Understanding Estate Planning with Qualified Personal Residence Trusts
Some estate planners and commentators describe Qualified Personal Residence Trusts (QPRTs) as a “can’t miss” estate planning opportunity, while others consider them “having your cake and eating it too.”1 This article attempts to explain the issues involved in this complex estate planning technique in a manner intended to make estate planning with QPRTs comprehensible to all.2
Essentially, a QPRT is an irrevocable trust funded by the transfer of a personal residence to the trustee while retaining in the transferor a right to reside on the property for a term of years. Due to the complex valuation tables used to value the gift, a QPRT provides a means for clients to leverage their $650,000 applicable exclusion amounts.3 As so many estate planning techniques designed to leverage the applicable exclusion amount are now less attractive due to the enactment of Chapter 14, QPRTs provide one of the few remaining potent estate planning techniques for your client. Please note, however, that the time to create QPRTs is now, as the President’s budget proposals for 1998 and 1999 (also known as the Treasury Department’s “wish list”) have included a provision to repeal the section of the Code which permits the creation of QPRTs.
Transfer of Residence
with Retained Interest
As indicated above, a QPRT is funded by the transfer of a personal residence to the trustee. A personal residence includes an individual’s “principal residence,” one other residence (which may be a vacation home, for example), or an undivided fractional interest in either.4 Although this transfer is an irrevocable transfer of the client’s ownership interest in the residence, the trust provides that the client, as beneficiary of the trust, has the right to live in the residence for a term of years. The term selected is typically between five and 20 years, although the IRS imposes no minimum or maximum term. The longer the term, the greater the tax benefits that are available.
At the end of the term stated in the trust, the client no longer has the right to live in the residence; however, the client may then lease the property from the trust or its beneficiaries, if the client desires to continue to live there. If the QPRT is coupled with a continuing trust at the expiration of the QPRT term, and if the continuing trust is structured as a “grantor trust” for income tax purposes, then arguably the transferor may pay rent to the continuing trust without creating income tax. Revenue Ruling 85-13, 1985-1 C.B. 514 indicates that the continuing trust (the grantor trust) is ignored for income tax purposes regarding transactions with the individual being treated as grantor of such trust under §671 of the Code. Thus, if that revenue ruling is followed, the payment of rent to the ongoing trust after the QPRT term should not constitute taxable income.
Unfortunately, due to regulations passed by the IRS, the grantor may not purchase the home from the QPRT before the trust expires or from the continuing trust after the QPRT term. Therefore, clients who create QPRTs must be aware that if they outlive the term (which we expect), they will either need to vacate the residence or rent it. Of course, even if the rent cannot be paid income tax free, paying rent to one’s beneficiaries may be a good tax “trade-off”—it reduces the client’s taxable estate (at rates up to 55 percent) while generating income for the beneficiaries (who may be in much lower brackets—the highest federal income tax rate is 39.6 percent).
Trustees
The client has a variety of choices as to who shall serve as trustee of the trust. First, the client may select a corporate trustee who may bring professional management experience to the fiduciary role. However, where the sole asset of the trust is a personal residence, professional management may not be needed. Instead, the client may choose to serve as the trustee himself or herself; however, in that case the trust must either curtail the trustee’s discretion upon cessation of use of the property as a personal residence (regarding whether or not to convert the trust assets to a Qualified Grantor Retained Annuity Trust (GRAT) or to distribute them outright to the grantor), or it must require the grantor/trustee to either resign or to appoint an independent trustee to make that decision. Unless the discretion is so limited, the transfer to the QPRT may not be deemed as a completed gift. Finally, the grantor could choose an individual other than himself or herself who would serve as trustee—a spouse, child, or friend, for example. doing so, the trust could retain its flexibility while avoiding the costs of employing a professional fiduciary.
