Trusts could be a shield from estate taxes, creditors

You've toiled all those years to pay off the mortgage on your home, build a comfortable nest egg for retirement and even leave a small legacy for your heirs. But now, as you size up your estate, you realize that the value of your house, especially if you live in an area where real estate prices have boomed, could put your heirs at risk of paying estate taxes.

In some situations, relief might be found in a qualified personal residence trust, or QPRT (often pronounced 'cue-pert'). It's a trust that allows homeowners to give away their future interest in their homes, thereby potentially avoiding costly estate and gift taxes.

For physicians, whose personal assets might be targeted in a liability lawsuit, there is the added benefit that these trusts are believed to provide fairly secure asset protection.

"Creditor protection tends to be a hot-button issue for physicians," said Susan Meyers, an estate planning attorney at Warner Norcross & Judd LLP, in Grand Rapids, Mich. "In general, physicians have taxable estates, so they are always looking for ways to, one, protect their assets and, two, pass them on to families avoiding tax."

Using a QPRT might help the physician protect his or her property, whether it's a primary or second home -- because ownership is transferred to the trust, and therefore secured away from creditors, she said. But Meyers warned that the protection might disappear if the trust is improperly structured.

The way these trusts work is fairly straightforward: The homeowner puts the property into the trust and decides how long the life of the trust should be. The homeowner retains the right to live there during the life of the trust. When it expires, the beneficiaries own the home. If the homeowner wants to keep living there, he or she must pay fair market rent.

If successfully executed, the major benefits of these trusts are threefold. For one, the homeowner is shifting what is likely a major asset out of his or her estate so it won't count toward the limit on how much an estate can be worth before estate taxes are owed. In 2006, the federal estate tax limit jumped from $1.5 million to $2 million per person, though state levels might be lower.

Only about 1% of estates pay federal estate taxes, currently required of those with more than $2 million in assets. The number of estate taxpayers could go down as thresholds go up over the next few years. In fact, as it now stands, the estate tax is off the books in 2010. But in 2011, the estate tax comes back, with a threshold of only $1 million.

Secondly, the home is valued at the time it is put into that trust, and the value doesn't change while it is held there. That means any appreciation of that home during the life of the trust passes tax-free. For residences in trendy areas where home prices can more than double in a handful of years, that benefit alone could be significant.

Finally, when the homeowner "gifts" the home into the trust, it is valued at a discounted rate based on an Internal Revenue Service formula that takes into account the homeowner's age, the duration of the trust, the current interest rate and the market value of the home.

That discount could help some homeowners avoid paying steep federal gift taxes that kick in when a taxpayer makes more than $1 million in gifts during his or her lifetime.

Anthony Vitiello, chair of the estate planning and taxation group at Connell Foley LLP, in Roseland, N.J., said a $1 million home put into a 15-year QPRT at today's interest rates by a 60-year-old person would be valued at only $321,000. That means that $679,000 of value is wiped off the books -- a good thing in estate planning. (In many parts of the country, $1 million might sound like a lot for a home, but that might only get you a three-bedroom ranch in, say, Silicon Valley. Also, a physician living on a large lot or rural acreage could find his or her property valued at more than $1 million in many parts of the country.)

The way the formula works, the higher the interest rate, the higher the discount.

But the benefits come with a hitch: They are all erased if the homeowner who sets up the trust dies before the trust expires.

"The rub is this technique is only effective if you live the full term. If you die in year nine in a 10-year trust, the asset is included in your estate for estate tax purposes. And they will include the value of your house at its value at the time of your death," said Chris Sega, an estate attorney and partner with Venable LLP in Washington, D.C.

Estate experts say most QPRTs can be set up for roughly $3,000 to $6,000, mostly in attorney fees, and there is little administrative cost thereafter. If the person setting up the trust lives in a different state than where the home is located, there could be additional fees for additional attorneys.

The trusts likely won't have any short-term tax consequences for the homeowner, because he or she still has a stake in the property during the life of the trust and therefore still can take advantage of tax breaks enjoyed by homeowners.

"One of the upsides to this is there is very little immediate lifestyle changes to the grantor," said Scott Hill, vice president of Kanaly Trust Co., a Houston based fee-only financial services firm.

When the trust expires, however, the beneficiaries own the property. So you might end up with, say, your children as your landlord.

Hill said parents who are not prepared for the next generation to take that much control might want to avoid a QPRT. "Tax implications aside, anytime you're considering financial planning issues, the personal and family dynamic should be one of the issues you consider," he said.

Despite the benefits, these trusts might have tax consequences for the beneficiaries. Meyers said the beneficiaries could wind up paying more capital gains taxes on the property if they receive it through a QPRT, as opposed to inheriting it on death.

The tax picture can become more clouded if the home has a mortgage on it, because that can affect the valuation of the property. Also, it might be difficult to get the mortgage lender to agree to the terms of the trust, said Richard Rubino, an estate attorney with Rubino & Liang LLC in Newton, Mass. He recommends that all mortgages be paid off before putting a home in a QPRT.

It is possible to sell the home during the life of the trust and roll the value into another residence to be kept in the trust, but if the value of the two homes is dramatically different, it could complicate matters. Vitiello said you could wind up getting an annuity payment until the excess cash is gone, or, conversely, the trust could be a percentage owner in a more expensive home.

Still, there have been plenty of situations historically in which QPRTs have been attractive, and some experts predict there will be wider use of them in the future.

"They were extremely popular until interest rates dropped. Then the relative benefit of doing these compared to other techniques was not as beneficial. On the flip side, if people could have foreseen the wild explosion in real estate values, it still would have made a lot of sense for many clients," Vitiello said.