Qualified Personal Residence Trusts (QPRTs)
A Qualified Personal Residence Trust is powerful gifting tool that allows a person to protect a primary residence from creditors and to minimize estate taxes by leveraging his or her estate and gift tax credit and freezing an appreciating asset at its current value.
1. What Is a Qualified Personal Residence Trust or “QPRT”?
A Qualified Personal Residence Trust or “QPRT” is an irrevocable trust that holds a personal residence for a term of years. At the end of the trust term, the residence is distributed to the beneficiaries named in the trust – typically children. For example, you could create a QPRT and transfers your residence to the QPRT for a term of 12 years (or any other term), with the remainder passing to your children. You would have the right to live continue living in your residence and to use your residence for the next 12 years. At the end of the 12-year term, your residence would pass to your children, although arrangements could be made to lease the residence back so you could continue living in it.
2. What Are the Major Benefits of a QPRT?
There are several tax and economic benefits associated with a QPRT. QPRTs are especially good at leveraging a person’s estate and gift tax credit.
A transfer of property to a QPRT is currently treated as a taxable gift. The value of the gift is based on the present value of the remainder beneficiary’s right to receive the property at the end of the QPRT term. For example, if you were age 65, you could create a QPRT, transfer your residence to the QPRT for a term of 12 years (or any other term), and have the remainder pass to your children at the end of the 12-year term. Assuming the residence is valued at $1,000,000 and the transfer is made in the current month, based on IRS tables, you would be treated as having made a gift to your children valued at only $346,060. Because the estate tax rate can approach or even surpass 50%, this would obviously result in significant estate tax savings. You would have effectively transferred an asset worth $1,000,000 to your children by using only $346,060 of your estate and gift tax credit (your gift credit is currently valued at $1,000,000 as of January 2004, and you estate tax credit is $1,500,000 as of that date).
Because a QPRT is an irrevocable trust and the residence would no longer belong to the donor, the donor’s creditors would not be able to execute a judgment lien on the residence. Thus, a QPRT provides excellent asset protection benefits.
3. Are There Any Other Tax Benefits Offered By A QPRT?
Another tax and economic benefit is that all of the future appreciation of the residence will be transferred to the children estate and gift tax-free. A QPRT, as a result, is a powerful tool for freezing the value of your estate. Based on the prior example, assuming that the $1,000,000 residence appreciates at 4% per year for the 12-year term, the residence would be valued at $1,601,032 12 years from now. All of the appreciation during the 12-year term would inure to the benefit of your children. Thus, by making a gift valued for estate and gift tax purposes at $346,060, you would effectively transfer an asset worth $1,601,032. Assuming your estate is in the current maximum 48% federal estate tax bracket, this would save you $602,387 in federal estate taxes!
4. Is a Gift Tax Return Required When a Gift is Made to a QPRT?
Yes. A Federal Gift Tax Return Form 709 must be filed in the year in which the gift to the QPRT is made. Based on the foregoing example, you would be required to prepare and file a Federal Gift Tax Return to report the gift, which would consume $346,060 of your estate and gift tax credit. Assuming you had not made prior gifts that had consumed the rest of your gift tax credit, no gift tax would be due.
5. Does a Gift to a QPRT Qualify for the $11,000 Gift Tax Annual Exclusion?
No. A gift to a QPRT is a gift of a future interest and does not qualify for the $11,000 gift tax annual exclusion. Only gifts of a present interest qualify for the $11,000 gift tax annual exclusion.
6. How Does My Age and the QPRT Term Affect the Tax Consequences of the QPRT?
The term of the QPRT is an important factor in determining the tax savings freezing of future appreciation of a QPRT. The longer the QPRT term, the greater your tax savings and the more future appreciation you can freeze at current value.
7. What If I Die During the QPRT’s Term?
If you die during the term of the QPRT, the residence would be included in your estate at its full fair market value at the time of year death. Although the asset protection benefits would have been realized, the tax and economic benefits of the QPRT would be lost. However, you would be no worse off than if you had not created the QPRT, other than transactional costs in establishing the QPRT. For example, if you were age 50, created a QPRT with a 15-year term, transferred your $1,000,000 house to the QPRT, and then died 14 years and 11 months later when the residence were valued at $1,800,944, the value of the residence would be included in your estate at $1,800,944 – just as it would have been had the QPRT never existed. However, you would still receive the gift and estate tax credit for the initial gift to the QPRT.
8. How Is the QPRT Term Determined?
The term is selected by the donor. Because dying before the expiration of the QPRT term would result in losing its tax advantages, typically we consult the donor’s actuarial tables and life expectancy and select a term equal to about two-thirds of the donor’s life expectancy. For example, an average individual age 65 has a life expectancy of 17.4 years. As a result, we would typically recommend using a 12-year QPRT term. Obviously, we could adjust this based on the client’s risk tolerance and other issues such as known health problems, family history, etc.
9. What if I Outlive the QPRT’s Term QPRT and Want to Continue Living in the Residence?
If you outlive the QPRT term, the residence would pass to the remainder beneficiaries. They would own the property. You could, however, lease the property back from the remainder beneficiaries at a fair market value rent. The obligation to rent your residence back from your children is viewed by some as a negative QPRT feature. However, many people view it as an opportunity to transfer additional assets, via rent payments, to their children. IRS Private Letter Rulings have allowed QPRTs that included mandatory fair market lease provisions at the end of the QPRT term.
10. My Residence Has a Mortgage. What Are the Tax Consequences of Transferring the Residence, Subject to the Mortgage, to a QPRT?
