A Qualified Personal Residence Trust (“QPRT”) is a type of GRIT which provides an opportunity for significant estate and gift tax savings for taxpayers with substantial equity in their principal residences and vacation homes. The settlor transfers his or her personal residence to the QPRT, which is an irrevocable trust, retaining the exclusive use of the residence for a term of years selected by the settlor. If the settlor survives the term of the trust, the QPRT terminates and the residence is either retained in further trust for, or distributed to, one or more third party beneficiaries selected by the settlor, such as the settlor’s children or grandchildren.
The QPRT has no income tax consequences during the term of the trust. The settlor may still use the principal residence capital gain exclusion and deduct mortgage interest and property taxes. Transferring the property to the trust will not trigger a property tax reassessment, although the termination of the settlor’s retained interest would trigger a reassessment unless the parent-child transfer exclusion applies. During the term of the trust, the settlor may sell the house and purchase a replacement residence. If the residence sold is not replaced, the QPRT pays an annuity to the settlor.
The “catch” is that after the term of the trust, the settlor will no longer have the right to live in the residence. At this point, the settlor could lease the residence for fair rental value from the beneficiaries. However, the IRS will closely scrutinize such a leaseback transaction. It may contest the validity of the QPRT if the settlor leases the residence upon expiration of the term of the trust and pays less than fair rent, and seek to include the property in the settlor’s taxable estate at his or her subsequent death.
The principal advantages of a QPRT are as follows:
- Appreciation of the residence’s value is moved out of the estate and avoids gift tax.
- Compared with a direct gift, transfer costs (i.e., gift tax) are greatly reduced, because a taxable gift is made only to the extent that the value of the residence at the time of the transfer exceeds the actuarial value of the retained income interest plus the value of the contingent reversion.
- The settlor retains the right to use the residence for the term of the QPRT.
- So long as the settlor survives the term of the QPRT, the value of the residence is not taxed in the settlor’s estate on his/her subsequent death.
Three cautions apply to a QPRT, however.
- If the settlor dies during the trust term, the full value of the residence would be includable in the settlor’s estate, thus failing to achieve the benefits of the transaction while incurring the transaction costs. The trust term must be carefully selected to provide a great likelihood that the settlor will outlive the term of the trust.
- This leads to the second caution, which is that the settlor will (or should) lose the right to use his or her home during his or her remaining lifetime.
- Furthermore, any mortgage principal payments made by the settlor during the term of the trust, and the value of any improvements made to the residence during the trust term, would be treated as additional taxable gifts to the beneficiaries. Therefore, the settlor should pay off any encumbrances before transferring property to a QPRT, if feasible.
This article is intended to give you enough information to decide which of these estate planning tools might be appropriate, and which are definitely not. We can then discuss further how the ones in which you remain interested may be tailored to meet your goals.