Typically, in a QPRT, clients prefer to be the trustee. The trust can provide that in the event of a discretionary decision to distribute principal to the grantor or to convert the QPRT to a GRAT ( i.e., on the sale of the residence), if the grantor is serving as the sole trustee then there shall be no discretion. The trustee must convert to a GRAT. If the grantor is not serving as the sole trustee at that time (perhaps due to resignation), or if there is a co-trustee serving, then such other trustee may make the discretionary decision. Generally, the decision should be to convert to a GRAT except in the case of the grantor’s hardship. To distribute principal back to the grantor wastes applicable credit and subjects the principal to inclusion in the grantor’s estate.
Sale of Residence
It is not necessary to retain the same residence in the trust during the entire trust term. The governing trust instrument may provide the trustee the power to sell the residence and within a reasonable period of time—two years—reinvest the proceeds therefrom in a new residence.5 In addition, to the extent that the proceeds of the sale of the residence are not reinvested in a new residence, the excess cash may be either distributed outright to the term-holder or may be converted to a GRAT.6 The GRAT would then pay to the client a periodic annuity (fixed sum of money) for the remainder of the trust term. For example, if the residence was sold for $1,500,000 and only $500,000 of the proceeds were reinvested in a new residence, then the trust would pay to the client an annuity based upon the $1,000,000 in cash remaining in the trust. The terms for the annuity must be provided in the trust at the time it is created, and the amount of the annuity payments will depend upon a calculation made pursuant to the relevant IRS actuarial tables and interest rates.7
Cash Additions to Facilitate Payment of Expenses
The trust may permit the trustee to hold additions of cash to the trust for improvements to the residence or for payment of trust expenses (including mortgage payments and insurance premiums), which are either already incurred or reasonably expected to be incurred by the trust within six months from the date that such cash is added.8 If the trust permits additions of cash to the trust, then it must also require that the trustee make a quarterly determination of any amounts of cash held in the trust in excess of the amounts necessary to meet the costs of expenses and improvements permitted under the Regulations.9 Any excess cash in the trust not used to pay permissible expenses must be distributed to the term-holder (the client) within 30 days of termination as defined in the Regulations.10
Other Trust Requirements
In addition to the other requirements described above, the governing instrument of the QPRT must also provide:
1) that any income of the trust be distributed to the term-holder at least annually;11
2) that the trustee may not distribute trust principal to any beneficiary other than the transferor to the trust until the expiration of the retained term interest;12
3) that other than additions discussed above, the trust may not hold any assets other than one personal residence;13
4) that the transferor (or anyone else) may not prepay the term- holder’s interest in the QPRT—often referred to as “commutation”;14
5) what happens when the trust ceases to be a QPRT, except under certain circumstances (such as the sale of the residence, or destruction of the residence), and what happens to the trust assets upon the cessation of the term interest;15 and
6) that the term holder may not re-acquire the residence.
Gift and Estate
Tax Advantages
The preliminary reason for considering creating a QPRT is that your client may achieve significant estate and gift tax savings (while still retaining income tax benefits) by using one. transferring a personal residence to the irrevocable trust, the client is making a completed gift for gift tax purposes to the beneficiaries whom the client chooses to receive the principal of the trust upon the expiration of the retained term interest. The value of such gift, however, is computed under the actuarial tables promulgated by the IRS for purposes of valuing term and remainder interests; these values fluctuate with interest rates on a monthly basis.16 Thus, the value of the gift (for gift tax purposes) is not the entire value of the property transferred, but the fair market value of the residence at the time of the transfer minus the value (as calculated under the tables) of the client’s retained right to use the residence for the term of years chosen. Therefore, the gift tax due upon the date of transfer is a mere fraction of the full fair market value of the residence at the time of the transfer. The relevant valuation fraction depends upon the monthly interest rate, the client’s age at the time of the transfer and the term of the trust.17
Moreover,
the client may, of course, apply his or her applicable credit (protecting up to $650,000) to shield the transfer from current taxation. If the client outlives the term of the trust, not only will the full value of the property pass to the beneficiaries—without any further transfer tax—but any post-transfer appreciation (which on real property may be quite significant) will also pass to the beneficiaries escaping transfer taxation. In addition, by making a lifetime transfer, the value of the property plus all of the post-transfer appreciation will pass to the beneficiaries without the need to include that property in the transferor’s gross estate for estate tax purposes.18
Income Tax
Since a QPRT is treated as a grantor trust for income tax purposes, the transferor may still take advantage of several of the income tax incentives provided for homeowners. For example, even if the client transfers his or her personal residence to a QPRT, the transferor may still deduct interest paid on a mortgage on the property.19 Also, the client may qualify for the exclusion of gain up to $250,000 from the sale of a residence owned and used as a personal residence for at least two of the last five years by the taxpayer.
