The New York Times recently ran a story painting a gloomy picture about the Southwest Florida real estate market. Some say that it was too gloomy. Bill Valenti, President and Chief Executive Officer at Florida Gulf Bank tells me that he was interviewed for the story by the Times correspondent. Mr. Valenti’s points didn’t make it into the feature, however, possibly because his comments were more hopeful than the picture that the Times wished to paint.

“I told [the Times correspondent] that things weren’t as bad as some make it out to be,” Valenti said. “And that the Southwest Florida market has been up and down before, and that some of the problems in this market were made by people who don’t live here. Those that do live here will weather this storm. I also pointed out that the baby boomers are still going to retire to places like Southwest Florida, and now is a great time for those that are interested in coming here one day to invest in a primary or secondary residence.” 

While it is true that prices have dropped from their precarious highs of a few years ago, this drop brings to us an estate planning opportunity. That opportunity is called a “Qualified Personal Residence Trust” or “QPRT” for short.

A QPRT is an irrevocable trust that serves to “split” the value of your residence into two parts. The first part is your “retained interest”, which is defined as that time that you choose to remain the owner of the residence inside of this trust. The second part is the “remainder interest” which is that part value left over after your retained interest expires. When you create the QPRT, you get to choose how long you intend to remain the owner of the residence under the terms of the trust. So if you create a ten year QPRT, you retain the residence for ten years, after which time it is then transferred to those that you indicated in the trust, typically your children.If you choose a twenty year term, then you retain the residence for twenty years before it transfers to your children. 

By creating a QPRT and deeding your residence into it, special rules allow you to value the retained interest and deduct that value from the value of the residence itself, creating a discounted gift of the residence’s remainder interest. The potential estate and gift tax savings are enormous. 

Allow me to illustrate this with an example. Harry and Sally own a Sanibel residence valued at $2 million. Harry is 71 and Sally is 68. Each gifts their undivided ½ interest in the residence into a nine year QPRT. At the end of the 9 years their two children take title to the property. Under current calculations, Harry and Sally have made a gift to their children of the remainder interest, which is valued at approximately $950,000. In other words, the QPRT has made over one million dollars of the value of the residence (plus future appreciation) nontaxable for federal estate and gift tax purposes. 

As with all good things, there are a few caveats. First, Harry and Sally must survive the terms of their respective QPRTs for their estates to reap all of the benefits. The longer the term (here I calculated it at 9 years) the greater the benefit. A fifteen year term, for example, could have eliminated approximately $1.5 million of the value of the residence from federal estate and gift tax purposes. The longer term, however, increases the risk that either Harry or Sally won’t survive the term. If one survives and the other does not, then Harry and Sally may reap some of the benefits, but not all. So Harry and Sally want to be careful to choose a term that each believes they will survive. 

Second, after the term is over, the children own the residence. In order to keep the residence out of Harry and Sally’s estate for federal estate tax purposes, they need to pay their children fair market value rent for the continued use of the residence. This is not necessarily a bad result, as the children can then use the rental income to offset taxes, expenses and association fees. 

Third, because a QPRT is deemed a current, lifetime gift, Harry and Sally’s children inherit the same tax cost basis in the residence that Harry and Sally had. In other words, the children do not receive the beneficial “step up” in tax cost basis at their parents’ deaths. When you consider that the estate tax rate that would apply to the residence (up to 45% in current law) far exceeds the potential capital gains tax rate (15% under current law), this does not appear to be a bad trade off. This point is further emphasized when you consider that the capital gains tax is not paid unless and until the children one day sell the property. 

Further, Harry and Sally may lose the valuable Save Our Homes property tax exemption, although one of the statutory allowances to maintain the exemption includes having a long term lease in place. These issues are too complicated for a short column, but should be discussed with one’s estate planning counsel when reviewing the QPRT strategies.  

Since low market values enhance the tax savings, now is the time to consider a QPRT as an effective estate planning tool.