QUALIFIED PERSONAL RESIDENCE TRUST OUTLINE
copyright © 1996-2009 Peter Bassing
Prepared by Peter Bassing
(Member, California Bar--State Bar
A qualified personal residence trust ("QPRT") is a special type of trust, detailed by Internal Revenue Service regulations. It should not be confused with a Revocable Inter Vivos Trust (a "Living Trust"). QPRTs are sometimes called QPRGRITs, "house GRITs," or "personal residence GRITs." (The term "GRIT" is an acronym for "Grantor Retained Interest Trust".) A QPRT takes advantage of certain provisions of the law to allow a gift to the QPRT by its creator (the "settlor") of his or her personal residence, usually for the ultimate benefit of children, at a "discounted" value. This, in turn, may remove the asset from the settlor's estate, reducing potential estate taxes on the settlor's death. If a trust conforms to all of the requirements set forth in the regulations, it is not subject to certain special valuation provisions of Internal Revenue Code which limit such discounts, and the retained and remainder interests will be valued under traditional gift tax valuation rules.
Under a QPRT, the SETTLOR is the person who owns the residence to begin with and creates the trust, reserving the right to live in the house for a specified period of time. This interest is called the RETAINED INTEREST because it is what the settlor retains. At the end of that period, the ownership of the residence goes to the beneficiary or beneficiaries. This interest is called the REMAINDER INTEREST, and the beneficiar(y)(ies) is called the REMAINDER BENEFICIARY.
The Basic Idea:
A QPRT may serve a useful purpose when the settlor wishes to transfer his or her personal residence to family members (usually children) at some time in the future, and to reduce the overall transfer tax cost--that is, estate and gift tax cost-- of the transfer. For gift tax purposes, the original transfer will be treated as a gift of the remainder to the remainder beneficiaries (for example, the children) and the settlor must file a gift tax return at the time the residence is transferred to the trust. The value of the remainder is derived by first determining the fair market value of the entire property, and then subtracting the value of the retained interest. The value of the retained interest is a function of the length of the trust term, calculated in conjunction with interest rates published by the IRS for making present value calculations (Applicable Federal Rate ("AFR") IRC Section 7520). Other things equal, the longer the term of the trust, the larger the value of the retained interest, the smaller the value of the remainder, and the smaller the taxable gift. The amount of gift tax due will usually be offset by the settlor's unified credit ( the equivalent of the tax on a $1,000,000 gift) so there frequently will not be any out of pocket payment, but the settlor's credit (against future taxable gifts or estate tax) will of course be reduced.
A fractional interest -- that is, less than 100% -- of the home can be gifted to the QPRT in the event that the value of the home, term of the trust and applicable interest rates result in a taxable gift in excess of the lifetime transfer exclusion.
The "Bet":If the settlor dies before the trust has terminated, the residence will be included in his or her taxable estate, and estate tax will be paid on it, because the settlor retained the use of the property for a period that did not end before his or her death. That is, the purpose of the trust will have been defeated. If the settlor does not die during the trust term, however, the property will be distributed to the child(ren) without further transfer tax. As mentioned above, when the trust term is relatively long, the value of the gift to the remainder beneficiaries will be relatively low, and the gift tax cost of transferring the residence to the trust will be correspondingly low. In contrast, when the trust term is relatively short, the value of the gift to the remainder beneficiaries will be relatively high and the gift tax cost of transferring the residence to the trust will also be correspondingly high. However, the lower gift tax cost that results from a relatively long trust term must be weighed against the greater risk that the residence will be included in the settlor's gross estate if he or she dies before expiration of the trust term. In theory, a QPRT will afford the greatest transfer tax savings when the settlor is young and the trust term is long. For a settlor who is not young, the risk of death before expiration of the trust term is real and has to be weighed against the expenses of the trust (including initial documentation and ongoing accounting services), the loss of stepped up basis, discussed below, and the loss of alternative strategies (e.g., annual exclusion gifts of interests in the property to donees not now the beneficiaries of such gifts.)
Potential Savings:The calculations involved in determining the valuation of the gift are rather complex. However, if the term of the trust were to be set at five years, it is likely that the value of the gift would be about two thirds of the value of the property, and the gift tax would probably be about 40% of that. If, on the other hand, the trust term were set at ten years, the value of the gift would be closer to 40% of the present value, and the gift tax would be about 40% of that. The obvious disadvantage with the longer term is that it reduces the likelihood that the settlor will outlive the trust term; that is, it increases the chance that none of the hoped-for benefits of the trust will be realized. The longer term also increases the likelihood of substantial market appreciation, i.e., a large trade-off of capital gains tax savings (see below) for transfer (estate and gift) tax savings.
Capital Gains Tax Savings Tradeoff:The effects of a carry-over income tax basis must also be considered. This concerns the income tax liability to the remainder beneficiar(y)(ies) (the children, for example) if they sell the residence either following the settlor's death or following termination of the trust. If they were to take the residence by inheritance, it would have an income tax basis "stepped up" to its value as of the date of the parent's death. On the other hand, if the QPRT "bet" succeeds, i.e., if the settlor outlives the trust term and the children take the remainder under the terms of the trust, their basis will be the same as the settlor's. If there is substantial market appreciation over the price the settlor paid, the increased capital gains tax may well offset the lower gift tax achieved by the QPRT.
Permanence:A QPRT is an irrevocable trust. Unless the trust ceases to qualify as a qualified personal residence trust, the settlor cannot expect to regain ownership of the residence, and when the trust term expires according to the provisions of the trust instrument, the residence will automatically pass to the remainder beneficiaries. After expiration of the trust term the residence may be unavailable to the settlor either as a residence or as an asset that can be sold if financially necessary.
Administrative Burden and Expense:Because the trust is irrevocable, it must keep its own books and file annual federal and state income tax returns. The expense and bother of these factors should be considered.
Effect on Property Tax (California):
The property tax benefits of Proposition 13 will not be lost when the residence is transferred to children through the medium of a trust. The original transfer of the residence to the QPRT does not require any reassessment of taxes under Proposition 13, as no "change in ownership" will have occurred for Proposition 13 purposes as long as the settlor retains the right to use and occupy the residence. Use of Residence on Termination of Trust: The settlor may be required to leave the personal residence when it is distributed, at the end of the trust term, to the remainder beneficiaries, although they may also permit the settlor to remain and pay rent for its use. It may be risky to enter into a lease arrangement before the end of the original trust term: if, before the residence is transferred to the trust, there is any arrangement, whether formal or informal, that the settlor will not in fact lose the use of the residence on expiration of the trust term, but will have some right to remain in the residence beyond that time, it is possible that the trust might not be recognized as a QPRT and the advantages of the trust would be totally lost.
Sale from the Trust; Capital Gain Exclusion:
If the residence is sold from the QPRT during the trust's term it can be replaced with another residence. If it is not replaced the proceeds are returned to the SETTLOR(s) or the trust is be converted into a "Grantor Retained Annuity Trust" (GRAT) which makes periodic payments to the original owner. Because the QPRT is considered a "grantor trust" it can take advantage of the SETTLORS' capital gains exclusion ($250,000 per person).
Although the question is complicated and dependent upon a number of factors which would have to be analyzed for each situation, including the length of time between the creation of the QPRT and a creditor's attempt to reach its assets, a QPRT may furnish a degree of protection from the SETTLORS' creditors.