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Using a Qualified Personal Residence Trust

Date

April 2, 2002

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11 minutes

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A qualified personal residence trust (QPRT) is one of the most effective wealth transfer strategies for many families, as that technique offers significant gift and estate tax savings. Placing your client's residence in a QPRT allows your client to shift future appreciation on his or her home out of his or her estate for estate tax purposes. Your client leverages the gift to the trust for the benefit of his or her spouse, children or loved ones.

ABCs of QPRTs

The statute crated QPRTs as part of Treasury Regulation Section 25.2702-5(c) under Chapter 14 of the Internal Revenue Code. A QPRT is an irrevocable trust to which your client can transfer its primary or vacation residence and retain the right to use the residence for a certain period, the trust's term. The term of the trust generally is for 5, 10, or 15 years, but the term may be for 2 years or 30 or more years.

These are the consequences if your client survives the term:

  • The property (or its replacement, if sold) will pass outright or in trust to the remainder beneficiaries that your client named in the trust instrument.

  • Your client may lease the residence back and pay a fair rent, or your client may relocate; and

  • The property and its value, including all appreciation, will be excluded from your client's estate for estate tax purposes.

If, however, the client does not survive the term, the property will be included in your client's estate as if no special planning took place. The portion of your client's transfer tax exemption that your client may have used in crating the rust will be restored.

Gift and Estate Tax Savings

Chapter 14 of the Internal Revenue Code provides special rues to determine the value of a gift whenever an individual transfer property in trust to or for the benefit of a member of his or her family and the individual transferor or an applicable family member retains an interest in the trust. Generally, if Chapter 14 applies, the retained interest is valued at zero, meaning that the gift tax value of the transferred interest is equal to the full market value of the property transferred to the trust.

However, a QPRT arrangement is an exception to that general gift valuation rule. With a QPRT, the value of the gift is a fair market value of the residence less the present value of your client's retained interest.

A QPRT is an irrevocable trust to which your client can transfer its primary or vacation residence and retain the right to use the residence for a certain time period, the trust's term.

Example: Assume Bruce, age 55 owns an Aspen, Colo., home worth $1.5 million. Bruce transfers the Aspen home to his QPRT and retains the right to reside in and use the home for 15 years. The value of Bruce's retained interest is approximately 55.84 percent of the $1.6 million amount or $837,600. The value of the remainder interest of 44.16 percent for gift tax purposes is about $662,400.

Assuming that Bruce still has his gift and estate tax exclusion amount available, Bruce would pay no gift tax at the time of the transfer, meaning that he effectively leveraged the value of this gift. Assume that the valuation of the transfer increases to $3 million at the expiration of the term (assuming a 5 percent annual growth). The entire value of the residence is excluded from Bruce's estate, resulting in a projected estate tax savings of about $1.23 million.

A fractional interest in the home may be transferred to the QPRT. In that event, the fair market value of the home may be discounted for gift tax purposes due to a gift of a minority or fractional interest. Each spouse may transfer his or her undivided interest in the residence to a separate QPRT [Priv. Ltr. Rul. 9606003].

Defining "Personal Residence"

A personal residence is:

  • Your client's principal residence,
  • One additional residence for which your client meets the minimum use test, or
  • An undivided fractional interest in either [Treas. Reg. Section 25.2702-5c(2)].

Accordingly, a married couple may together have up to three personal residences – their principal residence and one other residence such as a summer home or a winter home.

An individual is deemed to use a dwelling unit during the taxable year as a personal residence if he or she uses the unit (or a portion of it) for personal purposes for a number of days that exceed the grate of 14 days or 10 percent of the number of days during the year for which the unit is rented at a fair rental. The term dwelling unit" includes a house, apartment, condominium, mobile home, houseboat or similar property that provides basic living accommodations, such as sleeping space, toilet and cooking facilities [Prop. Treas. Reg. Section 1.280A-1c(1)].

A personal residence may also include certain additional property, such as appurtenant structures used by the owner for residential purposes and adjacent land not in excess of that which is reasonably appropriate for residential purposes taking into account the residence's size and location [Treas. Reg. Section 25.2702-5©(2)(ii)]. The Internal Revenue Service regularly issues letter rulings addressing the type of property that will qualify as a personal residence. Based upon the facts and circumstances, a guesthouse, caretaker's house, carriage house, storage barn, swimming pool, pool house, greenhouse, tennis court, pier, and boat dock may be included as part of a personal residence.

The following rulings are illustrative in determining a personal residence:

  • Priv. Ltr. Rul. 9639064 (43-acre lot improved by single family residence, swimming pool, pool house, greenhouse, tool shed and storage barn)
  • Priv. Ltr. Rul. 9714025 (caretaker's house, carriage house, pool building, and storage barn)
  • Priv. Ltr. Rul. 9718007 (caretaker's house)
  • Priv. Ltr. Rul. 9739024 (caretaker's house)
  • Priv. Ltr. Rul. 9750048 (pool and guest house)
  • Priv. Ltr. Rul. 9817004 (detached garage, pool house, swimming pool, gazebo, camping house, and storage building)
  • Priv. Ltr. Rul. 981014 (guest cottage, swimming pool with cabana, and two barns)
  • Priv. Ltr. Rul. 199908032 (guest house, pier, and boat dock)

A vacation home is an excellent choice for a QPRT. Transferring your client's vacation home to the trust moves one of your client's non-cash producing assets to a younger generation, while avoiding the problem of having a place to live after the term of your client's retained interest expires.

