Qualified Personal Residence Trusts Generally
Qualified personal residence trusts (QPRTs) are generally used to reduce estate taxes by removing a Grantor's residence from the Grantor's estate at a low gift tax value. Once the trust is funded with the Grantor's residence, the residence and any future appreciation of the residence is generally excluded from Grantor's estate if the Grantor survives the term of the trust. Each person is permitted to create one QPRT for a principal residence and one for an occasional residence. A QPRT would allow the individual to save estate and gift taxes without directly parting with cash or giving up the home or homes.
To create a QPRT, an individual (the "Grantor") transfers title of a personal residence to a qualifying trust, a QPRT, and retains the right to live in the home for a specified number of years (the term of the trust). A QPRT must satisfy the following requirements in order to accomplish the desired gift and estate tax consequences: (i) income must be distributed to the Grantor at least annually; (ii) no distributions of principal may be made to any person other than the Grantor; (iii) only one personal residence may be held in the trust, although certain other assets may be held in the trust also; (iv) to the extent the trust holds cash in excess of the amount allowed, such cash must be distributed at least quarterly; (v) the QPRT status will cease if the residence is no longer used in such capacity.
Tax Consequences
Upon creation of the QPRT, the transfer of the home to the QPRT is a taxable gift. However, the amount of the gift is not the full fair market value of the home. Rather, the amount of the gift is equal to the value of the property that will pass to the children at the end of the term because the Grantor is retaining the right to live in the home for that period. In addition, if the Grantor has made no other gifts to his or her children, the individual would likely pay no gift tax on the transfer, because the gift would be applied against his or her lifetime unified credit.
If the Grantor survives the term of the trust, the entire value of the property transferred to the trust will pass to his or her children free of estate tax. If the property has appreciated during the term of the trust all of the appreciation on the home would pass to the children tax free. It is important to note that if the children sell the home after the death of the Grantor, they do not receive a step-up in basis as they would if the parent had retained the home until death. However, capital gains tax payable on the sale may be substantially less than the estate tax.
If an individual dies before the term of the trust ends, the entire value of the property will be includable in his estate. However, while nothing will have been accomplished from a tax standpoint, nothing will have been lost. For this reason, individuals should choose a term of years that they are likely to survive. A longer term will increase the tax benefits of creating the trust by reducing the value of the gift upon the transfer of the residence to the trust, but could also increase the likelihood that the Grantor will not survive the term of the trust and, therefore, result in inclusion of the asset in the Grantor's estate for estate tax purposes.
Generally, if a husband and wife own a home jointly, they can increase the tax benefits of the QPRT. One spouse can transfer a one-half interest in the home to a QPRT, and the other spouse can transfer the other one-half interest in the home to a second QPRT. Both the husband and the wife's QPRTs would grant each of them the right to live in the home for a term of years. Each may be entitled to take an additional discount on the value of their gift because they would have each made gifts of a fractional interest in their home. Furthermore, if a spouse dies before the end of the initial term of the trust, only the half of the value of the home that is in his or her QPRT is includable in his or her estate.
Trust Administration
During the term of the trust, the Grantor does not pay rent, but is responsible for all of the expenses of the home, including mortgage and real estate taxes. The Grantor will be treated for income tax purposes as if he or she were still the owner of the property and can deduct real estate taxes, etc. At the end of the specified term, if the Grantor survives, he or she must generally pay rent to the trust or the trust beneficiaries in order to continue residing in the home. The trust or the trust beneficiaries would have to include the rent as ordinary income, but they would likely be entitled to deductions which would offset the income. In addition, rental payments are another way for the Grantor to pass money to the children free of gift and estate tax.
As an alternative, if a Grantor is married, the QPRT could provide that, at the end of the initial term, the home would remain in trust for the Grantor's spouse for the spouse's life. According to a ruling issued by the IRS, during the spouse's lifetime, the Grantor could reside in the home rent free. The spouse would be responsible for the upkeep and expenses of the home. At the spouse's death, the home would pass to the children, either outright or in trust, free of estate tax. In this scenario, the Grantor would not have to pay rent to the children unless the spouse had passed away prior to the termination of the trust, and no rent would ever be paid if the spouse survived the Grantor.
If, during the term of the trust, the Grantor wants to sell the residence held in trust, the trustee of the QPRT could sell the original home and would be required use the proceeds to purchase a replacement home in the name of the QPRT. The purchase must occur within two years of the date the original home was sold.
If the original home sold for $750,000 and the replacement home costs $1 million, the trustee of the QPRT would purchase a 75% interest in the new home and the Grantor would purchase the remaining 25% interest. On the other hand, if the replacement home cost less than the sales price of the original home, the trustee of the QPRT would have a number of options for the difference in price. The amount not reinvested in the new home could be distributed back to the Grantor, however, this would defeat much of the tax planning that had been done as it would put the property back in the hands of the Grantor for estate tax purposes. Another option, if the trust instrument so provides, is that the amount not reinvested could be retained in the trust and converted into a Grantor Retained Annuity Trust (GRAT). This means that the Grantor would receive an annuity payment until the end of the initial 10-year term.
If no home is purchased within the two year period, the trust will cease to be a QPRT and the trustee must either distribute the proceeds back to the Grantor or convert the trust to a GRAT within 30 days.
If you believe a personal residence trust is an estate planning strategy that you would like to explore, please give our office a call and speak with one of our knowledgeable estate planning attorneys.
