What is a Qualified Personal Residence Trust?
Advise your clients with the latest in QPRT planning
Do you understand the ins and outs of a Qualified Personal Residence Trust (QPRT) and how it is applied to your clients' lives? No? That's OK.
Proper application and execution of a QPRT has many benefits, and this article aims to set you down the right path for the benefit of your clients.
What is a QPRT?
QPRTs are typically used to transfer ownership of a residence or second home with estate and gift tax savings. The property is transferred to an irrevocable trust, and the owner (grantor) retains the right to remain in the home for a specified period, after which the residence becomes the property of the trust beneficiaries. However, specific requirements must be met to qualify for the transfer tax savings, which are covered in IRC §2702 and its regulations.
The tax benefits of using a QPRT as a gifting tool.
- When an individual transfers the property to the QPRT, the transfer is treated as a currently taxable gift. But the value of the gift is based on the present value of the beneficiaries' right to receive the property at the end of the trust term. The longer the trust term, the more the gift is discounted.
- The gift tax value is calculated at the time of the transfer, and all of the future appreciation will escape the grantor's taxable estate.
- You avoid probate upon death.
Case in point
Assume a client in the 40-percent estate tax bracket places a $500,000 personal residence into an irrevocable trust. The trust provides that the client will live in the personal residence for a 10-year term. At the end of that time, the personal residence will pass to the children. Also assume a discount (AFR) rate of 2 percent (2016 levels). Based on the JRS valuation tables, the present value of the future interest gift (not eligible for the $14,000 "annual gift tax exclusion") is $408,536.50 (.817073 x $500,000). In 2016, $5.45 million of lifetime gifts can be sheltered by the unified credit equivalent. If the client had already made $5.45 million of lifetime gifts, the gift tax would be $163,414.60 ($408,536.50 x 40 percent). As AFR interest rates increase, the tax benefits increase.
If the client dies before the term expires, the trust assets will be included in the taxable estate at date-of-death value. There would be no transfer tax savings. If the client survives the term, the value will escape all transfer taxes at death. If the property described in the earlier example appreciates at 5 percent per year, it would be worth approximately $814,500 after 10 years. The estate tax savings on appreciation alone would then be approximately $162,385.40 [40 percent x ($814,500 - $408,536.50)].
Are there any drawbacks?
The inability to mortgage the residence after the QPRT is created may be one reason not to create a QPRT. The fact that the residence may already be mortgaged when it's transferred to the trust is no bar, although it complicates the arrangement. If there is a mortgage, the grantor may consider paying it off, since additional mortgage payments after the trust is funded will be considered additional gifts for transfer tax purposes.
- The costs involved in creating a QPRT may also be a drawback for some. They include: attorneys' fees, appraisal fees and property titling costs when establishing the trust.
- The QPRT is an irrevocable trust and may preclude other planning measures. If the grantor uses up a sizable part of the unified credit to offset the gift value, the client may not be in a position to make other large gifts expected to appreciate in value.
- If the grantor dies during the specified trust term, the benefits are lost and the executor may be liable for tax on the includable assets -- but the property itself might not be available to pay that tax.
It's recommended that one or more qualified appraisers value the property shortly before it is placed into trust. During the trust term, the residence may not be occupied by any person other than the grantor, a spouse, or dependent; must be available at all times for such use; cannot be used for any other purpose; and must prohibit sale or transfer to the grantor, the grantor's spouse, or an entity they control. The parties should execute a written lease after the specified term expires, with the grantor paying a fair market rental to avoid additional gifts or estate tax inclusion.
No more than two QPRTs created by the same grantor may exist at the same time. To achieve three QPRTs between a married couple, a separate QPRT can be used for one property, by first changing title to a tenancy-in-common, and then each spouse giving their fractional interest to the trust. The value of each interest will be discounted from its proportional share of the entire value of the residence, permitting further discounting of the gifts being made on creation of the QPRTs. Each spouse can then set up a QPRT for another individually-owned property.
What's considered a residence?
A "personal residence" is defined as: (1) the principal residence of the term holder; (2) one other residence of the term holder; or (3) an undivided factional interest in either of the foregoing. Contributions of additional property are allowed for: (1) "Appurtenant pertinent structures" used by the term holder for residential purposes; and (2) adjacent land not in excess of that which is reasonably appropriate for residential purposes (taking into account the residence's size and location). Finally, the primary use must be as a residence of the term holder (e.g., the grantor). The governing instrument must prohibit the trust from holding, for the entire term of the retained interest, any asset other than one property to be used or held for use as a personal residence of the term holder.
