Estate Planning for Qualified Personal Residence Trusts

By Philip J. Michaels and Laura M. Twomey

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Making a gift of a personal residence to a qualified personal residence trust (QPRT) is a straightforward strategy for removing the value of a home from an individual’s taxable estate. A QPRT is an appealing estate planning device because it combines significant estate and gift tax savings with minimal lifestyle changes, while avoiding fears that too much is being given away. Under Treasury Regulations section 25.2702-5(c)(2), each person is permitted to create QPRTs, one for a principal residence, and one for an occasional residence.

Assume that an individual owns an apartment in New York City appraised at $2 million, a summer home worth $1 million, and a stock portfolio worth $3 million. The grantor would like to maximize the inheritance passing to his children, but is concerned about giving away too much. A QPRT would allow the individual to save estate and gift taxes without directly parting with cash or giving up either of the two homes.

Terms of a QPRT

Under Treasury Regulations section 25.2702-5(c), which creates the concept of a QPRT, an individual would transfer title to either the apartment or the summer home to a QPRT trust. The individual would retain the right to live in the home for a specific length of time, such as 10 years. Under Revenue Procedure 2003-42 [2003-23 I.R.B. 993, section 4, Art. II(B)(2)], during that period, the grantor would not pay rent, but would be responsible for all of the expenses of the home, including real estate taxes, maintenance fees, and the cost of ordinary repairs. Thus, during the initial 10-year period, the individual would not notice any change in his day-to-day living patterns.

At the end of the 10-year term, assuming the individual is still alive, the home would pass to his children free of estate tax. The grantor may remain in the home, if he agrees to pay rent to the children at the going rate for such rentals.

Tax Advantages of a QPRT

Assume that the individual above creates the QPRT with the $1 million summer home. The transfer of the home to the QPRT is a taxable gift, but the amount of the gift will not be $1 million, because the grantor is retaining the right to live in the home for 10 years. Instead, the amount of the gift equals the actuarial value of the property that will pass to the children at the end of the 10-year term. The actuarial value is determined by using tables published by the IRS that take into account the term of the retained interest, the grantor’s age, and the monthly interest rate set by the IRS for the month of the actual transfer.

If the individual is 50 years old and the relevant interest rate is 5.6%, then the gift to the trust would be $537,010. Assuming he has made no prior gifts, the individual would pay no gift tax on this transfer, because the gift would be applied against the $1 million lifetime unified credit (the amount that each person may give away tax free). Thus, the grantor, in effect, receives a discount on the gift.

If the grantor survives the 10-year term, the entire value of the property will ultimately pass to the children free of estate tax. If the property has appreciated from $1 million to $2 million by the time the grantor dies, a $2 million asset would have been transferred to the children for a gift tax value of only $537,010. All of the appreciation on the home would have passed to the children tax free. If the children elect to sell the home, they would not receive a stepped-up basis as they would if the parent had retained the home until death, but any capital gains tax payable on the sale would be substantially less than the estate tax. The maximum federal capital gains rate is 15%, while the federal estate tax rate is 45% to 48%.

On the other hand, under IRC section 2036(a)(1), if an individual dies before the 10-year term ends, the entire value of the property will be includable in his estate. The grantor would not have accomplished anything, but nothing would have been lost. The $537,000 originally allocated to the gift would be restored. For this reason, individuals should choose a term of years that they are likely to survive.

Under Treasury Regulations section 25.2702-5(c)(2)(iv), if a husband and wife own the home jointly, they can enhance the tax benefits of the QPRT. The husband could transfer a one-half interest in the home to a QPRT, and the wife could transfer a 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. They should be entitled to take an additional discount on the value of their gift because they would have each made gifts of an undivided interest in real property (typically in the 10% to 20% range). Furthermore, if the husband dies before the end of the term, only the half of the home that is in the husband’s QPRT would be includable in the husband’s estate.

Administration of a QPRT

Payment of rent. If the client survives the 10-year term and must pay rent to the children, the rent is not troublesome from an estate planning perspective. Paying rent is another way for the grantor to pass money to the children free of gift and estate tax. The children would have to include the rent as ordinary income, but they could have offsetting deductions.

