How to reduce estate taxes on your home

If your estate is substantial and you're concerned about the federal estate tax bill your heirs will pay, there's a way you might be able to use your house to remedy the situation. It may be as simple as giving away your home or as complex as knowing the mechanics of an estate-planning tool called a qualified personal residence trust.

My home is my largest asset and would cause my estate to be subject to substantial estate taxes. Is there a way to exclude its value?

With a QPRT, you essentially transfer ownership of your primary residence or vacation home to a trust while you retain the right to continue to use the property during the trust term. After that, your children or other designated beneficiaries become the owners of the property. If you still want to use the property when the trust term ends, you can work out a rental arrangement with them.

Transferring property to a QPRT is considered a taxable gift, but you get a substantial break. The value of the house is discounted for gift tax purposes because you're allowed to continue using it for the term of the trust.

It is important to understand that interest rate fluctuations can affect qualified personal residence trusts. For example, if interest rates are falling, a QPRT loses some of its allure as a tax shelter because the value of the gift increases as rates decline, which could trigger a gift tax liability.

With a QPRT, you make a deferred gift, meaning your heirs get the property sometime in the future. As a result, you get a substantial discount on the value of the asset. The exact valuation is calculated using Internal Revenue Service tables, which change along with interest rates. Take, for example, a home valued at $1 million. At a 7% interest rate, the present value of a gift of that home in 20 years would be $258,420. At 6%, the value rises to $311,804. At 5%, it increases to $376,889. The prospect of declining rates can be an incentive to set up a trust before they drop further. Of course, if rates rise before you set up a QPRT, that would have favorable gift tax implications for you.

The main advantage of the QPRT is that it allows you to get your home out of your taxable estate at a reduced tax cost. And because setting up the trust is a private transaction, there is no public record at your death that can be contested.

Does that sound too good to be true? A QPRT can save your heirs taxes. However, the trust is irrevocable, and the tax rules are very complex. You need a firm grip on the pros and cons of QPRTs before you give away such a valuable asset-and one that many people are emotionally attached to as well.

Next: Four key considerations

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Here are four key considerations when establishing a QPRT:

Find an expert. Consult with an attorney and tax adviser who specializes in estate planning. One mistake could render the trust worthless.

Pick a short term. Your goal is to continue using the home while getting it out of your taxable estate. Choose a term for the trust that you expect to outlive. If you die before the end of the term, the home goes back into your taxable estate with no tax savings.

Get a handle on your future. If you're planning to rent the house from your children or other beneficiaries after the trust ends, don't make the future rental a provision of the QPRT. The IRS could invalidate the trust. Also, don't set up a QPRT unless you have a good relationship with the beneficiaries, including in-laws. You don't want to worry about being thrown out of your own home after the trust ends.

Stay put. It's important to keep using the home for the duration of the trust or you risk losing the tax benefits.

How does one start to formalize a retirement goal?

When setting a clear retirement goal, give thought to the age that you would like to achieve financial independence. Consider “financial independence” to be the ability not to have to earn an income to support yourself. So first, give some thought as to what age you would like to achieve true financial independence. Once you determine the age goal, you will next have to quantify the amount of income needed to maintain a comfortable standard of living. While doing this, consider which expenses you won’t have or those that will decrease during retirement.

Likewise, think about the types of expenses that may increase, such as travel and other leisure activities. These factors will allow you to begin a conversation with your adviser to determine your own retirement feasibility situation.

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