The problem. Planning for the transfer of a Florida homestead on death can be surprisingly difficult. The problem arises because Florida law provides that the homestead cannot be devised (i.e., disposed of by will) if the owner is survived by a spouse or a minor child, but instead must pass in equal shares to the children (or their descendants) of the owner, subject to a life estate in the surviving spouse. That is, the children get the homestead, but the surviving spouse, if any, gets the right to live there for so long as he or she is alive. The one exception is that the homestead can be devised to the surviving spouse if there are no minor children.

Very few people want their homestead to actually pass as provided by Florida law. Why, for example, would anyone want to transfer real property to a minor child? And many people want to do something else with their homestead, such as cutting out a wayward child and/or directing a post-death sale of the homestead. In the latter case, the clients may want the proceeds either held in trust or distributed in some fashion other than in equal shares to the last owner’s descendants.

Joint title. As an aside, it should be noted that if title is held jointly with rights of survivorship, the property passes to the surviving spouse without reference to the above-described Florida law. While that is often satisfactory, in many instances such passage merely delays the homestead problem until the death of the survivor.

Revocable "living" trusts. Many estate planners advise their clients to transfer title of homestead to a revocable living trust; the idea being that the homestead would then pass on death as provided in the trust, rather than as provided by Florida law. Unfortunately, that advice is simply wrong. Florida homestead law continues to apply in such circumstances as if the transfer to the trust had not occurred - a prescription for disaster.  Even worse, holding title of homestead via a trust (arguably even a revocable trust) loses the exempt status of the homestead and thus renders the homestead subject to seizure by the owner’s judgment creditors

Irrevocable trusts. The obvious solution to the homestead problem is to make a gift of an interest in the homestead to an irrevocable trust. The trick is to design the trust so that there is minimal real-world impact during the lifetime of the owner. This is most easily accomplished by having the owner act as trustee and by only transferring a remainder interest to the irrevocable trust (i.e., the owner retains the right to possession for some time period, such as his or her lifetime.)

Gift taxation. Unless such transfer of a remainder ineterst is to an irrevocable trust which has been designed so as to make the gift "incomplete" (see next paragraph), the transfer is a taxable gift, requiring the filing of a federal gift tax return. Compounding the problem, unless certain technical requirements are met, the gift is equal to the full fair market value of the home even though only a remainder interest was transferred. This is true even if the remainder interest were sold to the irrevocable trust for its fair market value.

To avoid gift taxation, the owner could make a gift of a remainder interest .  To avoid gift taxation, he could retain a limited power to alter the rights of the trust beneficiaries. This would render the gift "incomplete" for gift tax purposes. (Even though incomplete for federal gift tax purposes, the transaction would nevertheless be a valid gift for purposes of Florida law.)

Estate taxation. If the owner dies while still owning the right to possess the homestead or a power to alter the rights of the trust beneficiaries, the homestead is included in his or her taxable estate as if the transfer to the irrevocable trust had not occurred. (To avoid double taxation, any prior taxable gift of an interest in the homestead would offset the estate tax value.) The problem, of course, is that inclusion of the full date-of-death value of the homestead would generally be inconsistent with the goal of avoiding estate and gift taxation.

QPRT’s

The basic structure. The best way to achieve estate tax reduction with respect to a homestead while simultaneously achieving the dual goals of retaining the right to possess and avoiding the Florida law regarding who takes on death of the owner is for the owner (hereafter, the "grantor") to declare that he or she is holding title of his or principal residence as trustee of a so-called "qualified personal residence trust" (i.e., a QPRT.) The QPRT would be an irrevocable trust which provides that the grantor’s only right in the homestead consists of the right to possess the homestead for a pre-established number of years (the "term" of the trust.) Each person may establish a QPRT for his or her primary residence and one other personal-use residence (e.g., the condo at the beach.)

Ideally, on expiration of the term the homestead would pass to the grantor as trustee of a second irrevocable trust, presumably for the benefit of his or her family. The grantor would then continue to have the right to possess the homestead by renting it from such second trust.

If the homestead is sold or insurance proceeds are received for damages to the homestead, any funds which are not used to buy a replacement or to repair the damages are used to pay an annuity of, say, 8% of the principal to the grantor for the balance of the QPRT term.

If the homestead is owned by a husband and wife, a preliminary step might be to divide the homestead into equal tenancies in common without rights of survivorship. Each spouse would then transfer his or her half interest to himself or herself as trustee of his or her own QPRT. Such a structure has the side benefit of achieving valuation discounts (for partial interests) for gift tax purposes (see below.)

Transfer taxation. If the grantor survives the QPRT term, the homestead is not included in his or her taxable estate. However, there is a taxable gift (unavoidably requiring the filing of a gift tax return) on the transfer to the QPRT, the value of which gift is measured by the value of the homestead less the value of the grantor’s retained (rent-free) right of possession.

