(Source: WealthManagement): Laura E. LaForgia, Kathi Mintzer
Transfer a house to beneficiaries at a reduced gift-tax cost and remove an asset expected to appreciate in value from an estate.
A qualified personal residence trust (QPRT) is an estate-planning vehicle that allows a homeowner to transfer his or her home to a trust, while retaining the right to live in it for a term of years.
This technique allows the individual to transfer the house to beneficiaries with a reduced gift-tax cost and, should the benefactor live long enough, remove the value from his or her estate.
Though these trusts are now a little less popular than they once were, given the high estate- and gift-tax exemptions, many older clients may have put one in place years ago, so advisors of all stripes should be aware of some of the rules that govern these valuable instruments. Here are some (but by no means all) of the issues to consider.
What Are Some of the Benefits?
Under current law, if someone holds a home in his or her name until their death, the cost basis for purposes of determining gain on a sale is increased to the date-of-death value. This reduces the taxable gain reportable by the heirs when the property is subsequently sold, at the expense of the asset being included in the descendant’s estate for estate-tax purposes. The ability of QPRTs to transfer property with a carryover basis, not a step-up in basis, makes them ideal for heirs who want to hold on to the property for generations. It’s important to maintain records for basis, as they’ll be needed for computing depreciation if the property is rented or to determine capital gains if the property is sold. Further, if the new trust qualifies as a grantor trust, and the residence is the grantor’s principal residence, the capital-gains exclusion may also be available.
QPRTs aren’t generally used in planning for GST taxes because the GST tax exemption isn’t effective until the end of the initial QPRT term. Rules governing the period during which the residence would be included in the grantor’s estate if he or she died require that the property be valued at fair market value (FMV) on the termination date of the QPRT, and that a U.S. Gift Tax Return (Form 709) be filed for the year the QPRT ends.
What happens when the QPRT term runs out?
One of the most fundamental reasons for planning what to do once the QPRT expires is that, at the end of a QPRT term, the grantor is no longer the owner of the home and loses control of the property.
The value of the subsequent gift is determined by subtracting the value of the “retained interest” from the FMV of the residence. But what the heck does “retained interest” mean? It’s determined by a computation spelled out in the Internal Revenue Code involving the terms of the trust, the life expectancy of the grantor, and the “7520 rate” in effect for the month of the transfer. Essentially, the longer the term of the trust, the greater the gift-tax discount.
Prior to the end of the fixed term, you must review the trust document for the QPRT to determine what happens to the property at the QPRT’s termination. Typical scenarios are:
- It might be distributed outright to one or more individual beneficiaries, often the children of the grantor.
- It might pour into another trust for the benefit of the children, in which case the client must determine if this has been structured as a grantor trust.
- It might provide that a trust for the grantor’s spouse be the initial beneficiary, giving the spouse the right to use the residence for life, rent free (and indirectly allowing the grantor the use of the residence as long as they’re married).
What if the Grantor Dies?
If the grantor dies during the QPRT fixed period, the FMV of the trust is included in the grantor’s estate for tax purposes. So such vehicles are effectively a gamble against the grantor’s life expectancy. The longer the term, the larger the eventual discount, but also the greater the risk of the grantor’s dying during that period, nullifying any benefit.
What Do Beneficiaries Need to Do?
Beneficiaries of the QPRT may not know how to manage the property or may not want to take on the responsibility. Part of the pre-termination planning should include determining who’ll be responsible for paying the bills for the residence, continuing homeowners insurance on the property, making improvements to the property, collecting the rental income if the property is rented, or arranging for a sale if the property is to be sold. A checking account needs to be set up in the name of the new owner(s) as well.
Other considerations when there’s more than one individual beneficiary include: Do the individuals want to own the property as a joint venture, with each owner reporting his or her pro rata share of rental income and expenses (or of sales proceeds) on his or her individual tax return? If so, who’ll be in charge of the record keeping and informing the other owners of their share? What will the owners do if the rental income doesn’t cover expenses or if improvements are needed? How much of a reserve fund will be kept if rental income is in excess of expenses? What will happen if one of the individual beneficiaries dies? All of these questions are best addressed sooner rather than later.
Can the Grantor Buy the Property Back?
Nope. Many complex rules govern the creation of a QPRT, but one of the key ones to be aware of is that the grantor may not repurchase the residence at the end of the QPRT initial term. In addition, the Treasury regulations also prohibit the grantor, grantor’s spouse, and any entity benefiting the grantor or grantor’s spouse from repurchasing the residence either during the trust term or afterward.
How About Sales?
Should the grantor want to sell the property during the fixed term, the Treasury regulations stipulate that the sale proceeds must be invested into a new home to preserve the QPRT. If there’s no desire to replace the property, the sale proceeds will be converted into a qualified annuity interest within 30 days after the sale, with payments going back to the grantor or distributed outright. These rules are particularly complex and must be permitted by the governing instrument.