Transferring your client's vacation home to the trust moves one of your client's non-cash producing assets to a younger generation, while avoiding the problem of having a place to live after the term of your client's retained interest expires.

Mortgaged Property

If a residence is subject to a mortgage, the mortgage does not affect its status as a personal residence. Mortgaged property may be transferred to a QPRT [Treas. Reg. Section 25.2702-5(b)(2)(ii)]. For purposes of determining the value of the transfer, however the amount of the mortgage generally must be taken into consideration, thereby making the amount of the gift equal to the value of the remainder interest in the net equity amount. That rule applies whether the loan is with recourse or not.

If the grantor remains legally obligated personally to pay off the mortgage, the mortgage should be disregarded in determining the value of the gift. The grantor should consider executing a side letter agreement that he will be solely responsible for the remaining indebtedness. Without that type of side agreement, each mortgage payment would be an additional taxable gift to the QPRT.

Specific Statutory Requirements

In addition to the general rules discussed above, a QPRT must satisfy certain specific requirements under Treas. Reg. Section 25.2702-5(c):

  1. The trust instrument must prohibit the QPRT from holding during the original term any asset other than one personal residence (or a fractional interest in one residence) and qualified proceeds. Qualified proceeds mean the proceeds payable as a result of damage to, or destruction or involuntary conversion of, the residence, provided the proceeds are reinvested in another personal residence within two years from the date the proceeds are received.
  2. During the term, the trust instrument must require any trust income to be distributed to the term holder, at lease annually. No trust principal may be distributable to any beneficiary other than the transferor prior to expiration of the term.
  3. The trust instrument may permit additions of cash to be made to the trust for the purchase by the trust of the initial residence within three months of the date the trust was created, provided the trustee previously entered into a contract to purchase the residence.
  4. The trust instrument may permit additions of cash for the purchase by the trust of a residence to replace another residence to replace another residence within there months of the date the cash addition is made, provided the trustee previously entered into a contract to purchase the replacement residence.
  5. The trust instrument may permit additions of cash to the trust to be held in a separate account, provided the additional cash is used to pay trust expenses (including mortgage payments) already incurred or reasonably expected to be paid by the trust within six months or to pay for improvements to the residence expected to be paid within six months from the date the addition is made. If the trust instrument permits cash additions to the trust, the trustee must determine at least quarterly amounts held for payment of expenses in excess of the amounts permitted and distribute such excess amounts to the term holder immediately.
  6. A QPRT can permit the sale of the residence, and the trustee may hold the proceeds in a separate account. However, the trust will cease to qualify as a QPRT if a replacement residence is not purchased and within two years from the date the original residence was sold.
  7. The trust instrument must prohibit commutation (repayment) of the term holder's interest.
  8. The residence cannot be sold by the trust to the grantor or the grantor's spouse during the trust's term or at any time when the trust is a grantor trust for federal income tax purposes.

Within 30 days after a trust ceases to qualify as a QPRT, the trust instrument must require the distribution of the trust assets to the term holder or the conversion of the trust assets into a qualified annuity interest. The term holder's right to receive the annuity amount begins on the date of sale of the residence, the date of damage to or destruction of the residence, or the date on which the residence ceased to be used as a personal residence. The annuity amount is computed by dividing the lesser of the term holder's retained interest or the trust's value as for the conversion date by the applicable annuity factor, based upon the applicable Section 7520 rate for the shorter of the term or the life expectancy of the term holder.

Payment of Expenses

All expenses of the trust, such as mortgage payments, real estate taxes, utilities, homeowner's insurance premiums, and ordinary repairs, are borne by the grantor. Because the trust is a grantor trust during the retained term, the grantor may deduct mortgage interest and real estate taxes paid.

All expenses that are properly chargeable to the remainder beneficiaries, such as an improvement to the residence, should be paid by the trust. If the grantor pays that expense, it may constitute an additional gift to the trust. To avoid that gift tax implication, the trust instrument should require the trustee require the trustee to reimburse the grantor.

Who Should Be Your Client's Trustee?

To simplify trust administration, the grantor may serve as his or her own trustee during the initial term of the trust. In the event the grantor becomes incapacitated, a successor trustee should be designated. Following the term, the grantor should step aside as trustee. Otherwise, the grantor may hold powers that would cause the trust assets to be includible in his or her estate for federal estate tax purposes.

Summary

By creating a QPRT, your client may effectively transfer a personal residence to a younger generation at little or not gift or estate tax cost, and all future appreciation on the residence will be removed from your client's estate.

Circular 230 Disclaimer
In conformity with U.S. Treasury Department Circular 230 this document and any tax advice contained herein is not intended to be used, and cannot be used, for the purpose of avoiding penalties that maybe imposed under the Internal Revenue Code, nor may any such tax advice be used to promote, market or recommend to any person any transaction or matter that is the subject of this document. The intended recipients of this document are not subject to any limitation on the disclosure of the tax treatment or tax structure of any transaction or matter that is the subject of this document.

 

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