Time to Revisit QPRTs and Split-Purchase Trusts?

Federal interest rates are on the rise, which opens new planning options for many individuals to consider. These federal interest rates are used to value retained interests for federal gift tax purposes. Specifically, the so-called IRC 7520 rate is equal to the mid-term applicable federal rate (AFR) times 120%, rounded to the nearest two tenths of 1%. The mid-term AFR rate for August 2022 was 3.80% [3.15 times 1.2.] One year ago, the same 7520 rate was 1.2%. Accordingly, if an individual were to transfer $1 million to a trust and retain the right to income for 10 years when the IRC 7520 rate was 3.8%, the value of the right to receive income for 10 years would be about $300,000; subtracting that amount from the $1 million value of the transferred property to the trust would result in a taxable gift of about $700,000.

Low interest rates have prevailed over the past several years which, in turn, have reduced the benefits of funding a personal residence trust or engaging in a split purchase of a residence. However, the recent rise in the federal interest rates makes using either a personal residence trust or a split-purchase of a residence something more individuals should consider as a part of their estate plans. In contrast, the rapidly increasing IRC 7520 rate has made a grantor retained annuity trust, or GRAT, less effective as an estate planning tool to shift wealth in a tax efficient manner.

Example: In August 2021, the IRC 7520 rate was 1.2%. If a 72 year-old senior family member transferred their $1 million home into a qualified personal residence trust (QPRT), and they retained a 10-year right to use and occupy the home, that transfer would result in a taxable gift of about $890,000 of the remainder interest in the QPRT. If the same transfer of the $1.0 million home to the QPRT occurred in August, 2022, when the IRC 7520 rate is 3.8%, that results in a taxable gift by the senior of about $690,000. Note that the $690,000 current gift would result in a transfer of a $1 million asset in 10 years, which from the beneficiary’s perspective represents a 3.78% annualized compounded return. If the transferred home grew in 10 years from $1 million in value to $1.5 million, (an approximate 4% annualized compounded return in the home’s value) then the return to the QPRT remainder beneficiary is greater than an 8% annualized compounded return. The benefit with the use of a QPRT is that all future appreciation in the home is transferred to the QPRT remainder beneficiaries free from any gift tax.

Consequently, while the reduction in the IRC 7520 rate in recent years may have been viewed as reducing the effectiveness of a personal residence trust, the increase in the rate over the past year has increased the viability of a QPRT as an effective estate planning tool. Moreover, for those individuals who are concerned about the scheduled ‘sunset’ of their applicable federal estate and gift tax exemption starting in 2026, the use of a QPRT to shift future appreciation in a residence outside of their taxable estates makes sense.

Alternatively, instead of an individual giving a remainder interest in a home that he/she already owns, he/she could acquire a life estate in a new residence and have another family member (or a trust for younger family members) acquire a remainder interest in the new residence. This might be an appealing option if recent retirees decide to move to another state, like Florida. Even if the senior family member already owns the home, he/she could sell the remainder interest to a family member (or a trust for family members) for full consideration without causing any federal estate tax problems or the payment of any federal gift tax.

Both the split purchase of a new residence and the sale for full value of the remainder interest in an existing residence will fall under the personal residence exception of the Tax Code. [IRC 2702.] In addition, if the sale of the remainder interest was to a grantor trust established for family members,([i.e. its income is taxed to the residence owner) there should be no capital gain recognized on the sale of the remainder interest to the grantor trust.

Example: A 72-year-old individual under the IRS mortality tables has a life expectancy of 14 years. Assume that he/she would like to retain a 10-year interest in the new residence. The value of the purchased 10-year right-to-exclusively-use term in the residence is about 31% and the remainder interest is worth 69% of the value, again using the IRC 7520 rate of 3.8% for August 2022. The 72-year-old could also purchase a life estate in a new residence; the value of that purchased life estate would be about 39% with the remainder interest paying about 61% of the residence’s fair market value.

Or consider an even younger senior family member who is age 60; their life estate would reflect about 54% of the purchase price, and the remainder interest’s purchase price would be about 45% of the residence’s fair market value if the IRC 7520 rate is 3.8%. In fact, the value of the remainder interest in the residence deceases when the IRC 7520 rate increases. If the 60-year-old individual purchased a life estate, and the IRC 7520 rate was 5%, the value of the life estate increases to 63% and the value of the remainder interest decreases to 36% of the residence’s fair market value. In short, the split purchase of a new residence, or the sale of a remainder interest in an existing residence is best either for younger individuals, or when a higher IRC 7520 rate prevails.

An additional benefit to a split purchase of a new home over a QPRT is that there should be no valuation issues to worry about. The home’s value will presumably be its purchase price, and the individual who purchases the life estate’s share of the that price will be determined under the IRS’ life expectancy tables. Another potential benefit with a split purchase of a new residence is that unlike a QPRT, which when its exclusive use term ends either requires the senior family member to move out of the residence, or start to pay fair rental value for the use of the residence, the purchase of the life estate interest means that the senior family member who purchases a life estate will not have to move out at a later date or pay fair rental value for the use of the home when the QPRT exclusive use term comes to an end.

While the recent rise in the IRC 7520 rate has reduced the tax benefits of a GRAT as a wealth-shifting strategy, that same increase in rates has given new life to QPRTs under the IRC 2702 exception of the Tax Code, and even more so to a split purchase of a new residence. Estate planning strategies come and go depending upon the IRC 7520. That is something to keep in mind.