Written for the Succession Advisors website
Qualified Personal Residence Trusts (“QPRTs”) Can be Used to Effectively Transfer an Interest in a Residence
A QPRT is a trust that may be used to transfer an interest in a principal residence and/or one “vacation home” on a tax effective basis. For this purpose, a “principal residence” is an individual’s primary residence. A “vacation home” is one home that someone owns which is not rented to others more than 14 days/year.
When a person transfers his or her residence (or vacation home) to a QPRT, he or she keeps the right to live there for a certain number of years (“QPRT Term”) At the end of the QPRT Term, the residence passes out of the QPRT to children directly (or to trusts for their benefit, if desired). The value of the “gift of the residence” is reduced by the actuarial value (determined using IRS tables) of the person’s right to live there during the QPRT Term. As a result, the gift (for gift tax purposes) is a much smaller amount than if the QPRT were not employed.
For example, assume a person owns a residence worth $2,000,000. That person gifts the residence to a QPRT, retaining the right to live there for 10 years. At the end of the 10-year term, the house passes out of the QPRT to a trust for children. The value of the actuarial right to live in the residence for 10 years is calculated using IRS tables to equal $750,000. The value of the person’s gift – for gift tax purposes – is calculated as follows: $2,000,000 (Residence Value) – $750,000 (QPRT Term Value) = $1,250,000 (Gift Value).
Valuing The Retained Right To Live In The Residence
IRS tables value the grantor’s retained right to live in the residence based on the Section 7520 rate. The Section 7520 rate is determined on a monthly basis, and can be found at: https://apps.irs.gov/app/picklist/list/federalRates.html.
If interest rates are high, the value of the retained right to live in the residence is high and the “gift” value will be low. Likewise, if interest rates are low, the value of the retained right to live there is low and the gift value will be high. Therefore, the best time to use a QPRT is when interest rates are high – the retained interest is worth more, so the gift of the remainder (or residence) is less. Finally, note that the longer the QPRT Term, the lower the gift value as well.
The Grantor Must Survive the QPRT Term For The QPRT To Work
Since the grantor’s gift is less if he or she retains the right to live in the residence for a longer term, when planning a QPRT gift one’s instinct is to make the term very long. However, if the grantor does not outlive the QPRT term, the residence is taxed on the grantor’s death as part of the grantor’s estate. Therefore, when determining the QPRT Term, it should be as long as possible to reduce the gift (as much as possible), but not so long that there is a likely risk that the grantor may die beforehand.
How Can The Gift Be Kept To A Minimum?
The QPRT provides a way to reduce the value of the gift of a principal residence or vacation home by using the IRS actuarial tables to reduce the value of the gift by the value of the grantor’s retained interest in the QPRT (referred to below as the “QPRT Reduction”). However, the grantor can reduce the value of the gift using standard discounting techniques even before the QPRT Reduction is accomplished.
Example: Let’s consider an example where the value of the residence is, in actuality, $4,000,000:
Step One. Have the residence appraised. There is no “fixed” value to a residence. In this example, the residence could be viewed as being worth between $3,500,000 and $4,000,000. In this circumstance, assume the appraiser values the residence at $3,500,000.
Assume further that the grantor has two children. Rather than create one QPRT the grantor creates two separate QPRTs: “QPRT 1” distributes to a trust for one child at the end of the QPRT 1 Term; and “QPRT 2” distributes to a trust for second child at the end of the QPRT 2 Term. In that circumstance, the grantor will transfer 50% of the residence to QPRT 1 and 50% to QPRT 2.
Step Two. Value the 50% residence interest at a discount.
Now assume the “discount” given (by appraisal) is equal to 20%. Therefore, the $1,750,000 value of half the residence would be reduced to $1,400,000. When the grantor makes gifts of 50% of the residence to each QPRT, there would be two separate $1,400,000 gifts.
