| EXECUTIVE SUMMARY | |
 Transferring a residence to a qualified
personal residence trust (QPRT) is a popular estate
planning technique that can help reduce the size of the
grantor’s estate. If structured properly, the QPRT will freeze
the value of the taxpayer’s residence at the time he or she
creates the trust and result in significant estate tax savings.
James P. King, CPA, MST, is a partner with Tobin & Collins, CPA, PA, in Hackensack, N.J. His e-mail address is jking@tccpa.net . |
any taxpayers assume their estates will escape federal
and state estate taxes because they underestimate the worth of their
most valuable asset—their principal residence or vacation home. When
an individual dies, the value of the residence is included in the
estate just like any other asset. If the value of the estate exceeds
$2 million in 2006, the estate may be subject to a maximum federal tax
rate of up to 46%. Under the Economic Growth and Tax Relief
Reconciliation Act of 2001, the exclusion gradually increases until
the estate tax is repealed in 2010. That law sunsets on December 31,
2010, and the estate tax is reinstated again in 2011. While it’s
possible Congress will modify the estate tax structure, no one knows
for sure how and when, making planning beyond 2010 difficult.
In today’s real estate market, a popular estate planning technique is to reduce the size of an estate by transferring a residence to a qualified personal residence trust (QPRT). A properly structured QPRT will freeze the value of the residence at the time the trust is created, resulting in significant estate tax savings while helping to keep the value of many estates below the $2 million threshold. Although minimizing estate taxes and expected appreciation are strong incentives for creating a QPRT, the prevailing federal interest rate under IRC section 7520 (discussed below) is also an important factor when deciding when to implement one.
| Real Estate Wealth
From 2001 to 2005 the collective wealth of property owners in the United States grew by more than $4 trillion. Source: National Association of Realtors, www.realtor.org . |
PUTTING IT TOGETHER
Before recommending QPRTs to their clients, CPAs first must
understand the mechanics of creating and funding such a trust and the
potential savings, benefits and disadvantages.
Step 1. Transfer of property to a QPRT. The grantor creates a QPRT for a term of years and designates beneficiaries, usually family members. The grantor contributes the residence to the trust, thus removing it from his or her own name and creating a taxable gift. The fair market value of the residence is discounted for gift tax purposes. This gift does not qualify for the annual gift tax exclusion since the transfer of a residence to a QPRT is not a gift of a present interest.
Step 2. Use of residence. The grantor retains the exclusive rent-free use, possession and enjoyment of the residence during the term of the QPRT. The grantor pays any ordinary and recurring expenses such as real estate taxes, insurance and minor repairs. If the grantor makes a capital improvement, the cost is treated as an additional gift to the trust and the amount of the taxable gift is based on the fair market value of the improvement, as well as the remaining term of the QPRT.
Step 3. For the QPRT technique to be effective for estate tax purposes, the grantor must outlive the term of the trust. If the grantor dies before the trust term expires, the date-of-death value of the QPRT will be included in the grantor’s estate and subject to estate taxes. However, the grantor’s estate will receive full credit for any tax consequences of the initial gift to the QPRT and the grantor is no worse off than if he or she had not created the QPRT.
Step 4. Termination of the QPRT. If the grantor outlives the term of the trust, the residence passes to the beneficiaries at the end of the term.
Step 5. Rental of residence. At the end of the QPRT term, the grantor can lease the residence back from the beneficiaries at fair market rent, thereby allowing the grantor to continue living in the house. Note that the rental payments the grantor makes further reduce the value of his or her estate.
Step 6. Other considerations. If the property ceases to be used as a personal residence, the trust ceases to be a QPRT and the trustee must distribute the assets outright to the grantor or convert the QPRT to a grantor retained annuity trust (GRAT). A GRAT 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. A QPRT also will convert to a GRAT if the residence is sold while it is in the QPRT and the sales proceeds are not reinvested in a new residence.
Planning point. Any gain recognized on the sale of a principal residence that has been transferred to a QPRT may qualify for the $250,000/$500,000 gain exclusion from the sale of a principal residence, provided all other IRC section 121 requirements are met. The exclusion of gain does not apply to the sale of a property that is not a principal residence, such as a vacation home.
A grantor may establish a QPRT for no more than two residences. The trusts can be funded using (1) a principal residence; (2) a vacation home or secondary residence; or (3) a fractional interest in either.
Planning point. The transfer of fractional interests in a residence can be used to hedge against the possibility of premature death. For example, a taxpayer might create three QPRTs with terms of 5, 10 and 15 years. The taxpayer transfers a 33% interest in her residence to each of the trusts. If she dies after 12 years, only the 33% interest in the last QPRT is included in her estate.
A CASE IN POINT
The following case study will help illustrate the gift tax
calculations and benefits of creating a QPRT.
Facts. John and Gabrielle are married, have one son, Chris, and live in New Jersey. Both John and Gabrielle are 66 years of age. John owns (individually) a residence located at the Jersey Shore with a fair market value of $425,000 with no mortgage on the property.
Objectives. The couple is very concerned about its potential estate tax liability and is seeking estate planning advice. John is willing to consider a future interest gift, but because of family issues is reluctant to make a large current gift.
Proposed planning. John and Gabrielle should consider a future interest gift of the residence via a QPRT as part of their overall estate plan. They will retain the use and enjoyment of the home for the term of the trust. The QPRT can include a provision that allows the residence to revert back to John’s estate if he does not survive the QPRT term. The residence may pass to Gabrielle via the marital deduction.