The QPRT trust can be structured, however, so that the parent’s rental payments are not deemed to be taxable income to the children. Instead of passing the home outright to the children at the end of the 10-year term, the QPRT could direct that it pass into a grantor trust for the benefit of the children. In this case, rental payments would be made to the trust. Grantor trust status means that, for income tax purposes, the grantor is treated as the owner of the income. Thus, the rental payments would not be subject to income tax, because they would be deemed to be made to the grantor. Grantor trust status would also provide two other benefits: Under Treasury Regulations section 1.121-1(c)(3)(i) the individual would be able to take advantage of all of the income tax benefits associated with home ownership, together with the income tax exclusion for sale of a personal residence if the property is sold during his lifetime; and if the property is sold, the individual would be responsible for the capital gains tax (if any) on the sale, rather than the children.

Alternatively, if an individual is married, the QPRT could provide that, at the end of the initial 10-year term, the home would remain in trust for the spouse for the spouse’s life. According to Private Letter Ruling 9735035, 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, and no rent would ever be paid if the spouse survived the grantor.

Payment of expenses. Under Private Letter Ruling 9249014, after creating the QPRT, an individual will continue to be responsible for paying all utility expenses, maintenance fees, real estate taxes, and ordinary repairs on the home during the 10-year term. If the grantor adds a new wing to the home, however, it will likely be deemed an additional gift to the trust, because major capital improvements are generally considered the responsibility of the remainder beneficiaries of a trust. If, after the initial 10-year term, the client pays rent to a trust for the children, those rent payments may be used to make improvements. Also, under Treasury Regulations section 25.2702-5(c)(9), the grantor may not purchase the home back from the trust during the initial term.

Sale of the home. Assume that an individual wants to sell a summer home owned by the QPRT and purchase a new one. The trustee of the QPRT (most likely the client’s spouse or one of his children) would sell the original summer home and use the proceeds to purchase the replacement home in the name of the QPRT. If the original home sold for $1.5 million and the replacement home cost $2 million, the trustee of the QPRT would purchase a 75% interest in the new home, and the grantor or the spouse would purchase the remaining one-quarter.

If the replacement home cost $1 million, the trustee of the QPRT would have several options for the $500,000 difference between the $1.5 million sale price of the original home and the cost of the replacement. Under Treasury Regulations section 25.2702-5(c)(7) and (8), the $500,000 could be distributed back to the grantor. This would be simple, but would defeat much of the tax planning that had been done. Also, if the trust instrument provides, the $500,000 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.

Under Treasury Regulations section 25.2702, if a replacement residence is to be purchased, then the purchase must occur within two years from the date the original home was sold. If no home is purchased within that time, 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.

Purchase of another residence. If an individual decided not to purchase a substitute summer home, then a portion of the estate planning benefits would be lost whether the proceeds are distributed back to the grantor or converted to a GRAT, because in either scenario, he would be forced to take back some of the property that had been given away.

Because, however, the individual owns a residence outside of the QPRT (in this example, a $2 million apartment), there is an additional option. Under Treasury Regulations section 25.2702, one could sell a portion of the New York City apartment to the QPRT in exchange for the cash in the QPRT. Thus, the individual could sell to the QPRT a 75% interest in the New York apartment in exchange for the $1.5 million in cash that the QPRT received from the sale of the summer home. The QPRT would hold a personal residence again and would not need to terminate or convert to a GRAT, while the grantor would be able to invest or spend the sales proceeds freely. The transaction would not be subject to capital gains tax, because the QPRT would be a grantor trust during the 10-year term and, thus, would be treated as if the grantor sold the apartment to himself. Under NYS Tax Advisory Opinion TBS-A-02(1)R, the transaction could potentiallly incur a real estate transfer tax in New York State.

Not everyone will have this option available to them, because not everyone will own a residence outside of the QPRT. Regarding the individual used in the example, however, this option might be the most advantageous, because the client would not receive back any of the property initially transferred to the QPRT and, therefore, would obtain the maximum estate planning advantage.

Conversion to a GRAT

Once the trustee of a QPRT determines that all or part of the proceeds from the sale of a property held by a QPRT should be converted to a GRAT, and assuming the trust instrument contains all of the necessary provisions permitting the trustee to make the conversion, the trustee must then determine the amount of the annuity to be paid to the grantor each year.