Step Three. Determine the amount of the QPRT Reduction. The QPRT Term selected by the grantor is 12 years. Assume that based on the Section 7520 rate, the amount of the QPRT Reduction is $400,000. When the grantor makes a gift of 50% of the residence to each QPRT, the $1,400,000 is reduced by $400,000 and the gift value is $1,000,000. The grantor made gifts to two separate QPRTs; therefore, the total value of the gifts: 2 (Number of Gifts) x $1,000,000 (Gift Value) = $2,000,000 (Total Gifts).
Through the magic of appraisal, discounts, and the QPRT Reduction, the grantor is able to gift a $4,000,000 residence at a “gift tax value” of $2,000,000!
Other QPRT Rules
There are additional “rules” that apply to QPRTs, which require certain provisions to be present within the QPRT’s governing instrument in order for the QPRT to qualify. These include:
- Nothing Can be Held by the QPRT Other than an Interest in a Principal Residence or Vacation Home. The QPRT may only hold an interest in a principal residence or vacation home. If the residence or vacation home is sold, the trustee must re-invest in another residence or vacation home within 2 years. Otherwise, the QPRT must (by its terms) convert to a GRAT for the balance of the QPRT Term.
- Funds for Improvements. The QPRT may hold funds for improvements reasonably expected to be undertaken within the next 6 months. Any excess cash must be distributed to the grantor.
- Insurance Recovery. The QPRT may hold funds received that are recovered from insurance if the residence or vacation home is damaged or destroyed, but fund must be used to repair or replace the residence or vacation home within 2 years. Otherwise, the QPRT must (by its terms) convert to a GRAT.
- Grantor Must be Prohibited from Purchasing the Residence Back from the QPRT. A QPRT is a grantor trust. When QPRTs first became part of the law, grantors typically sought to purchase the residence or vacation home back from the QPRT shortly before the end of the QPRT Term. This allowed the grantor to continue to live in the residence or vacation home until he or she died (with the cash in the QPRT transferring on a transfer tax-effective basis to children), and also provided a way to get a basis step-up for the residence or vacation home at the grantor’s death. This is no longer permitted and the QPRT will be disqualified unless the prohibition is part of the governing instrument.
Where Does The Grantor Live At the End of The QPRT Term?
At the end of the QPRT Term, the residence (or vacation home) passes from the QPRT to other beneficiaries (typically children or trusts for children). In order for the grantor to continue living in the home, he or she must pay fair market rent to the new owners (whether children or trusts). Failure to pay fair market rent will cause inclusion of the residence (or vacation home) in the grantor’s estate and the tax benefits sought by the QPRT will be entirely lost.
If the residence passes to a grantor trust for children at the end of the QPRT Term, the grantor can pay rent without the trust having to pay income tax on the rent received. That is a better result than if the remainder beneficiaries of the QPRT were the children themselves, as the children would instead pay income tax on the rental income received. What’s more, every dollar of rent received by the grantor trust is effectively a transfer from the grantor out of the grantor’s estate without gift or income tax consequence.
What If The Grantor Wants To Downsize?
A QPRT can only hold one residence at a time. If a grantor created a QPRT with a $4,000,000 residence, and later decides he wants to sell the residence and purchase a smaller residence, it’s best if the grantor creates two separate QPRTs. For example, assume the grantor created two QPRTs, each owning half of a $4,000,000 residence. If the residence is sold, $2,000,000 will be received by each QPRT. One could reinvest the sale proceeds and purchase a new $2,000,000 home, while the other could convert to a GRAT and provide the grantor with funds on which to live (in the form of annual annuity payments from the GRAT).
The same approach can be used for a person who wants to sell his residence, buy a smaller residence and a new vacation home. Using the facts in the above example, each QPRT could sell its half of the residence. One QPRT could buy a now $2,000,000 residence in which the grantor could reside, and the other could buy the vacation home the grantor wishes to enjoy.
Using The Grantor’s Gain Exclusion On The Sale Of A Principal Residence
There is a $250,000 capital gain exclusion for the sale of a principal residence for each individual. The QPRT is a grantor trust. Therefore, if the grantor’s principal residence is sold before the end of the QPRT Term, the gain exclusion is available to offset gain on sale. If the principal residence is sold after the end of the QPRT Term, that benefit is lost. Therefore, if the grantor does not intend to reside in the residence after the QPRT Term, the residence should be sold prior to the termination of the QPRT.