Homestead Ad Valorem
Tax Exemption
Until 1995 there was confusion regarding the availability of the homestead ad valorem tax exemptions from real property taxes after a transfer to a QPRT. Since the transferor retained all the requisite beneficial rights to use of the property ( see F.S. §196.041), planners agreed the exemption should still be available during the QPRT term. Unfortunately, various property appraisers affected disagreed. Ultimately in Robbins v. Welbaum, 664 So. 2d 1 (Fla. 3d DCA 1995), the appellate court found that the taxpayer/transferor was entitled to the homestead ad valorem tax exemptions for the QPRT term.
Mortgaged Property
If the transferred property is subject to a debt, then the value of the property transferred to the trust must be reduced by the amount of the debt. If the transferor then pays part or all of the debt, the payment would be deemed an addition to the trust. In the case of a QPRT, the value of this subsequent gift would be reduced by the value of the grantor’s retained interest as of the date of the transfer.
Nevertheless, under most circumstances, the client should prefer to avoid the reduced initial gift and subsequent additional gifts. If 1) the grantor remains personally liable on the mortgage, 2) the trustee may enforce the debt against the grantor, and 3) the trustee has the right to be subrogated to the lender’s right to proceed against the grantor, then the initial gift should be the entire value of the property transferred without reduction for the indebtedness. Plus future payments on the mortgage should not be additional gifts to the QPRT.20
Of course, the client could also satisfy the mortgage with other assets or substitute other property as collateral prior to funding the trust. doing so the client will also avoid reduction in the amount of the initial gift.
For example, assume a client transfers a personal residence valued at $500,000. The client is 72 years old, and he or she creates the QPRT with a retained term of 10 years. Also, assume an after-tax growth rate of four percent on the property. Using, for example, the applicable interest rate of 6.4 percent—as it was in April of 1999—the example works as follows:
Explanation 6.4% April 1999
Value of assets transferred $500,000
Value of gift of residence
to a 10-year QPRT
per IRS valuation tables $156,235
Reduction in taxable estate
($500,000 gift value) $343,765
Tax saved at assumed
50% estate tax rate $171,883
Tax saved at assumed 50%
estate tax rate and assumed
4% growth rate $291,944
Fraction Interest
Discount; Joint Property
If the clients are a married couple who own a residence jointly, there are a few options. First, they can put the property in one spouse’s name and then that spouse can create a QPRT. This works best where one spouse has a below-normal life expectancy (so as not to have that spouse be a grantor at all). Second, they could create a joint QPRT where they both contribute their halves to one QPRT. There is some allure, since the value of the gift decreases if the QPRT terminates on the first death of a spouse. However, that also increases the likelihood that the benefits of the QPRT will be lost, as the residence would then be included in the deceased spouse’s estate. Thus, to gain the tax benefits, both spouses must outlive the term. As a result, I believe the third option—create separate QPRTs—is probably best for most clients. Each spouse can transfer a fractional interest in the residence (presumably a one-half undivided interest) to a separate QPRT. Then the terms can be different to consider the spouses’ different life expectancies. Plus, if one spouse fails to survive the QPRT term, there is a chance the other spouse will survive his/her QPRT, providing at least one-half the intended tax benefits.
An additional benefit of splitting the residence and using fractional interests to fund the QPRTs is the availability of fractional interest discounts. Since each transfer to a QPRT would constitute a noncontrolling fractional interest in the underlying real property, there should be some reasonable discount from the liquidation value, prior to applying the §7520 rates.21 This discount can further compound the tax benefits of the QPRTs.
