Question 36: What Is a Qualified Personal Residence Trust?
A Qualified Personal Residence Trust (QPRT) is powerful gifting tool that allows you to leverage your estate and gift tax credit and to freeze an appreciating asset at its current value. It is an Irrevocable Trust that holds a personal residence for a term of years. At the end of the Trust term, the residence is distributed to the beneficiaries named in the Trust. These beneficiaries are typically your children.
What Are the Tax Benefits Associated with a Qualified Personal Residence Trust (QPRT)?
There are several tax benefits associated with a QPRT.
The QPRT legislation was drafted because Congress wanted to ensure that a family residence could pass to the heirs without forcing a sale of the residence to pay the estate taxes on the property. In most instances, if a person makes a gift in which he or she retains some benefit, the gift is either not considered to have been made for estate tax purposes, or the gift is valued at full fair market value, even though the person receiving the gift does not have full possession of it because the gift is subject to the retained benefit.
To achieve its goal of protecting personal residences from forced estate tax sales, Congress allowed an exception to these general rules. In consideration of the retained interest, the exception allows a reduction in the fair market value of the residence when calculating the value of the gift. The annuity factor is determined by using tables set by the IRS, which take into account the IRS assumed interest rate at the time of the initial gift, the age of the individual at the time of the gift, and the term of years of the QPRT. The gift to the Trust can be calculated with this information and the value of the property.
Assuming you have made no prior gifts, you would pay no gift tax on this transfer, because the gift would be applied against the $5.49 million lifetime unified credit (the amount that each person may give away tax free). Thus, you, in effect, receive a discount on the gift. Keep in mind that a gift to a QPRT is a gift of a future interest and does not qualify for the $14,000 gift tax annual exclusion. Only gifts of a present interest qualify for the $14,000 gift tax annual exclusion. A Federal Gift Tax Return, Form 709, must be filed in the year in which the gift to the QPRT is made. Depending on your prior taxable gifts, gift tax may or may not be due.
Another tax and economic benefit is that all of the future appreciation of the residence will be transferred to your children estate and gift tax-free. A QPRT, as a result, is a powerful estate freezing tool. Assuming that the $1 million residence appreciates at 4 percent per year for a ten-year term, the residence would be worth approximately $1.5 million at the expiration of the QPRT term. This increase in value will go untaxed!
A QPRT is typically considered a Grantor Trust for income tax purposes. Most QPRTs do not generate any income and an income tax return is not typically required. If the property generates income, a Grantor Trust Tax Return, Form 1041, may be required.
What If I Die During the Term of the QPRT?
If you die during the term of the QPRT, the residence is included in your estate at its full fair market value at the time of your death. The benefit of the transaction is lost, but you are no worse off than if you did not create a QPRT, other than transactional costs in establishing the QPRT.
How Is the Term of the QPRT Determined?
The term is selected by you. Because of the negative tax consequences of dying before the expiration of the QPRT term, you will typically review your actuarial tables and life expectancy and use approximately two-thirds of your life expectancy.
For example, an average individual age 65 has a life expectancy of 17.2 years. As a result, you would want to use a QPRT term of perhaps 12 years. Obviously, this depends upon known health problems and family history.
What If I Outlive the Term of the QPRT and Want To Continue Living in the Residence?
If you outlive the term of the QPRT, the residence passes to the remainder beneficiaries. They are the owners of the property. You can, however, lease the property back from the remainder beneficiaries at a fair market value rent. The option to rent your residence back from your children can be viewed, by some, as a negative feature; however, many clients view it as an opportunity to transfer additional assets, via rent payments, to their children.
How Are Real Estate Taxes, Hazard Insurance Premiums, Repairs, and Capital Improvements Paid?
Ordinary and recurring expense associated with the residence, such as real estate taxes, hazard insurance premiums, and minor repairs may be paid by you. You can deposit the funds necessary to pay these amounts with the Trustee. The Trustee is permitted in a QPRT to retain sufficient funds to pay these amounts. A QPRT is treated as a Grantor Trust for income tax purposes and, thus, the you can deduct the real estate taxes paid on your income tax return.
In the event a capital improvement is made to the residence by you, this will be treated as an additional gift to the QPRT and the amount of the gift will be based on the value of the capital improvements and the remaining term of the Trust.
Can the Residence Be Sold While It Is in the QPRT?
The residence can be sold and the proceeds can be reinvested in a new residence. Since a QPRT is a Grantor Trust, any gain recognized on the sale of a principal residence should qualify for exclusion of gain from the sale of a principal residence just as it would outside the QPRT.
If the proceeds of sale are not reinvested in a personal residence, the QPRT will convert to a Grantor Retained Annuity Trust (GRAT) and will pay an annuity to you for the balance of the QPRT term.