What If The Grantor Dies During The Term – Can The Save Tax Benefit Be Saved?
If a grantor dies before the end of the QPRT Term, the QPRT may provide that the residence returns to the grantor’s living trust (to pass, for example, as part of a marital deduction trust thereby deferring estate tax until the grantor’s spouse dies). Alternatively, the QPRT could provide that even if the grantor dies before the end of the QPRT Term, the residence still passes to the grantor trust for children.
In most cases, the grantor acts as trustee of the QPRT (until the day before the end of the QPRT Term). If the grantor is trustee of the QPRT, and if the QPRT provides that even if the grantor dies before the end of the QPRT Term the residence still passes to the trust for the children, there is an opportunity to “save” the benefits of the QPRT that would otherwise be lost if the grantor dies before the QPRT ends.
In that circumstance, the grantor could decide to breach his or her duties as trustee of the QPRT and simply deed the residence back to him or herself before death. The grantor would die before the end of the QPRT Term and with the residence as part of the grantor’s taxable estate – and consequently, subject to estate tax. Because the grantor died before the end of the QPRT Term – even if he or she did not deed the residence back to him or herself – the residence would have been part of the grantor’s taxable estate – and subject to estate tax.
However, when the grantor breached his or her duties as trustee and deeded the residence back to him or herself before death, the trust for children that would have received the residence was denied that benefit. The trustee of that trust could assert a claim against the grantor’s estate in an amount equal to the value of the residence. The claim is considered to be valid and the children’s trust would win; hence, the trust would receive the residence (or assets equal to it in value). The claim against the decedent is an estate tax deduction. The effect is that the residence is part of the grantor’s taxable estate, but the value of that asset is offset by the claim against the decedent. Effectively, the benefits of the QPRT are accomplished – even though the grantor died before the end of the QPRT term.
The IRS could challenge the grantor’s breach of duty – arguing that he or she did so solely to “save” the QPRT tax benefits – and therefore, the claim should somehow be deemed illusory and not allowed to offset the value of the residence held as part of decedent’s estate when he or she died. However, if there is a legitimate family reason that encouraged the grantor to breach his duty (e.g., “I don’t like the spouse of the child who was going to receive the residence, and breached my duty so that spouse wouldn’t have the chance to live there with my child”) then that might provide a rebuttal against the IRS. Further, if the grantor is the first spouse to die, his or her estate tax return (which would show the claim of the children’s trust against the decedent due to the breach of his or her fiduciary duties as trustee) would typically be a “no tax estate” – leaving it very unlikely that IRS would even review the return and identify the issue.
This is an aggressive plan to save the benefits of the QPRT. But if not taken, when the grantor dies before the QPRT term ends those benefits will be lost anyway. Given that, there is essentially no downside in making this attempt.
Note that the children’s trust could assert its claim by writing a letter to the personal representative of the decedent’s estate. That personal representative would certainly recognize that the decedent breached his or her duties as trustee of the QPRT. In that circumstance, the personal representative is likely to simply reach a settlement agreement with the children’s trust – no formal lawsuit would be required. (However, perhaps filing a lawsuit and then reaching a settlement makes the claim look more “real” in the face of an IRS challenge.)
Downsides To QPRT Planning
Generation-skipping tax exemption cannot be allocated to the QPRT. It can be allocated to the children’s trust that receives the residence or vacation home when the QPRT ends. But the benefit of leveraging the GST exemption – by applying it to the value of the residence at the time of the transfer to the QPRT – is not available.
If generation-skipping benefits are sought, selling the residence to a grantor trust in exchange for a note is a better option. A small gift can be made to the trust before the sale (typically 10% of the value of what is being purchased), and GST exemption allocated to that small gift. The grantor would need to lease the home back at fair market rent to be able to reside there and allow appreciation to be transferred without incurring gift or estate tax. Those rent payments to the grantor trust could be used to service the debt on the note. Neither the rent nor the note payments would be subject to income tax if the purchasing trust is a grantor trust.
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