In essence, a QPRT is formed when a grantor transfers a personal residence (and some cash for expenses) into a residence trust, and retains the right to live in the residence for a term of years. If the grantor dies before the end of the trust term, the trust assets are returned to the grantor’s estate, and pass under the terms of the grantor’s will. However, if the grantor outlives the trust term, the residence passes to named beneficiaries without any gift or estate tax event.
A longer trust term will increase the value of reserved term and decrease the initial taxable gift. Any contingent reversionary interest the grantor retains will also reduce the value of the remainder interest for gift tax purposes. Accordingly, to minimize the initial taxable gift, the trust term should be as long as possible, taking into account that estate tax benefits will be diminished if not foregone if the grantor dies before the end of that term.
The QPRT is therefore a “split-interest” trust: the grantor retains a reserved use term and a contingent reversionary interest, and makes a a gift to beneficiaries of a future interest, which vests only if the grantor outlives the trust term. Note that any appreciation in the residence during the term of the trust would also have been diverted from the grantor’s estate.
The mechanics of the initial transfer illustrate why the QPRT may be an excellent hedge against the possibility that the estate tax, in some form, may remain over the next decade (or longer). Assume grantor is 60 years old, married, and owns more than $1 million in retirement and liquid assets. He deeds a residence worth $1.5 million into a qualified personal residence trust in 2001, naming his two children as remainder beneficiaries. The trust term is 10 years, and the IRC §7520 rate on the date of trust creation is 8 percent. From the annuity tables, it is determined that the reserved term use is worth .5023 of the trust and the contingent reversionary interest is worth .1113 of the trust. The taxable gift is therefore $643,475 [1- (.5023 + .1113) x $1.5 million]. The grantor in the example will file a gift tax return in 2002 reporting a taxable gift of $643,475, which will be fully covered by the applicable exclusion amount in 2001, which is $675,000.
The grantor has accomplished the following: First, provided he outlives the trust term, the grantor will have succeeded in removing the residence, as well as appreciation thereon, from his gross estate; second, the grantor will have retained the right to live in the residence during the entire trust term; third, the trust can contain a provision allowing the grantor’s spouse the right to reside in the residence following the trust term. Since the grantor is married to his spouse, the grantor should be able to continue to live in the residence past the trust term without the payment of rent.
There are three principal disadvantages to using a QPRT: First, if the grantor dies during the trust term, all trust assets will be included in his estate under IRC §2036(a); second, the grantor will not receive a basis step-up at death under IRC §1014; and third, neither the grantor nor the beneficiary may pledge the assets in the trust for a loan, nor can the assets be listed on a financial statement.
B. General QPRT Requirements
The qualified personal residence trust is an improved version of the personal residence trust which preceded the QPRT. Any residence trust drafted today, with rare exception, would seek to qualify as a QPRT. The major advantage of the QPRT is that it may hold a small amount of cash.
The QPRT may hold only one personal residence of the term-holder. The QPRT may also hold improvements related to the residence, but it may not hold the cash used to make the improvements. The regulations limit the number of residence trusts held by the grantor to two. Treas. Reg. §25.2702-5(a). A “personal residence” may, but is not required to be, the grantor’s “principal residence” as the latter term is defined under IRC §1034. Under the formula stated in IRC §280A(d)(1), a personal residence would be one used by the grantor for the greater of (i) 14 days per year or (ii) 10 percent of the number of days for which it is rented at fair market value.
The grantor may use a portion of a personal residence as an office without risking disqualification as a personal residence. So too, a personal residence includes appurtenant structures and any adjacent land that does not exceed an amount reasonably appropriate for residential purposes, taking into account the size and location of the residence. Treas. Reg. §§ 25.2702-5(b)(2)(C)(ii) and 25.2702-5(c)(2)(C)(ii).
C. Required Trust Provisions
A trust failing to qualify as a QPRT will result in an immediate taxable gift of the entire trust. The following provisions must be included in the trust instrument in order to qualify as a QPRT:
i. Mandatory Distribution of Income
The trust instrument must require, without qualification or exception, that all trust income will be distributed to the grantor at least annually. Treas. Reg. §25.2702-5(c)(3).
ii. Trust May Not Hold Excess Cash
A residence trust may hold only a personal residence. However, a QPRT may authorize the trustee to hold a limited amount of cash to pay trust expenses reasonably expected to be incurred within the next six months. Treas. Reg. §25.2702-5(c)(5)(ii)(A)(1).
iii. Distributions to Others Prohibited
A QPRT must expressly prohibit the distribution of income or principal to any person other than the grantor during the trust term. Treas. Reg. 25.2702-3(c)(4).
iv. Commutation Prohibited
Under state law, parties to a trust may terminate the trust and distribute a fractional share of the real estate to the term owner and the remaindermen based upon actuarial calculations. However, a QPRT must prohibit any commutation or prepayment of the interest of the term holder. Treas. Reg. §25.2702-5(c)(c). The rationale for this rule is that a sick grantor could, without this prohibition, commute the trust and exclude a portion of the trust proceeds in his estate.
