WHAT IS A QPRT?
A qualified personal residence trust (QPRT – pronounced “kew-pert”) is an irrevocable trust that allows you to leverage your $1 million lifetime gift tax exemption. A QPRT can dramatically increase the amount passing to your beneficiaries and reduce estate taxes. A QPRT takes advantage of certain provisions of the law to allow a gift to the QPRT by its creator (the “Grantor”) of his or her personal residence, usually for the ultimate benefit of children, at a “discounted” value. This, in turn, may remove the asset from the Grantor’s estate, reducing potential estate taxes on the Grantor’s death. If a trust conforms to all of the requirements set forth in the regulations, it is not subject to certain special valuation provisions of Internal Revenue Code which limit such discounts, and the retained and remainder interests will be valued under traditional gift tax valuation rules.
Under a QPRT, the Grantor is the person who owns the residence to begin with and creates the trust, reserving the right to live in the house for a specified period of time. This interest is called the “retained interest” because it is what the Grantor retains. At the end of that period, the ownership of the residence goes to the beneficiary or beneficiaries. This interest is called the “remainder interest,” and each beneficiary is called a “remainder beneficiary.”
THE BASIC IDEA
A QPRT may serve a useful purpose when the Grantor wishes to transfer his or her personal residence to family members (usually children) at some time in the future, and to reduce the overall transfer tax cost—that is, estate and gift tax cost—of the transfer. For gift tax purposes, the original transfer will be treated as a gift of the remainder to the remainder beneficiaries (for example, the children) and the Grantor must file a gift tax return at the time the residence is transferred to the trust. The value of the remainder is derived by first determining the fair market value of the entire property, and then subtracting the value of the retained interest.
The value of the retained interest is a function of the length of the trust term and the age of the Grantor, calculated in conjunction with interest rates published by the IRS for making present value calculations. Other things being equal, the longer the term of the trust, the larger the value of the retained interest, the smaller the value of the remainder, and the smaller the taxable gift. The amount of gift tax due will usually be offset by the Grantor’s lifetime gift tax exemption amount ($1,000,000).
To create a QPRT, a homeowner transfers his or her residence to a trust that exists for a predetermined period of time (for example, 5, 10, or 15 years). The homeowner retains the right to use the residence during the trust term. The trust terminates at the end of the term and title to the residence is transferred to the beneficiaries of the trust, usually the homeowner’s children or a trust for the homeowner’s children. If properly structured, the homeowner may also lease back the residence at the end of the trust term for its then fair market rental value, thereby making an even greater transfer out of his or her estate to his or her children. When rent is received, the child will then be required to pay income tax on this amount.
If the Grantor dies before the trust has terminated, the residence will be included in his or her taxable estate, and estate tax will be paid on it, because the Grantor retained the use of the property for a period that did not end before his or her death. That is, the purpose of the trust will have been defeated. However, the estate will get a credit for the exemption previously allocated.
Usually, a provision in the QPRT will provide that, in the event of premature death, the property will be distributed back to the homeowner’s probate estate to be distributed under his or her will, or to the homeowners revocable living trust to be distributed with his or her other assets. In other words, if the homeowner dies before the end of the trust term, the only thing to lose are the fees and costs incurred in setting up the trust. On the other hand, if the homeowner survives the term, the property will be distributed to the QPRT beneficiary (the children) without further transfer tax, which can result in substantial estate tax savings.
As mentioned above, when the trust term is relatively long, the value of the gift to the remainder beneficiaries will be relatively low, and the gift tax cost of transferring the residence to the trust will be correspondingly low. In contrast, when the trust term is relatively short, the value of the gift to the remainder beneficiaries will be relatively high and the gift tax cost of transferring the residence to the trust will also be correspondingly high. However, the lower gift tax cost that results from a relatively long trust term must be weighed against the greater risk that the residence will be included in the Grantor’s gross estate if he or she dies before expiration of the trust term. In theory, a QPRT will afford the greatest transfer tax savings when the Grantor is young and the trust term is long.
For a Grantor who is not young, the risk of death before expiration of the trust term is real and has to be weighed against the expenses of the trust (including initial documentation and ongoing accounting services), the loss of stepped up basis, discussed below, and the loss of alternative strategies (e.g., annual exclusion gifts of interests in the property to donees not now the beneficiaries of such gifts).
