Four years after Mort Comer, then 65, bought a $320,000 summer home on the New Jersey shore, he made a wise bet. Figuring he would live at least another decade, he put the house in a trust that would transfer ownership to his two daughters after seven years. When the trust expired in 2004, it passed out of his estate and to his children free of gift taxes -- even though it's now worth $1.5 million.
Comer bought before the latest real estate boom, so his family made out big. But if you think the market still has steam and you want to pass your house to your children without huge tax consequences, consider setting up a Qualified Personal Residence Trust (QPRT).
With such an arrangement, a parent can continue to live in the home for the length of the trust, usually set at 5 to 15 years. During that time, the parent is still considered the owner and can deduct mortgage interest, real estate taxes, and other qualified expenses from personal income tax. At the end of the term, the house passes to the children and out of the parent's estate, regardless of its value and accumulated appreciation. The parent may stay on in the house when the trust dissolves but must pay fair market rent to his or her children. The one big caveat: If the parent dies before the trust ends, the property goes back into the estate and is priced at the fair market value.
SPECIAL INTEREST RATE
Blanche Lark Christerson, a managing director at Deutsche Bank Private Wealth Management in New York, ran some numbers to show how a QPRT works. Say you're 60, and you have a $1.5 million property on the Massachusetts island of Martha's Vineyard that you want to remain in the family. You can't shelter the entire $1.5 million value because you are retaining the right to use the home. So the trust uses a discounted value instead.
The discount is computed based on a formula that takes into account your age, the trust's term, and a special interest rate that fluctuates with market rates, called the "hurdle rate," which the Internal Revenue Services resets monthly. For September the hurdle rate is 5.04%. Interestingly enough, a QPRT may be one of the few real estate deals that benefit from higher interest rates, says Mitchell Gaswirth, a tax expert with the Los Angeles law firm of Proskauer Rose. "The higher the interest rate, the smaller the corresponding gift."
Based on those factors, Christerson divided the property's $1.5 million worth into two parts: $783,000, known as the remainder interest, the value of the gift the kids are expected to receive at the end of the trust term, and $717,000, known as retained interest, which represents the value of the right to live in the house. The older you are or the higher the hurdle rate, the bigger the retained interest -- and the smaller the gift -- for gift tax purposes. Remember, you have a $1 million lifetime gift-tax exclusion ($2 million per couple), and you'll use $783,000 of it by putting the house in the trust.
THE NEW LANDLORD
Assume that 10 years later, the house is worth $2.5 million. Your kids now own it, and there is no additional gift tax, even though they are receiving a more valuable property. Giving the kids the house outright or leaving it to them as part of your estate would result in far higher tax bills.
If your children decide to sell the house, they must use your cost basis. So if you paid $100,000 for the house years ago and made $200,000 worth of improvements to it, the basis is $300,000. Sell it for $2.5 million, and your children would have capital gains of $2.2 million. Still, the capital gains tax rate is lower than estate or gift tax.
While the appeal of transferring one of your most valuable assets to children may be high, estate planning experts warn of the family friction that can result when children are their parents' landlords. To avoid that situation, it may be smarter to transfer the house to another trust with trustees of your choice after the QPRT expires. That way, the kids own the house, but the trustees make the decisions.
Mort Comer has had no such problem with his daughters, Caren Comer, 43, and Joya Comer Friedman, 39. He pays them $10,000 a year in rent, and he still uses the house when they and their families visit. For the Comers, the trust helped to keep the house in the family and ensure that everyone can enjoy it together.
By Toddi Gutner