[Some commentators have opined that the prohibition against commutation does not preclude a sale by the grantor of his term interest for “adequate and full consideration,” which would remove the trust from the grantor’s estate. IRC §§2035(d), 2036(a).]
v. Termination of Residence Status
The trust instrument must provide that the trust will cease to be a QPRT if the residence ceases to be used as the grantor’s personal residence by reason of its sale or destruction. However, the trust may provide that if the trustee purchases another residence within two years, QPRT qualification will continue.
The residence may however cease to be the grantor’s personal residence without the purchase of another residence by the trustee. The trust instrument must therefore provide that if the trust property ceases to be the grantor’s personal residence (i) the trustee must distribute all funds to the grantor; or (ii) the trust must be converted to a grantor retained annuity trust (GRAT). Since distribution of trust funds would result in inclusion in the grantor’s estate, conversion to a GRAT would generally be preferable.
vi. Limitation on Repurchase
The trust instrument must prohibit the trust from selling the personal residence to the grantor, the grantor’s spouse, or a related person during the trust term. Treas. Reg. §25.2702-5(b)(1). This rule was promulgated to prevent the grantor from repurchasing the property with a note, and then achieving a basis step-up at death while at the same time providing beneficiaries with cash.
D. Determining the QPRT Term
The length of the QPRT term is perhaps the most important decision when drafting the trust instrument. While the selection of a longer trust term will result in a smaller gift, if the grantor does not outlive the trust term, the entire trust will be returned to the grantor’s estate. On the other hand, the choice of a trust term which is short will result in few gift and estate tax savings and could, depending upon the fair market value of the house, result in a taxable gift not wholly shielded from current taxation. Whatever trust term is chosen, the residence should be valued by a professional appraiser in order to defend against, and minimize the consequences of, a later valuation inquiry by the IRS.
E. Remainder Interest in QPRT
The remainder interest in a QPRT may be distributed outright at the end of the trust term, or may be held in further trust for the beneficiaries. Treas. Reg. §25.2702-5(c)(1). If the grantor dies during the trust term, the assets will, of course, be included in the grantor’s gross estate for estate tax purposes. Still, trust assets will not pass under the grantor’s will, and therefore will not be part of the grantor’s probate estate. This means that the grantor’s probate estate may be required to pay taxes attributable to the QPRT.
To avoid this problem, the trust can either provide for (i) a remainder interest to the grantor’s spouse, which would qualify for the unlimited marital deduction; or (ii) a contingent reversionary interest in the grantor’s estate or a contingent power to appoint trust funds to the grantor’s estate, which could be used to satisfy estate tax liability. The contingent reversionary interest also helps to reduce the value of the taxable gift to the beneficiaries at the inception of the trust.
F. Designating a Trustee
Under the grantor trust provisions, a grantor is treated as the owner of the trust assets for income tax purposes. Therefore, for income tax purposes, the choice of the grantor as trustee is inconsequential if not helpful. However, the effect of the choice of the grantor as trustee must also be considered for gift tax purposes.
Since the right of remainder beneficiaries to receive the trust principal at the conclusion of the trust term is vested and not subject to divestment, the initial gift would not generally be imperiled by the choice of the grantor as trustee. However, if the trust gives the grantor the discretion to sell the residence and distribute the trust funds to the grantor, this would result in an incomplete gift at the outset. Therefore, on balance, it is probably best that the grantor not be named trustee of the QPRT. However, the choice of the grantor’s spouse as trustee should pose few problems, as would the choice of a child as trustee or successor trustee. However, as the trustee’s duties are not merely ministerial, but require management of trust property, choosing a precocious 14 year old as trustee of a QPRT might be injudicious.
G. Generation-Skipping Transfer Tax
The retained interest in a QPRT causes an “estate tax inclusion period” (ETIP). Therefore, any generation-skipping transfer tax exemption allocated to the QPRT will be based upon the value of the (appreciated) residence at the end of the trust term. In this respect, the QPRT has unfavorable GST tax attributes, but still no worse than if no trust had been utilized. (However, in contrast, the intentionally defective grantor trust does not suffer from this infirmity: the sale of assets to a grantor trust does not result in an ETIP.)
H. Possession after QPRT Term
The regulations now state that the grantor may not repurchase the residence from the QPRT. However, the regulations do not prohibit the grantor from continuing to reside in the residence if the grantor pays a fair rental price. The IRS has stated that the trust may even require the trustee to lease the residence to the grantor at the end of the trust term. Alternatively, the trust could also grant the term holder’s spouse a life estate in the residence following the trust term. Since the grantor is married to the spouse, inclusion in the gross estate should not occur under IRC §§2036 – 2038. See PLR 199906014.