Living (Revocable) Trusts
Estate Taxation - Federal & Vermont
Estate Planning for IRA's/Pensions
Life Insurance Trusts
Grantor Trusts (GRATS & GRUTS)
Qualified Personal Residence Trusts
Charitable Trusts (CRATS & CRUTS)
Special Needs Trusts
QUALIFIED PERSONAL RESIDENCE TRUSTS
What is a Qualified Personal Residence Trust?
A “qualified personal residence trust” or “QPRT” is a special type of grantor trust specifically authorized by the Internal Revenue Code. The trust is created by an individual (the "grantor"), and funded with with a "qualified residence." The grantor retains the right to use the residence for a term of years (or possibly for the grantor's life). In order to qualify as a QPRT under current tax laws, the trust must be irrevocable. When the trust ends, the assets pass to someone other than the grantor - usually the grantor's family members (i.e., his or her heirs).
What can you put in a QPRT? According to the Treasury Department regulations, a principal residence and one other residence (including a vacation home) can each qualify as a “personal residence.” Thus, every grantor has the ability to create a maximum of two QPRTs. Married couples who share the same principal residence may create three QPRTs without violating this rule, one to hold the shared principal residence and two others created separately by each spouse to hold a second and third home. Adjacent land reasonably appropriate for residential purposes also qualifies for transfer to a QPRT, as do appurtenant structures used for residential purposes (such as swimming pools and tennis courts). The fact that a residence is subject to a mortgage does not affect the residence’s qualification for transfer to a QPRT, nor does the fact that part of the residence is used for a home office or the fact that a portion of the property is leased to someone unrelated to the grantor, provided the property continues to remain the grantor’s personal residence.
The regulations restrict QPRTs from holding any other property (for example, household furnishings) except for limited amounts of cash. Any cash in excess of that needed for trust expenses (including mortgage payments), contemplated improvements or the purchase of a personal residence, all to be paid within six months, must be distributed out of the trust and back to the grantor.
If the grantor wants the trustee to sell the residence held in the trust, that can be done, but only if another residence is going to be purchased by the trustee within two years. If the trustee sells the residence, the trust may have the benefit of the Internal Revenue Code provision that allows the exclusion of gain on the sale of a principal residence (up to $500,000 for married individuals filing jointly and $250,000 for other individuals). If the grantor stops using the property in the trust as a personal residence, then the trust must terminate and the property must be distributed out of the trust and back to the grantor (or, alternatively, the trust must be converted into a “grantor retained annuity trust” — or “GRAT”).
Unlike the traditional trust where the income beneficiary receives distributions of income generated by the trust property, with a QPRT the grantor retains the right to use the property during the trust term. At the end of the term, the grantor should be prepared to give up use of the residence since the remainderman will then be its legal owner. If that is not acceptable, the grantor might then arrange to rent the property from the remainderman at fair market rental value. The right to rent the property can also be granted at the outset when the trust is created and made a part of the terms of the trust agreement.
When a grantor trust such as a QPRT is created, the grantor has essentially split the trust into two pieces: (1) the grantor's right to use the residence for a period of time (the "term") and (2) ownership of the residence after the term ends (the "remainder"). Since the trust is irrevocable, the grantor has made a gift of the remainder which is subject to all of the usual tax rules governing gifts (see the Lifetime Gifts webpage). A gift tax return must be filed. For most QPRT's, any resulting gift tax will be offset by the grantor's unified credit (currently sufficient to completely shield cumulative gifts up to $11,400,000) (2019). However, since the recipient must wait until the end of the trust term to receive the remainder, the present value of the remainder is less than the value of the trust property -- for the same reason that a dollar is worth more today than it is ten years from now. Subject to some important exceptions discussed below, when the recipient eventually receives the remainder, there are no additional gift taxes, even if the trust property has appreciated. In essence, a QPRT will freeze the value of the residence for transfer tax purposes on the date the trust is created.
Here's an example of how the gift tax operates on a QPRT: Bob, a 60-year-old, transfers his $600,000 residence to a QPRT and retains the use of the residence for 10 years. At the end of the ten year term, the residence will pass to Bob's children. According to the IRS, the present value of the remainder interest in the residence is $206,000. If Bob lives for ten years or more, he will no longer own the residence at his death, and no additional transfer taxes will be owed. The only transfer tax will be on the $206,000 gift -- and this tax is completely sheltered by Bob's unified credit. If the property appreciates at 5% annually, his children will receive a residence worth over $1 million -- free of all transfer taxation.
In each particular case, the value of the taxable gift will vary depending on such factors as the length of the trust term and the grantor’s age. The tax savings will depend on the size of the grantor’s entire estate and other factors. Since the top marginal estate bracket could be as high as 35%, the transfer tax advantages of this type of trust are obviously significant.
In order for a grantor to reap the tax benefits of QPRT, he or she must survive the term of the trust. If the grantor dies during the trust term, for estate tax purposes the full value of the property is brought back into the grantor’s gross estate. In this event, however, the grantor is simply left in the same situation as would have existed had the trust never been created. That being the case, there really is no risk or downside to creating a QPRT and, as noted above, the tax savings can be significant if the grantor does succeed in surviving the trust term.