Example with discount: Assume the same facts as the example above, but also assume the husband and wife create separate QPRTs and each transfer an undivided one-half interest in the residence. Also, assume a 20 percent discount for the two parcels (thus each grantor is transferring an asset valued at $200,000, not $250,000).
Explanation 6.4%
April 1999
Value of assets transferred
(2 x $200,000) $400,000
Value of gift of one-half
interests in the residences
to a 10-year QPRT
per IRS valuation tables
(2 x $62,494) $124,988
Reduction in taxable estate
($500,000 gift value) $375,012
Tax saved at assumed
50% estate tax rate $187,506
Additional tax savings due
to discounts $ 15,623
Disadvantages
Before creating a QPRT, the client must be aware that he or she cannot gain all of these advantages without some disadvantages; however, the disadvantages are minimal and essentially make QPRTs an everything to gain and virtually nothing to lose planning technique. The disadvantages are:
1) The client must either apply his or her unified credit to the transfer, or, if the client has already used his or her unified credit, he or she must pay gift tax on the transfer for the value of the remainder interest passed to the trust.
2) If the transferor dies before the term of the trust expires, he or she will fail to receive the transfer tax savings discussed above. That is because §2036(a)(1) of the Code requires the full value of the residence be included in the gross estate at the time of the transferor’s death. However, the transferor’s estate will receive a credit for any gift tax already paid or unified credit already applied.22 Of course, should this occur the transferor is not any worse off (from a transfer tax position) since, had he or she done nothing with the residence, it would have been included in his or her estate anyway. Moreover, the client may hedge against this risk by also creating an irrevocable life insurance trust for the same term as the QPRT, which, if properly created, will not be included in the client’s estate and will replace (hopefully at a discounted cost) any wealth lost to taxes due to the inclusion of the personal residence in the transferor’s gross estate.23
3) If the client does gain the aforementioned transfer tax benefits by outliving the term of the trust, he or she must either move out of the house or reach an agreement with the trustee or the beneficiaries who take title to the residence upon the end of the trust term to permit the client to lease back the property. When leasing the residence, the beneficiaries must charge the client at least fair market rent in order to lease the property back without risking potential gift, estate or income tax problems. On the other hand, this is not necessarily a bad result because paying fair market rent to one’s beneficiaries may be an excellent way for a client to continue to decrease his or her taxable estate while passing assets to his or her beneficiaries without incurring transfer taxes. Thus, the transferor may create income for his or her beneficiaries (which is currently taxable at a maximum rate of 39.6 percent), rather than gifts or bequests to them (which are currently taxed at rates up to 55 percent). You should also note that if a continuing trust is created at the expiration of the trust term, and if the trust is created as a “grantor” trust for income tax purposes, then the lease payments might not create taxable income.
4) Upon transferring his or her residence to the trust, the client has forever given up the right to use the principal of the trust, except for the right to live in the residence or receive the qualified annuity during the trust term. Therefore, the client needs to be completely comfortable with the other assets remaining available for his or her use.
Conclusion
There are many tax benefits which may be achieved by forming a QPRT. A client may achieve a leveraging of his or her unified credit, he or she may pass after-transfer appreciation in the value of the client’s residence to his or her beneficiaries tax free, and he or she may retain the income tax benefits associated with home ownership. Furthermore, the disadvantages associated with forming a QPRT are minimal. Therefore, if a client is willing to create a QPRT, and to jump through all of the IRS’ hoops, he or she will enter into a virtually no-lose tax planning situation. q
1 See, e.g., Jan M. Rosen of the N.Y. Times News Service has reported that Samuel J. Friedman, a partner in the New York law firm of Hall, Dickler, Lawler, Kent & Friedman called QPRTs “very close to the ideal of having your cake and eating it too.” Jan M. Rosen, Trusts Amid Taxes in Gifts of Home, Boca Raton News, Feb. 1, 1993; Mary Sit of The Boston Globe reported that Kennedy P. Brier, a tax attorney at Powers & Hall Professional Corp. in Boston, declared QPRTs are “virtually a no-lose bet with the government,” The Boston Globe, March 16, 1991; See also Jeffrey B. Kalan, Utilizing Qualified Personal Residence Trusts, 69 Fla. B.J. 35 (Feb. 1995).
