the taxpayer’s children. And pretend that this trust and the transfer of the residence into the trust is irrevocable, so that for gift and estate tax purposes, this transfer is considered to be a completed gift immediately upon the transfer to the QPRT. In that case, the taxpayer will have made an immediate gift of $560,280 to his children, probably not resulting in any gift tax since the taxpayer has the legal right to gift assets having a value of up to $1M without incurring a gift tax.
And pretend that the taxpayer occupies the home for seven years, at the end of seven years the taxpayer no longer has any further ownership interest in the residence. So if the taxpayer dies the very next day after the expiration of the seven years, what is the value of his ownership in the home? The answer is nothing, he has no ownership interest. Thus for estate tax purposes, he owns no interest in the home and the value of the home included in his taxable estate is zero.
Let us take this one step further. Pretend that in year one, the taxpayer transfers a 50% interest in the home into a QPRT and retains a right to occupy for seven years. The pro rata value of the 50% interest is $500,000, but reduced by a 50% fractional interest valuation discount, it is only worth $250,000. Running that number through the IRS actuarial tables, we see that the $250,000 value of a right to occupy for seven years is worth only $109,930, with the difference ($250,000 – $109,930 = $140,070) being the value of the gift he made to his children.
Pretend the next year, the taxpayer makes a gift of the remaining 50% into a QPRT and retains the right to occupy for six years. Again reducing the $500,000 pro rata value by a 50% fractional interest valuation discount, and further reducing it using the IRS actuarial tables to reflect the right to occupy for only six years, that value of what the taxpayer retained is $95,363 and thus the value of the gift he made at that time is $154,638.
Thus by the use of these combined techniques, the taxpayer was able to transfer his $1M home to his children was achieved using only $294,708 of his $1M lifetime exemption.
This is a simplified example, and there are many other factors to consider. But as you can see, this technique has great potential for the taxpayer who has an estate tax problem and a home of substantial value.
And this is a technique which very definitely should only be attempted with the guidance of a competent estate planning attorney.
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