Qualified Personal Residence Trusts (QPRTs)
Qualified Personal Residence Trusts (QPRTs) are valuable estate planning tools for homeowners, especially if a home has appreciated substantially in value since it was purchased, or if the personal residence or vacation home is of substantial value. Gifts to QPRTs are relatively straightforward estate planning strategies that allow you to remove your home's value from your taxable estate while providing minimal disruption to your lifestyle, since you are entitled to continue living in your home for the term specified in the trust. If you have hesitated to pursue other estate planning vehicles due to fear of giving too much away too soon, a QPRT may be an appropriate estate planning strategy for you because it provides substantial estate tax and gift tax savings while allowing you to continue residing in your home during the term of the trust.How the QPRT Works
Pursuant to 26 C.F.R. § 25.2702-5(c)(2) on personal residence trusts, an individual is allowed to create a QPRT for their legal residence and an occasional or vacation residence. Title to the residence is transferred to the QPRT. You maintain the ability to remain in your house for a certain period of years, as specified in the QPRT. During the term of the trust you are still responsible for the payment of any expenses related to the home, such as real estate property taxes, homeowner’s association or maintenance fees, or repair costs. However, any significant improvements to the property that increase the value of the residence, such as remodeling the kitchen or adding a new roof, will most likely be considered an additional gift to the trust.
At the expiration of the term of years specified in the trust, the home will pass to your children (or other beneficiaries stated in your QPRT), free of any estate tax. If you decide to remain living in the house, you will pay rent at the market rate to the beneficiaries of the QPRT. This additional payment of rent can actually benefit you in that it further reduces the size of your taxable estate and augments the portion of your estate passing to your children.Tax-related Advantages of the QPRT
For the purposes of illustration, assume you have a vacation home with a value of $1 million that you wish to transfer to a QPRT, and that you have not made any substantial gifts in the past that would impact your lifetime credit for estate or gift tax. Transfers of homes to QPRTs are taxable gifts, but in this case, the home's value is not $1 million. You have the right to continue living in your home for a stated length of time. You are entitled to a discount on the gift amount due to this retained interest in the residence. The amount of this discount is calculated by using the property's actuarial value for passing to your beneficiaries at the trust term's end point. The discount is calculated by using IRS-published tables to take into consideration various factors including the grantor’s age, time spent in the house (retained interest), and an IRS-determined monthly interest rate for the month the transfer is made (the “AFR” rate).
If you are 50 years old and you were to set up a QPRT with a term of 10 years and the AFR rate is 3.8% (the applicable rate for October, 2008), the potential estate tax savings is $421,247. You are therefore receiving a discount on the value of the gift, because the property's fair market value is $1,000,000, while the value of the gift is deemed to be only $637,750. If you survive beyond the term's 10 years, the value of the property in its entirety will pass to your beneficiaries free of any estate tax.
If the residence appreciates in value, the entire amount of appreciation in the property will pass tax-free to the beneficiaries of the trust. Suppose in the above example that the value of the property increased from $1 million to $2 million during the ten year trust term. In this illustration, the $2 million asset will still have a gift tax value of only $637,750.
One potential pitfall of the QPRT is the loss of the ability to take a step-up in basis if your beneficiaries choose to sell the home; if your beneficiaries received the home upon your death, they would have a step-up in basis equal to the fair market value on the date of your death. However, since the maximum federal rate for capital gains is 15% and the maximum estate tax rate is 45%, based on 2008 income and estate tax rates, the amount of capital gains tax payable is significantly less than the amount of potential estate tax owed.
The longer the specified QPRT term, the greater the potential tax savings. However, if you fail to survive the term specified in the QPRT (i.e., 10 years, in our illustration), the value of the property in its entirety will be a part of your estate. It is important to select a reasonable term of years for the QPRT. Experienced legal counsel will review actuarial tables and ask you about any potential health issues prior to selecting the term of the QPRT. Some practitioners will, in select cases, “hedge their bets” by creating two or more QPRTs for the same grantor and property, each QPRT specifying a different term of years, and transfer an undivided interest in the property to each QPRT. Thus, if a client dies after the stated term of both QPRTs, the full amount of the property passes free of estate tax. However, if the client dies after the stated term of one QPRT but not the other, half of the value of the property will pass free of estate tax and the other half will be included in the taxable estate.Payment of Rent at the Expiration of the QPRT Term
If you survive the stated term of the QPRT, you will have to pay fair market value rent to the QPRT beneficiaries if you choose to remain in the residence. The payment of rent allows you to pass more money to your beneficiaries free of estate tax, however, the rent would be includable as ordinary income to your beneficiaries. Your beneficiaries are entitled to offsetting deductions, but a better option is to convert the trust to a grantor trust at the end of the trust term.
A grantor trust treats the grantor as owner of any income derived from the trust’s assets. By making the rental payments to the trust rather than the beneficiaries directly, the grantor, not the beneficiaries, would be subject to income taxes on the rental payments. Another benefit to grantor trust status is that it allows the grantor to utilize the income tax exclusion when selling a personal residence if the home is sold during the grantor’s lifetime. If sale of the property occurs, the grantor, not the trust beneficiaries, is responsible for any capital gains tax on the sale, not the beneficiaries of the trust.
If the grantor of the trust is married, another option to defer the payment of rent is to provide in the QPRT that at the expiration of the trust term, the house will remain in a trust for the benefit of the grantor’s spouse for the spouse’s lifetime. After the end of the QPRT term, but during the spouse’s lifetime, the grantor can reside in the residence rent-free. Under the terms of the trust, the spouse is responsible for the maintenance and expenses related to the home. Upon the spouse’s death, lifetime trust for the spouse terminates and the house would pass outright or in trust to the grantor’s children or other beneficiaries, with no estate tax due. In this case, the grantor does not have to pay any rent after the QPRT term expires if the spouse outlives the grantor.Sale of Home in a QPRT
What happens if you decide to sell the home that is in the QPRT? If you decide to sell the home and purchase another home, under IRS rules the purchase of the replacement home must occur within two years of when the original home in the QPRT was sold, or the trust will no longer qualify as a QPRT. If this happens, the trustee has to distribute the sale proceeds back to you or convert the trust to a Grantor Retained Annuity Trust (GRAT) within 30 days.
If you do decide to sell the home, the trustee will transfer title to the purchaser and will purchase a new home in the name of the QPRT. What happens if the purchase price on the new home is greater than the selling price on the home in the QPRT? In this scenario, only a percentage of the title to the newly purchased home will be in the name of the QPRT and the balance will be titled in the name of the grantor. For example, if the home in the QPRT sells for $1 million and the replacement home is $2 million, an undivided 50% of the new home will be titled in the name of the QPRT and an undivided 50% will be titled in the name of the grantor.
Suppose the reverse scenario occurs where the replacement house costs less than the house in the QPRT; if the newly purchased house costs $1 million, and the house in the QPRT sold for $2 million, the $1 million difference can be distributed back to the grantor, but this defeats the purpose of removing assets from the grantor’s taxable estate. Under the terms of the trust, the difference in the value of the properties will be placed in the GRAT until the end of the specified QPRT term.Seek Experienced Estate Planning Counsel
QPRTs are a valuable estate planning strategy that allows you to transfer substantial assets at a discount while having a minimal impact on your standard of living. QPRTs require careful drafting and implementation by experienced legal counsel. If you are interested in learning whether a QPRT is an appropriate estate planning strategy for you, contact us by e-mail, or call us toll-free at (877) 435-7411 within California, or (858) 618-5510 outside of California to schedule a free in-house consultation.