2 For other articles discussing estate planning in light of the recent developments provided in I.R.C. §2702, and the Treasury Regulations promulgated thereunder, see Scanlan, Jr., “Grits, Grats, Gruts: A Phoenix Rises from the Ashes of Section 2036(c),” Twenty-Seventh Annual Philip E. Heckerling Institute on Estate Planning, Miami, Florida, January 1993, Chapter 15; August and Kulunas, Planning for Grits, Grats and Gruts under new Chapter 14, 65 Fla. B.J. 40–43 (Nov. 1991); and Moore, Grantor Retained Income Trusts—Fish or Fowl, Trusts & Estates 18–28 (March 1991).
3 The valuation tables are prescribed by the Secretary and are based on mortality rates recalculated every 10 years and fluctuate by using an interest rate (rounded to the nearest 2/10ths of one percent) equal to 120 percent of the federal midterm rate in effect under §1274(d)(1) for the month in which the transfer occurs. See I.R.C. §7520. Currently the unified credit is $600,000 and is provided in I.R.C. §2010.
4 For purposes of meeting the requirements of a QPRT under Treas. Reg. §§25.2702-5(c)(1) and (2), the “personal residence” of the term holder means either (i) a “principal residence” as defined in I.R.C. §1034; or (ii) another qualified residence which must meet the definitions of a personal residence provided in I.R.C. §280A(d)(1). See Treas. Reg. §25.2702-5(c)(2)(A) and (B).
5 Treas. Reg. §25.2702-5(D)(ii) read in conjunction with §25.2702-5(c) states that the governing instrument may permit the sale of the residence and permit holding the proceeds therefrom in a separate account until the earlier of the purchase of a new residence, the termination of the term interest, or the date which is two years after the date of the sale of the residence.
6 Treas. Reg. §25.2702-5(c)(8). If so desired, then the governing instrument must provide the trustee the discretion to either distribute the assets or convert the property to a qualified annuity interest and must contain all of the provisions of §25.2702-3 with respect to such. But see the discussion regarding trustees infra.
7 I.R.C. §7520 and the Treasury Regulations thereunder provide the relevant valuation tables. See supra note 3.
8 Treas. Reg. §25.2702-5(c)(5)(ii)(A).
9 Treas. Reg. §25.2702(c)(5)(ii)(A)(1).
10 Treas. Reg. §25.2702-5(c)(7)(ii)(A)-(C) and 5(c)(5)(ii)(A)(2).
11 Treas. Reg. §25.2702-5(c)(3).
12 Treas. Reg. §25.2702-5(c)(4).
13 Treas. Reg. §25.2702-5(c)(5).
14 Treas. Reg. §25.2702-5(c)(6). As a result, clients desiring to transfer a primary residence and a second residence must create two QPRTs—one for each property.
15 Treas. Reg. §25.2702-5(c)(7) and (F). See supra note 6.
16 Id. The appropriate interest rate is 120 percent of the mid-term Applicable Federal Rate in effect on the date of the transfer. I.R.C. §7520.
17 Id.
18 outliving the term, no part of the value of the property transferred will be required to be brought into the client’s gross estate by reason of I.R.C. §2036(a).
19 I.R.C. §163.
20 See Susan L. Miller, Practical Problems and Solutions in Establishing A Qualified Personal Residence Trust, J. Tax’n 102, 104 (Feb. 1997).
21 See Le Frak, Samuel J. (1993) TC Memo 1993-526.
22 I.R.C. §2001(b).
23 See discussion in Scanlan, supra note 2, at 15–52.
Jeffrey A. Baskies, a partner of Ruden McClosky Smith Schuster & Russell, P.A., is a graduate of Trinity College (B.A., with highest honors, 1988) and received his law degree from Harvard University (J.D., cum laude, 1991). He is admitted to practice in both Florida and Massachusetts.
This column is submitted on behalf of the Tax Section, David E. Bowers, chair, and Michael D. Miller and Lester B. Law, editors.