Can the QPRT hold cash?
The QPRT can hold cash in a separate account for: (1) trust expenses (including a mortgage) already incurred or reasonably expected to be paid within six months from the date a deposit was made; (2) improvements to the residence to be paid within six months from the date of the addition; (3) the purchase by the trust of the initial residence within three months of the date the trust is created; or (4) the purchase of a replacement residence within three months of the date of the deposit. If the property is sold or insurance proceeds are received, a two-year replacement period is permitted. Excess cash must be distributed at least quarterly and at the termination of the trust term. Sale may also qualify for the $250,000/$500,000 personal residence exclusion.
What about distributions of income?
If the trust has income, it must be distributed at least annually to the term holder; no distributions can be made to any other person. The governing instrument must also prohibit distributions of principal to any beneficiary other than the transferor before the expiration of the retained term interest.
If the property is no longer used as a personal residence, the trust (1) must terminate and its assets distributed to the term holder, or (2) must convert into a qualified annuity trust. It is also possible to sell a residence, reinvest only part of the proceeds in a new residence, and convert the rest to the annuity trust. The governing instrument must also prohibit the commutation (prepayment) of the term interest.
What's a GRAT?
If all or any portion of a trust ceases to qualify as a QPRT, the governing instrument must require the distribution of the trust assets to the term holder, or alternatively the conversion of the trust into a Grantor Retained Annuity Trust (GRAT). Generally, this must occur within 30 days after the date when the trust ceases to be a QPRT.
Who should be the trustee?
While it is not a requirement, especially during the retained term, the trustee should generally be someone other than the grantor or the grantor's spouse. Retention of an interest as a trustee could lead to additional income tax or estate tax issues. The grantor also should not be the trustee of any succeeding trust for the settlor's spouse or descendants, unless the settlor is excluded from participating in discretionary distribution decisions.
The grantor can directly pay the expenses of the trust. Under most state statutes, the grantor can pay mortgage interest, taxes, maintenance, utilities and repairs to the extent properly chargeable against the grantor without adverse tax consequences. However, if the grantor pays any expenses properly chargeable to the beneficiaries (e.g., an improvement to the personal residence), the payment of that expense may be an additional taxable gift. To avoid this issue, the trust instrument can include a provision that, to the extent the grantor pays any expenses properly chargeable to the beneficiaries, the grantor is authorized to recover or be reimbursed immediately from the trust or the beneficiaries.
What about income tax?
If the grantor dies after the specified term, no step up in income tax basis is allowed. The basis is allocated based on the present value calculation at inception. In the aforementioned gift tax example, the grantor would take about 20 percent of the basis, and the beneficiaries would take 80 percent. So, if the client's original basis in the example was $400,000, the donee's basis would be $321,774 (.804435 x $400,000). Although there may be some income tax (most likely capital gain) to pay upon later sale, the tax may be well below the federal estate and GST tax rates that could have been imposed had the property been included in the grantor's estate. Furthermore, the potential for additional significant tax deferral exists; if the $500,000 had been retained by the grantor, an estate tax would have been due on the presumably appreciated date of death value. Finally, the income tax would be imposed only if and when the beneficiaries dispose of the property.
Generation-skipping transfer tax
The Internal Revenue Code and Regulations prohibit any allocation of GST exemption to this transfer until the end of the Estate Tax Inclusion Period (i.e., the end of the term). The GST allocation would be based on the property value at that time.
For clients with significant residential real estate, the CPA should suggest the QPRT as an option to be considered as part of their estate plan.
In addition to the income and transfer tax advantages, QPRTs provide asset protection, gradual transition to family members or irrevocable trusts, and additional gifting opportunities during the retained term without gift tax consequences. Estate planners have many tools available for real estate planning, some involving lifetime or testamentary trusts, and a general understanding of QPRTs is helpful to initiate or facilitate the discussion with your clients.
Scott Nelson, CPA, JD is a trusts and estates lawyer with a transfer and fiduciary income tax focus at Hellmuth and Johnson PLLP. He counsels clients on business succession, asset protection, and estate, legacy and philanthropic planning. He also collaborates with fiduciaries and professionals on probate, estate and trust administration.