Hank Client, a widower aged 67, owns a home worth $500,000. Hank owns other assets which puts him in the 35 percent estate tax bracket (the top estate tax bracket for 2010). Hank has a life expectancy of 15.2 years. After consultation with his estate planning attorney and CPA, Hank decides to create a 15-year QPRT. At the end of the term, the property will pass to Hank’s children outright. The applicable IRS table rate for the month in which the QPRT is established is 4.8%. Hank estimates that the property will appreciate at 5% per year.
Present value of residence: 500,000
Value of residence at Hank’s death: 1,039,464
Death tax paid on residence: 498,943
Net to children at Hank’s death: 540,521
Present value of residence: 500,000
Amount of taxable gift: 132,880
Value of residence at Hank’s death: 1,039,464
Death tax paid on residence: 0
Net to children at Hank’s death: 906,564
Net to children without QPRT: 540,521
Net to children with QPRT: 906,564
Increase to children (estate tax savings): 366,043
The calculations involved in determining the valuation of the gift are rather complex. In general, the longer the term of the trust, the lower the use of the gift tax exemption and the higher the estate tax savings. Of course, if the Grantor does not survive the term of the trust, there is no estate tax savings at all because the trust assets are included in the Grantor’s estate for estate tax purposes. The obvious disadvantage with the longer term is that it reduces the likelihood that the Grantor will outlive the trust term; that is, it increases the chance that none of the hoped-for benefits of the trust will be realized. The longer term also increases the likelihood of substantial market appreciation, i.e., a large tradeoff of capital gains tax savings (see below) for transfer (estate and gift) tax savings.
CAPITAL GAINS TAX SAVINGS TRADEOFF
The effects of a carry-over income tax basis must also be considered. This concerns the income tax liability to the remainder beneficiaries if they sell the residence either following the Grantor’s death or following termination of the trust. If they were to take the residence by inheritance, it would have an income tax basis “stepped- up” to its value as of the date of the parent’s death. On the other hand, if the QPRT “bet” succeeds, i.e., if the Grantor outlives the trust term and the children take the remainder under the terms of the trust, their basis will be the same as the Grantor’s. If there is substantial market appreciation over the price the Grantor paid, the increased capital gains tax may well offset the lower gift tax achieved by the QPRT.
However, the estate tax rates currently far exceed the capital gains rates. Moreover, the children could defer or eliminate the income tax by structuring the sale as a like-kind exchange or establishing a charitable remainder trust. The basis step-up might also be preserved if the homeowner buys back the residence at the end of the trust term.
WHAT PROPERTY CAN BE USED?
A QPRT may be created using a primary residence or second home, such as a cabin, a vacation condominium, or even a yacht. Business or investment property, such as an apartment complex, office building, or farm, cannot be used. For a married couple owning a home jointly, even greater estate tax savings are possible because their respective ownership interests are entitled to minority interest and marketability discounts.
A QPRT is an irrevocable trust. Unless the trust ceases to qualify as a qualified personal residence trust, the Grantor cannot expect to regain ownership of the residence, and when the trust term expires according to the provisions of the trust instrument, the residence will automatically pass to the remainder beneficiaries. After expiration of the trust term the residence may be unavailable to the Grantor either as a residence or as an asset that can be sold if financially necessary. However, you may rent back the respective residence at their fair market rent.
ADMINISTRATIVE BURDEN AND EXPENSE
Because the trust is irrevocable, it must keep its own books and file annual federal and state income tax returns if there is any income, which is usually not the case unless your residence is sold. The expense and bother of these factors should be considered.
USE OF RESIDENCE ON TERMINATION OF TRUST
The Grantor may be required to leave the personal residence when it is distributed, at the end of the trust term, to the remainder beneficiaries. However, the Grantor may be permitted to remain in the residence if he or she pays fair market rent for the use of the residence. This rental payment will also allow the Grantor to transfer more money out of his or her estate to the ultimate beneficiaries. It may be risky to enter into a lease arrangement before the end of the original trust term. If, before the residence is transferred to the trust, there is any arrangement, whether formal or informal, that the Grantor will not in fact lose the use of the residence on expiration of the trust term, but will have some right to remain in the residence beyond that time, it is possible that the trust might not be recognized as a QPRT and the advantages of the trust would be totally lost.