Under Treasury Regulations section 25.2702-5(c)(7) and (8), the annuity due will begin to accrue on the date the trust sells the initial residence and will continue until the end of the initial term.

If, however, the trust instrument permits it, the trustee may defer payment of the annuity until 30 days after the GRAT conversion. The GRAT conversion must occur within 30 days of either the two-year anniversary of the sale of the initial residence or the purchase of a substitute residence. The deferred payment must bear interest from the date of the original sale at a rate not less than the IRC section 7520 rate in effect on the date of the conversion.

The Treasury Regulations provide two methods of calculating the annuity amount: the first is used if no substitute residence is purchased and the whole trust will be converted to a GRAT; the second is used if a substitute residence is purchased with a portion of the trust property and the excess will be converted to a GRAT.

Under Treasury Regulations section 25.2702, if the entire trust will be converted to a GRAT, the annuity is determined by taking 1) the lesser of the value of all interests retained by the client as of the date of the original transfer, including any right of reversion, or 2) the value of all the trust assets as of the conversion date, and dividing it by an annuity factor determined 1) for the initial term, and 2) using the IRC section 7520 rate that applied as of the date of the original transfer.

For example, if an individual sells the vacation home for $1.5 million and decides not to reinvest any of the proceeds in a new residence, but has provided in the trust instrument for a conversion to a GRAT, the annuity calculation will be the lesser of:

$462,990 (retained interest at start oftrust, including reversion) or
$1,500,000 (net sale proceeds)
7.2865 (annuity factor)

(The annuity factor is determined by using tables set by the IRS, which take into account the section 7520 rate at the time of the initial gift, 5.6% in our example, the age of the individual at the time of the gift, and the term of years of the QPRT.) The result would be an annuity payment of $63,541 each year until the end of the initial 10-year term.
If only a portion of the trust is converted to a GRAT, the annuity amount to be distributed to the client is decreased proportionally. To reach the correct result, begin by determining the annuity as if the whole trust was to be converted to a GRAT, using the formula above. Then multiply that result by a fraction. The fraction is calculated by using a numerator that is the fair market value of the trust assets on the conversion date, less the amount reinvested in the new residence, and a denominator that is the fair market value of the trust assets on the conversion date [see Treasury Regulations section 25.2702-5(c)(8)(C)(3)]. For example, continuing with the scenario above, where the client sells the summer home for $1.5 million, and assuming that the client reinvested $1 million of the sale proceeds into a new residence, leaving $500,000 to be converted to a GRAT, the calculation would be:

$63,541 (annuity amount for whole trust) x $500,000 (amount
remaining after reinvestment)
$1,500,000 (fair market value of trust on the conversion date)

Thus, the annuity for the $500,000 that has been converted to a GRAT would be $21,180.

Generally, and depending on prevailing economic factors, the QPRT tax benefits can be diluted by the conversion to a GRAT when the conversion occurs early in the initial term. For example, if the conversion occurs in the second year of a 10-year term, the loss of tax benefits will be much greater than if the conversion occurs in the ninth year of the term.

Finally, under IRC sections 677 and 673(a), because the trust will be a grantor trust for the remainder of the term, the grantor must include all income and capital gains taxes incurred by the QPRT on his personal income tax return, even if the taxes exceed the amount of the annuity received.

Requirements with QPRTs

QPRTs are an excellent technique for transferring substantial assets at a discount with minimal impact on the client’s standard of living. Advisors should be careful to follow all of the governing instrument requirements when drafting a trust, so that the tax advantages are assured. Under Revenue Procedure 2003-42, the new IRS form QPRT may be relied on for this purpose. While the QPRT is a flexible vehicle which permits the sale of the home and purchase of a substitute residence, many technical issues may arise on such a sale. Thus, the legal counsel handling the sale of property held in a QPRT should be conversant with these requirements and advise individuals of their implications.

Reprinted with permission from the New York State Bar Association Journal, November/December 2003, Vol. 75, No. 9, published by the New York State Bar Association, One Elk Street, Albany, N.Y., 12207.