Planning point. It is imperative to coordinate the terms of the QPRT with the terms of the taxpayer’s will to avoid adverse tax ramifications at the time of the taxpayer’s death.
| Assumptions. | |
| Date of transfer | 06/01/2006 |
| Donor’s date of birth | 06/24/1940 |
| Age (nearest birthday) at transfer date | 66 |
| Term of trust in whole years | 10 |
| IRC section 7520 interest rate | 106.0% |
| Amount placed in QPRT (FMV of residence) | $425,000 |
Assuming the transfer of the residence to the QPRT is a completed taxable gift for gift tax purposes and the trust satisfies all of the requirements for a QPRT, the taxable gift is the value of the residence transferred to the QPRT, less the value of the retained income interest. The value of that interest is calculated by using the valuation tables under section 7520. The calculation of the value of the taxable gift is as follows:
| Annuity factor for calculating the remainder factor. | |
| Initial age (Donor’s age at transfer date) | 66 |
| Term of trust in whole years | 10 |
| Terminal age | 76 |
| Value for donor’s age at beginning of trust term (Table 90CM) | $78,066 |
| Value for donor’s age at end of trust term (Table 90CM) | $57,955 |
| End of term factor divided by beginning of term factor | 0.74238465 |
| Remainder interest factor from actuarial table B | 0.55839500 |
| Remainder factor (Taxable gift) | 0 .41454388 |
| Calculation of taxable gift. | |
| Amount placed in QPRT (FMV of residence) | $425,000 |
| Multiplied by remainder factor from above | 0.41454388 |
| Value of taxable gift | $176,181 |
Results and benefits. John reports a taxable gift of just $176,181 today and in 10 years will have removed about $692,000 from his estate (assuming a conservative 5% annual appreciation rate on the residence for the duration of the QPRT). If John survives the 10-year period, the residence will then be owned by his son, Chris. John then must pay fair market rent to Chris for the use of the property. The rental payments further reduce John’s estate without any gift tax ramifications. The payment of fair market rent will help avoid an IRS challenge that the grantor’s continued enjoyment of the home draws it back into his or her estate.
If John does not survive the 10-year period, the residence reverts to his estate and the $176,181 gift amount is restored. Thus, there is no loss of the unified credit amount. If John survives the QPRT term, Chris will take the residence with his father’s tax basis.
Planning point. It’s important for CPAs to note that the trust document must provide that neither John nor Gabrielle can purchase the residence. Legislation enacted in December 1997 eliminated the ability of the grantor, his or her spouse or any entity controlled by either to buy the property back from the QPRT. This regulatory change is effective for trusts created after May 16, 1996.
INTEREST RATES AND INCOME TAXES
The federal interest rate under section 7520 is one of the main
factors that drive the favorable tax outcome of valuing the gift of
the residence. The higher the federal interest rate, the lower the
gift value and the lower the potential gift tax. Conversely, a low
federal interest rate usually translates into lower estate tax
savings. When federal interest rates are low, practitioners should
carefully consider whether a transfer to a QPRT is the right estate
planning strategy for their clients. The exhibit below shows the most
recent section 7520 rates.
In recommending that clients set up QPRTs, CPAs also must take into account certain income tax considerations:
A QPRT is a grantor trust for income tax purposes. This
means the trust is not a separate taxpayer and all of the income or
capital gain during the term is taxed to the grantor and reported on
his or her personal income tax return.
During the term of the QPRT, the grantor can claim an
income tax deduction for real estate taxes. Furthermore, if a primary
residence is used, the grantor can still benefit from the capital gain
exclusion if the residence is sold during the QPRT term.
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Federal Interest
Rates—IRC Section 7520
THE DISADVANTAGES
As with any estate planning technique, QPRTs aren’t right for
everyone. There are some concerns.
The grantor has a predetermined limit (the trust term) on
the right to occupy the residence and must relinquish ownership of the
property at the expiration of the QPRT term. The beneficiaries,
generally the grantor’s children, then have ownership of the home and
will collect fair market rent from the grantor. Since some taxpayers
might find this situation awkward, they should carefully evaluate the
nontax factors, including family relationships, before setting up a
trust.
If the beneficiaries sell the residence they may incur a
significant income tax liability. If the QPRT had not been created and
the children inherited the residence at the grantor’s death, they
would have received a step-up in basis to the value of the property on
the grantor’s date of death. If the grantor survives the QPRT term,
there is no step-up in basis and the children’s basis carries over
from the grantor. Thus it’s important that the estate tax benefits of
setting up the trust outweigh any later income tax consequences of
losing the stepped-up basis.
If the residence transferred to the QPRT is subject to a
mortgage, there may be some complexity in accounting for the monthly
mortgage payments and minimizing the tax consequences. If possible,
pay off the mortgage before transferring the residence to a QPRT.
The family will incur legal, accounting and professional
fees to create and maintain the trust.
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As a hedge against the client’s premature
death, consider recommending transfer of fractional
interests in a residence to two or more trusts with
different terms. Even if the client does not outlive
all of the trust terms, he or she still will save some
estate taxes.
BALANCING ACT
The decision to create a QPRT requires the balancing of the
potential estate tax savings, based in part on current interest rates,
against the consequences of relinquishing ownership to the next
generation. CPAs should help clients give careful consideration to
both the tax and nontax consequences. A QPRT has many technical
requirements and establishing one is very complicated. A poorly
executed trust document may create undesirable effects. Taxpayers
considering the use of a QPRT should consult with qualified legal
professionals about establishing, drafting and funding the trust. 
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