Ideally, property contributed to a QPRT should not be subject to a mortgage. If property subject to a mortgage is transferred to a QPRT, there are two possible tax treatments. First, the transfer may be treated as a net gift of the difference between the fair market value of the property and the amount of the debt. For example, if a residence valued at $500,000 is encumbered with a $150,000 mortgage, the value of the underlying property gifted to the QPRT would be only $350,000. The gift tax consequences would be based on a $350,000 value. However, each time a mortgage payment is made and a portion of the principal loan balance is reduced, the donor would be treated as having made an additional gift to the QPRT. This could create additional accounting, tax, and administrative burdens.
Another approach is to include a provision in the QPRT Trust Agreement in which the donor agrees to indemnify the Trustee of the QPRT for any liability associated with the mortgage. Arguably, only the value of the underlying residence would be considered, the value of the mortgage would be excluded, and additional mortgage payments would not be considered. However, we are not aware of the IRS either approving or disapproving of this approach.
An existing mortgage cannot be refinanced. However, with mortgage rates apparently on the rise for the foreseeable future, this should not be much of a drawback.
11. How Are Other Expenses of Relating to the Residence Handled While the Residence Is in the QPRT?
The donor may pay other ordinary and recurring expense associated with the residence, such as real estate taxes, hazard insurance premiums, and minor repairs. The donor can deposit the funds necessary to pay these amounts with the QPRT’s trustee. A QPRT’s trustee is permitted to retain sufficient funds to pay these amounts. A QPRT is treated as a grantor trust for income tax purposes and thus the donor can deduct the real estate taxes paid on his or her personal income tax return just as if the QPRT did not exist.
If the donor were to make any capital improvement to the residence, it would be treated as an additional gift to the QPRT and the gift amount would be based on the value of the capital improvement and the remaining term of the QPRT.
12. Can the Residence Be Sold While It Is in the QPRT?
Yes. The residence can be sold and the proceeds can be reinvested in a new residence. Because a QPRT is a grantor trust, any gain recognized on the sale of a principal residence should qualify for the $250,000/$500,000 exclusion of gain from the sale of a principal residence, provided all of the other Code §121 requirements are met. The exclusion of gain does not apply to the sale of a personal residence that is not a principal residence, such as a vacation home.
If the proceeds of sale are not reinvested in a personal residence, the QPRT will convert to a Grantor Retained Annuity Trust or “GRAT” and will pay an annuity to the donor for the balance of the QPRT term. GRATs are discussed below.
13. What Happens if the Property Ceases to Be Used as a Personal Residence?
If the property ceases to be used a personal residence, the trust ceases to be a QPRT and the Trustee must convert the QPRT to a GRAT. GRATs are discussed below.
14. What Is A GRAT?
A GRAT is a Grantor Retained Annuity Trust. It provides for the payment of an annuity for a fixed term with the balance passing to the remainder beneficiaries at the end of the term. If a QPRT converts to a GRAT, it will pay a fixed annuity amount to the donor for the balance of the Trust term and will distribute the balance to the remainder beneficiaries. The amount of the annuity must be based, at a minimum, on the Code §7520 rate in effect in the month the QPRT ceases to be a QPRT.
For example, if you were age 50 and transferred a personal residence worth $1,000,000 to a QPRT in a month in which the Code §7520 rate were 8.4% and the term were 10 years, the approximate value of your retained interest would be $591,650. Five years later, if you sold the personal residence for $1,500,000 and converted your interest to a qualified annuity interest in a GRAT, under the formula contained in the regulations the annuity payable to you must be $92,726 annually. The annuity amount is computed by dividing $591,650 (the lesser of your retained interest or the value on the conversion date) by 6.3806 (the annuity factor at 8.4% for the shorter of 10 years or the life of a person age 50).
15. I Purchased My Residence Many Years Ago and Have a Very Low Basis. Will My Children Receive the Residence with the Same Basis at the End of the QPRT Term?
Yes. Gifts made during lifetime are subject to a carryover basis. Thus, the basis of the residence in your hands would be the same in the hands of your children when they receive the residence at the QPRT’s expiration.
16. Is There Any Way to Take Advantage of the $250,000/$500,000 Gain Exclusion from the Sale of a Principal Residence and to Provide a Step-Up in Basis to the Remainder Beneficiaries?
It is possible to structure a sale shortly before the expiration of the QPRT term to give the remainder beneficiaries a step-up in basis.
Shortly before the expiration of the QPRT term, the remainder beneficiaries could purchase the residence from the QPRT at its full fair market value for a 10% cash down payment and a promissory note for the balance. As a result of the purchase, they would own the residence with a basis equal to its full fair market value. When the QPRT terminates, the remainder beneficiaries would receive the cash and the promissory notes back and the notes would be extinguished.
The tax consequences to the donor are such that, assuming (i) the gain recognized on the sale of the property is less than $250,000/$500,000, (ii) the residence being sold is the donor’s principal residence, and (iii) all other applicable requirements for the Code §121 exclusion of gain requirements were met, the donor could exclude up to $250,00/$500,000 of gain in connection with this sale.
17. Who Should Serve As The Trustee Of The QPRT?
The donor may serve as the Trustee of the QPRT during the trust term. This generally keeps administrative costs and burdens to a minimum. If the trust would continue after the expiration of the trust term, in order to avoid any estate tax traps under Code §§ 2036 or 238, the donor should not serve as the Trustee.
18. Do Any Income Tax Returns Have To Be Filed In Connection With A QPRT?
A QPRT is typically considered a Grantor Trust for income tax purposes. Most QPRTs do not generate any income and an income tax return is not typically required. If the property generates income, a Grantor Trust Tax Return, Form 1041, may be required.
See our flat fee for preparing a QPRT.