Real Estate Woes Create Wealth Transfer Opportunities
The recent decline in residential real estate values and the fall home sales is well documented. The feverish pace of new home and condominium construction that typified the early years of the new millennium created housing inventories that far exceed current demand. The euphoric investors who capitalized on rapidly increasing real estate values by "flipping" residential properties have sobered to the reality that real estate prices are heading downward and that the housing market is moribund. Credit, that until recently flowed freely from mortgage lenders, has dried up amid the sub-prime lending debacle. Despite the bad news, opportunistic individuals can capitalize on the fallen real estate prices by implementing several estate planning techniques through which they can transfer real estate at a reduced transfer tax cost. The Qualified Personal Residence Trust (QPRT) is one tried and true structure that can be used in this manner.
A QPRT is an irrevocable "split interest" trust. An individual, usually called the grantor, creates a QPRT and funds the trust with his or her primary residence or a vacation residence. The grantor retains the right to live in the residence for a term of years that he or she selects, then, after expiration of that term, the entire interest in the residence is transferred to the grantor's selected beneficiaries. Additionally, the grantor may retain the right to rent the residence from the beneficiaries following the expiration of the retained term. To achieve the results discussed in this article, there are numerous additional provisions (set forth in Section 2702(a)(3)(A)(ii) of the Internal Revenue Code and the Treasury Regulations thereto) that must be contained in the QPRT agreement.
Simply put, the QPRT creates two separate interests in the transferred residence, the retained interest and the remainder interest. The grantor is deemed to have made a taxable gift only to the extent of the remainder interest passing to the beneficiaries following the expiration of the term. The value of the gift then is only a fraction of the overall fair market value of the personal residence. Consequently, if the grantor survives the retained term, the full value of the personal residence, including appreciation, will be excluded from the grantor's taxable estate for federal estate tax purposes, even if the grantor rents the residence from the QPRT until his or her death.
The value of the remainder interest passing to the beneficiaries following the trust term (i.e. the amount that will be subject to federal gift taxation) is determined by a subtraction method of valuation. The taxable amount is calculated by reducing the value of the retained term from the fair market value of the residence determined as of the date that the QPRT was created. By removing the value of the transferred residence from the taxable estate of the grantor (so long as the grantor survives the retained term), QPRT's provide significant estate tax planning opportunities.
The "fair market value" of the residence is the price at which the property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or to sell and both having reasonable knowledge of all relevant facts (Treasury Regulation 20.2031-1(b)). The grantor's qualified appraiser should consider the current market condition and trends when computing a valuation. Relevant factors would include declining prices in the real estate market, the reduced prices of recent sales of properties that are comparable to the residence, the increased time periods required to sell real property in a saturated market, the reduced availability of credit for potential buyers, and other similar information. These negative factors might justify valuing the residence well below the price at which it would have been valued in the recent past.
The value of the grantor's retained interest in the QPRT is determined pursuant to Section 7520 of the Internal Revenue Code. That provision values the retained term as a percentage of the fair market value of the residence based on the length of the retained term, considering the grantor's age at the time of transfer, plus interest. The value of the retained term increases and the value of the remainder interest passing to the beneficiaries decreases as the QPRT term is lengthened. This results in a smaller taxable transfer to the beneficiaries. However, if a grantor dies prior to the expiration of the retained term, the full value of the residence will be included in his or her taxable estate for federal estate tax purposes. In the latter case, the grantor will be in the same position as he or she was prior to the creation of the QPRT less only professional fees. A balancing of the relative benefits and costs associated with the length of the retained term is therefore important for the grantor to consider prior to the transfer. The grantor and his or her attorney should run calculations that show the tax implications associated with several proposed retained terms and then select the one best suited for the grantor's needs.
The value of the retained term is calculated by multiplying a percentage of the fair market value of the residence by a factor contained in the actuarial tables promulgated under Section 7520 of the Internal Revenue Code. The "7520 Rate" of interest is then added to the factor to arrive at the current value of the retained interest. The Internal Revenue Service publishes the 7520 Rate on a monthly basis. The upward or downward movement of the 7520 Rate usually follows the direction of the federal funds rate as determined by the Federal Reserve. As the 7520 Rate increases, the value of the retained interest increases (and the value of the remainder interest passing to the beneficiaries decreases). In recent months the 7520 Rate has tended to go down after several years of slightly higher rates. The negative affect of the lowering rates on the QPRT is inconsequential, when considered in light of the falling real estate market.
The following two examples illustrate the gift tax consequences of a QPRT, while showing the effects that falling real estate prices and a changed 7520 Rate can have.
Assume that Jack is a 60-year-old man who owns a condominium on Miami Beach. It is 2006, at the height of the frenzied housing market. The fair market value of Jack's condominium, as determined by a qualified appraiser, is $3 million. The 7520 Rate for January 2006 is 5.4 percent. Jack wants to create a QPRT for the benefit of his children. He wants to retain the right to live in the condominium for 15 years and then have the ability to rent it from the QPRT for the remainder of his lifetime. Based upon the foregoing, Jack's retained interest in the condominium will be $2,036,730. The value, for federal gift tax purposes, of the remainder interest passing to Jack's children will therefore be $963,270 ($3 million fair market value less $2,036,730 value of retained term). Jack will avoid paying gift taxes on the transfer by allocating his unused gift tax exemption (currently $1 million) to the transfer. However, since the real estate market will sharply decline in 2006 and 2007, the condominium will only appreciate at an estimated rate of 3 percent over the 15-year term. Under these facts, the potential estate tax savings to Jack is $1,669,784.
Now let's assume that Jane, a 60-year-old woman, owns the identical condominium on Miami Beach. It is 2008 and the real estate market has suffered a 20 percent decline. The fair market value of the condominium, as determined by the same qualified appraiser that Jack used, is $2.4 million. The 7520 Rate for August 2008 is 4.2 percent. Jane wants to create a QPRT for the benefit of her children. She wants to retain the right to live in the condominium for 15 years and then have the ability to rent it from the QPRT for the remainder of her lifetime. Based upon the foregoing, Jane's retained interest in the condominium will be $1,484,976. The remainder interest passing to Jane's children will therefore be $915,024 ($2.4 million fair market value less $1,484,976 value of retained term). Jane, too, would avoid paying estate taxes by allocating her unused lifetime exemption. However, since the real estate market will increase over the term of the QPRT, the condominium will appreciate at an estimated rate of 8 percent over the entire term. Under these facts, the potential estate tax savings to Jane's estate is $3,014,182! The dramatic difference between Jane's savings and Jack's savings are a direct result of our current market conditions.
The foregoing examples illustrate the immense gift tax savings opportunities that are available due to the current real estate market. Jane's valuation was merely 20 percent less than Jack's valuation yet it resulted in an additional savings of $1,344,398. The savings could be potentially much greater in areas where the real estate market has been particularly hard hit.
Individuals can use the current slump in the real estate market to transfer wealth to their family members at a reduced transfer tax cost. The QPRT is an effective tool that can be used in this regard. An individual can reduce or eliminate the gift tax costs and effectively transfer wealth by funding a QPRT with real property that is valued to account for a depressed real estate market.
Alex Espenkotter is a partner in Bilzin Sumberg's Tax and Wealth Transfer Groups.