For example, a retained 15 year term might mean the gift is only half of the current value of the homestead. If the homestead doubles in value and the grantor dies just after the 15 year term, the taxable gift would have been only one-fourth of the value of the property passing to the grantor’s beneficiaries, thus achieving substantial estate tax savings.

Since a longer QPRT term means the value of the grantor’s retained right to possess is larger, a longer term means a smaller taxable gift. But while a longer term QPRT leverages the gift, there is a trade-off. If the grantor dies during the term, the date-of-death value of the homestead will be included in his or her estate. This puts the grantor in the position of guessing the date of his or her death. On the other hand, even if the grantor dies prematurely, the estate and gift tax consequences would be no worse than if the QPRT had not been established. There is also the benefit that the QPRT would govern the disposition of the homestead instead of Florida law.

The emotional problem. While many taxpayers have emotional reservations about renting their own home, they engage in a regular gifting program, taking maximum advantage of the $13,000 annual exclusions. One way to alleviate the emotional hurdle is to think of the rental payments as nontaxable gifts for the children beyond what is achievable by the gifting program. An alternative is take half a bite, establishing the QPRT only with the second home.

Income taxation. Properly designed, both the QPRT and the second ("family") trust will be considered as "grantor trusts" for federal income tax purposes. This means that the trusts will be considered as "disregarded entities" and will be ignored. That is, all of both trusts’ assets, liabilities, income and expenses will be treated as the grantor’s assets, liabilities, income and expenses. Thus, the grantor continues to be able to deduct mortgage interest and real estate taxes and continues to qualify for the exclusion of gain on sale of the homestead.

Grantor trust status also means that the rent is not reportable as taxable income because the rent is considered as a payment to one’s self for something one already owns. Further, on the same logic, after the QPRT term expires, the grantor can purchase the homestead back from the second trust for its then-market value without triggering income taxation. Such a purchase means that the homestead might be eligible for a fair-market-value-on-date-of-death basis (which would not be the case if the homestead were owned by the family trust on the grantor’s death and not included in the grantor’s taxable estate.)

The short-term QPRT. Suppose the term of the QPRT is only two years. The gift element would be much larger than with a long-term QPRT, but the risk of death during the term would be much smaller. The big benefit of the short-term QPRT is that the rent would commence much sooner. The rent would dissipate the grantor’s taxable estate and could be considered as nothing more than an enhancement of the grantor’s gifting program. The taxable income generated by investment of the rent would be reported by the grantor, thus further dissipating his or her taxable estate. The "gift" to the family trust would thus be leveraged because neither the trust nor the trust beneficiaries would be subject to income taxation.

An example. With reasonable assumptions, it is easy to see that very significant estate tax benefits could result from a short-term QPRT. For example, suppose a homestead worth $300,000 is owned by a husband and wife. Suppose they transfer the homestead to themselves as equal tenants in common without rights of survivorship and that each then declares that he (or she) is holding his (or her) half interest as trustee of a QPRT which provides that he (or she) is entitled to possession of such transferred half interest for a period of two years, after which time each half interest passes to an irrevocable trust that both the husband and wife had set up for the benefit of their children (with one or both of themselves as trustee(s).)

The taxable gifts on formation of the QPRT’s would be, say, $200,000, using up part of the grantors’ respective exemption equivalents, thus avoiding an out of pocket check to the IRS. After two years the rent would be, say, $36,000 per year, plus an annual CPI increase. Over the following 15 year period the total rent would be, say, $700,000 and the earnings on the investments of the accumulated rent moneys would be, say, $350,000, all of which would be reported by the grantors on their personal 1040. If the survivor of the grantors died at the end of the 15 year period and the homestead were then worth $600,000, the net effect would be that the children received the full $1,050,000 in the trust plus the $600,000 homestead, with only $200,000 of gifts reported. In addition, the grantors’ taxable estates would have been reduced by the income tax liabilities generated by the earnings on the investment of the accumulated rents. (The longer the time until the survivor’s death, the greater the transfer tax savings.)

Ad valorem exemption. A downside of the QPRT is that the homestead will not qualify for the homestead exemption. This result can be avoided by the grantor retaining an interest in the homestead with a value exceeding $25,000. For example, if the homestead were valued at $250,000 for ad valorem purposes, the grantor could retain a 10% interest (assuming the local tax authorities did not bother to determine a partial interest discount) and thus qualify for the full homestead ad valorem exemption. However, it should be noted that the complexity is probably not worth it.  Further,  the overall tax and nontax benefits of transferring 100% of the homestead (instead of 90%) to a short-term QPRT and leasing same from a family trust probably outweigh the additional ad valorem tax burden.

Exemption from creditors. Since both the QPRT and the second ("family") trust will presumably be designed to avoid the grantor’s creditors, loss of homestead status for purpose of the exemption from creditors would generally not have the effect of rendering the homestead available to the grantor’s creditors. The only possible exception would appear to be where the creditors existed (or were contemplated) at the time of the transfer to the QPRT, but even that exception is suspect since the creditors would not be harmed by the transfer (i.e., the homestead was exempt from creditors to begin with.)