A key part of the financial planning process involves being cognizant of the estate tax. A large portion of the estate at death could be your home, and although you may be far from the time your estate goes through probate, removing this asset from your estate could save you and your family millions of dollars in estate tax expenses.

Let’s suppose we owned a two million dollar home and we did not plan correctly. In 20 years, this home may be worth around four million dollars, assuming the value of the home grows at 3.5% (which is near the annual inflation rate the US has experienced since 1914). If we were to pass away in 20 years, our heirs would inherit a four million dollar estate comprised of the home. After deducting the applicable estate tax exclusion amount, we would be left with a taxable estate of $500,000 (four million minus 3.5 million). The top estate tax rate is 45%, so this means our beneficiaries just inherited a home with a $225,000 tax bill. Since our beneficiaries will inherit our assets after the estate tax is settled, selling the home in order to pay the estate tax remains possible.

Suppose, on the other hand, we engaged in some good planning. We heard from our financial planner that the home can be a great asset to gift. A Qualified Personal Residence Trust (QPRT) can be set up to pass on a personal residence to future generations, without facing our previous estate tax issue. The way this works is that a title to a home can be placed in a trust for a specified term. This type of trust will freeze the home’s value and allow it to appreciate outside of the estate. Furthermore, the IRS allows a discount to be assessed on the home’s actuarial value. This means the value of the home when it is transferred to our heirs may be a lot higher than the calculated future value going into the trust, yet the gift tax will be assessed at the time the QPRT is set up, using the calculated future value.

At the end of the QPRT term, ownership of the home will be passed on to our heirs. We would then have to pay rent to our heirs, or put the transaction at risk. If we take the previous example, the actuarial value may be three million dollars (lower than our estimated future value). This value would fall below the 3.5 million dollar estate tax exclusion amount, saving our heirs $225,000 in estate tax and allowing us to shield an additional $500,000 from the estate tax.

There are some catches to the QPRT, however. If the home depreciates in value, we would be obligated to take the deduction as outlined in the QPRT. Furthermore, we need to outlive the life of the QPRT to see any of the benefits. For this reason, we may want to structure the QPRT with a shorter tenor. Last but not least, we are entering into an irrevocable agreement and are relinquishing control of our property when starting the trust.

The QPRT is just one of the many available financial planning tools that can help us pass more of our assets to our younger generations. Given the current financial storm, which has devalued real estate properties around the country, a little planning can go a long way.