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Publications
Transferring the McMansion at a Reduced Cost, A look at the Qualified Personal Residence Trust,
Stuart M. Gladstone and Bonnie Leibowitz-Carchi
The housing market has seen a drop in prices as the U.S. economy grapples with the unfolding credit crisis. But the housing slump may work to a client’s advantage, if your client desires to pass on the family residence or vacation home to other family members at a considerable transfer tax discount. This may be accomplished by creating a Qualified Personal Residence Trust (QPRT), an estate planning freezing technique.
A QPRT is an irrevocable trust funded with one or a portion of one personal residence property, whereby the grantor retains both a contingent reversionary interest and an income interest in the residence for a term of years. Separate QPRTs may be created to hold a “principal residence” and one “other residence.” As defined in the regulations, “other residence” includes a residence used for personal purposes exceeding the greater of 14 days per year or 10 percent of the number of days that such residence is rented as a personal residence at fair market value. At the end of the term, trust assets may pass outright to the grantor’s family members or continue in further trust for them.
Benefits
A QPRT is a favored estate planning technique for several reasons. If the grantor survives the term of the trust, the value of the residence property will pass out of the grantor’s estate free of U.S. estate tax, including any appreciation. If the grantor does not survive the trust term, however, the property interest reverts back to the grantor and is included in the grantor’s estate. Therefore, the grantor should not select a term that is longer than his life expectancy.
The QPRT is a creature of statute. In fact, it is specifically authorized by Treasury Regulation Section 25.2702-5. Furthermore, Rev. Proc. 2003-42 supplies practitioners with a form for guidance in drafting.
Another advantage of the QPRT is the removal of the value of the home from the grantor’s estate at a gift tax cost far below the current fair market value. The gift by the grantor to the trust is measured at the time the trust is funded and is the fair market value of the residence transferred to the QPRT, less the value of the grantor’s retained interest which leverages the fact that the ultimate beneficiary will not receive the interest for a number of years. This value is determined by a number of factors, including the value of the property to be transferred, the grantor’s date of birth and the applicable federal rate (Section 7520) set by the Internal Revenue Service for the month the property is transferred.
Clients hate parting with control. However, the grantor does not need to surrender complete control over the asset and may continue to retain many of the benefits of home ownership. During the trust term, the grantor retains the right to use the property as a personal residence without any restrictions. At the conclusion of the term, the grantor may continue to reside in the premises, provided the grantor pays rent to the trust beneficiaries at current market rates. Alternatively, if the grantor is married, the trust may allow the grantor’s spouse (and the grantor) to continue to use the residence without paying rent, while the grantor’s spouse is living.
Illustration
For example, your client, divorcee John Doe, age 56, purchased a vacation home in Bayhead in 1984 for $300,000. He spends every summer in Bayhead and several weekends a year at his vacation home. The home is valued today at $1.4 million. John wishes to pass the family vacation home on to his three children. John has a taxable estate. He is Estate Planning & Elder law in good health and has a life expectancy of 80 years. If John waits until his death to transfer the Bayhead property, the residence is almost certain to appreciate in value, which will cause additional estate taxes to be due at his death. If he were to gift the house outright to his children, he will have exhausted his entire lifetime exemption amount and still owe gift tax.
Requirements
The practitioner must follow the statutory requirements meticulously or the trust will fail to be a QPRT, resulting in the client’s forfeiture of any used unified credit and/or gift tax actually paid to complete the transaction. Noteworthy requirements include: the governing instrument must require all accumulated trust income to be distributed to the term holder at least annually. The trustee must not be permitted to make any distributions of trust principal to any beneficiary other than the grantor before the expiration of the term. The trust must not be funded with any other property except the residence itself, an insurance policy on the residence and cash for limited purposes related to the residence. The personal residence may include a limited amount of adjacent land and appurtenant structures used as part of the residence, but not the personal property in the residence. The trust must prohibit the sale of the residence either directly or indirectly to the grantor or grantor’s spouse or any entity within their control. A QPRT must hold only one or a fractional interest in one personal residence. Mortgaged property may be used, but requires special planning.
Further Example
Ten years later, John returns to your office. He has some exciting news. He met someone and is about to be married. He wants to sell the Bayhead property as his children rarely visit and the property is very costly to maintain. The QPRT may be drafted to provide for such a situation. The independent trustee may return the sale proceeds to the grantor, but any unified credit utilized to consummate the transaction would be lost. In the alternative, the funds could be converted into an annuity in the form of a Grantor Retained Annuity Trust (GRAT). John may even downsize by purchasing a condo to live in with his spouse, using part of the sale proceeds from the Bayhead property and then the balance could be held in a GRAT.
Gift Tax
The QPRT is a completed gift of the remainder interest. The grantor is required to file a Form 709 to report the gift of the residence to the QPRT by April 15 in the year following the year of the transfer (or as properly extended). This involves obtaining a qualified appraiser to value the property as of the date of transfer.
The grantor’s unused lifetime unified credit amount will be reduced by the amount of the gift. If the grantor has utilized his lifetime credit, the grantor will be responsible for paying a gift tax. The transfer to a QPRT is a transfer of a future interest and does not qualify for the annual exclusion gifting in accordance with I.R.C. Section 2503(b).
Income Tax
During the term, most QPRTs are grantor trusts for income tax purposes, which means that the grantor pays any income tax on income generated by the trust. Upon the expiration of the term, grantor trust status may be possible without causing estate inclusion, by including a provision whereby an independent trustee has the power to add charitable beneficiaries. In the alternative, if the grantor is married, including the spouse as a beneficiary will trigger grantor trust status while the spouse is living.
Grantor trust status has favorable consequences. The grantor remains eligible to deduct real estate taxes and mortgage interest as prescribed by the Code. If the QPRT sells the residence, capital gains are excludable under I.R.C. Section 121 to the extent provided, if the home is the grantor’s principal residence. After the term, if the grantor pays rent, there will be no income tax or gift tax liability associated with the rental payments.
On the downside, however, the remainder beneficiaries take over the cost basis of the grantor under I.R.C. § 1015(a) for the purposes of determining gain. Moreover, I.R.C. § 1014 allows a step-up in basis at death of assets that are inherited. This is forfeited if the QPRT is successful and the asset bypasses transfer tax.
In conclusion, the QPRT is a powerful estate planning tool for the client who wishes to transfer the family or vacation home at a transfer tax discount to his family and still retain the use of the property for years to come.
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© COPYRIGHT 2012 .
BRACH EICHLER L.L.C.
101 EISENHOWER PARKWAY,
ROSELAND, NJ 07068
(973) 228-5700
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