The Federal estate tax exemption is high enough, $5.43 million per person and double that per couple, that it only affects the very wealthiest people in the country – not even 1% – but an outdated estate planning technique meant to get around a much lower exemption in the 1980s and 90s has left a nasty surprise for anyone still using a qualified personal residence trust (QPRT).
“Nobody could have predicted what would happen to the estate tax exemptions, and I wouldn’t fault any estate planner that did this in the 90s, but now it’s a mess,” says Jessica Goldsmith, partner and chair of the trusts and estates department at Kurzman Eisenberg Corbin & Lever LLP.
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Why QPRTs made sense in the 80s
Thirty years ago the estate taxes affected a much larger percentage of the population. Instead of basically $11 million ($5.43 million for each spouse), it was $600,000 per person and the surviving spouse couldn’t make use of his or her partner’s exemption. To reduce estate taxes, many people set up QPRTs that gradually transferred ownership of their homes to their children, eating into their lifetime gift tax exemptions to save on estate taxes down the road.
The problem is that QPRTs transferred ownership without an increase in basis. In other words, if a house was bought for $100,000 decades ago, transferred via QPRT, and later sold for $1 million (not at all unreasonable figures) the children would have to pay capital gains tax on the $900,000 increase. That might have made sense when there was the trade-off of avoiding estate taxes, but the rationale behind QPRTs has mostly disappeared. State taxes complicate the picture somewhat, but more and more states are following the Federal government’s lead and increasing estate tax exemptions if not eliminating estate taxes entirely.
What to do about a QPRT
Whether you can get out of a QPRT that’s already been set up depends on state law and the specific language of the trust itself, so you’ll need to talk to a lawyer to find out what your options are, but there is some hope that the QPRT won’t even be valid. For a QPRT to hold, children were supposed to charge their parents rent at fair market prices, pay for maintenance, and generally act like disinterested landlords. Needless to say, that hasn’t always happened.
“The IRS was very eager to combat this planning technique, so unless you had a real arm’s length structure in place you violated the rules,” says Goldsmith. “The good news for some people now is that if their parents failed to adhere to the rules it ended up, ironically, to the children’s advantage.”
Obviously, no lawyer can recommend that anyone violate their fiduciary obligations as a trustee, but if you haven’t been following the rules you shouldn’t kill yourself to prove otherwise since ownership would revert to the original owners avoiding the entire mess. And for those people who have been fastidiously following the rules, it might even make sense to simply give the house back using your gift tax exemption (under the original basis) so that it can later be passed on at full market value as part of an estate.