Prior
to 1987, a common estate planning technique was an
"estate freeze," by which a parent would transfer
appreciating assets to a child, while retaining an income
interest in those assets and, usually, other preferential
rights the parent never intended to exercise. Because of the
retained income interest and preferential rights, the value of
the transferred assets for gift tax purposes was less than
their fair market value. Moreover, since the potential
appreciation in the assets would be transferred to the child,
the interest retained by the parent would be
"frozen" for estate tax purposes.
Chapter 14 of the Internal
Revenue Code is designed to eliminate estate freezes by
restricting the valuation of the interest retained by the
parent for gift tax purposes. Unless that retained interest
satisfies certain requirements, it is deemed to have a value
of zero, with the result that the entire fair market value of
the property transferred is used in calculating the federal
gift tax.
An Exception for Qualified
Personal Residence Trusts
One remaining estate freeze
opportunity is a "qualified personal residence
trust" (QPRT).
A
Qualified Personal Residence Trust is powerful gifting tool
that allows a client to leverage his or her estate and gift
tax credit and to freeze an appreciating asset at its current
value.
We have prepared a summary of the benefits and features
of a Qualified Personal Residence Trust in question and answer
format.
1.
What is a Qualified Personal Residence Trust?
A Qualified Personal Residence
Trust or "QPRT" 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 – typically children. For example, John
creates a QPRT and transfers his residence to the QPRT for a
term of 12 years, with the remainder passing to his children.
John has the right to live in the residence and to use the
residence for the next 12 years. At the end of the 12-year
term, the residence passes to John's children.
2.
Are There Any Tax Benefits Associated With A QPRT?
There are several tax and
economic benefits associated with a QPRT. QPRTs are especially
well suited at leveraging a client's estate and gift
tax credit.
A transfer of property to a QPRT
is currently treated as a taxable gift. The value of the gift
is based on the present value of the remainder beneficiary's
right to receive the property at the end of the QPRT term. For
example, John, age 65, creates a QPRT and transfers his
residence to the Trust for a term of 12 years, with the
remainder passing to his children at the end of the 12-year
term. Assuming the residence is valued at $1,000,000 and the
transfer is made in April 2001, based on IRS tables, John is
treated as having made a gift to his children valued at
$346,060. This is the first place where there is a significant
tax savings. John has effectively transferred an asset worth
$1,000,000 to his children by using only $346,060 of his
estate and gift tax credit (currently valued at $675,000).
3.
Are There Any Other Tax Benefits Offered By A QPRT?
Another tax and economic benefit
is that all of the future appreciation of the residence will
be transferred to the children estate and gift tax-free. A
QPRT, as a result, is a powerful estate freezing tool.
Based on the prior example, assuming that the $1,000,000
residence appreciates at 4% per year for the 12-year term, the
residence will be valued at $1,601,032. All of the
appreciation during the 12-year term inures to the benefit of
the children. Therefore, by making a gift, valued for estate
and gift tax purposes at $346,060, John will effectively
transfer an asset worth $1,601,032. Assuming John's estate is
in the 55% estate tax bracket, this produces an estate tax
savings of $690,235.
4.
Is a Gift Tax Return Required When a Gift is Made to a QPRT?
Yes. A Federal Gift Tax Return,
Form 709, must be filed in the year in which the gift to the
QPRT is made. Based on the foregoing example, John is required
to prepare and file a Federal Gift Tax Return, Form 709,
reporting the gift which will consume $346,060 of his estate
and gift tax credit. Depending on John's prior taxable gifts,
gift tax may or may not be due.
5.
Does A Gift To A QPRT Qualify For The $10,000 Gift Tax Annual
Exclusion?
No. A gift to a QPRT is a gift of
a future interest and does not qualify for the $10,000
gift tax annual exclusion. Only gifts of a present
interest qualify for the $10,000 gift tax annual exclusion.
6.
How Does My Age and The QPRT Term Affect The Tax Consequences
Of The QPRT?
The term of the QPRT is an
important factor in determining the tax consequences of a QPRT.
As the QPRT term grows longer, the gift to the remainder
beneficiaries grows smaller, and the tax savings is greatly
improved. The table below shows the tax results and savings
for a $1,000,000 residence transferred to a QPRT, in April
2001, for varying terms:
|
QPRT for
Client Age 65, $1,000,000 Residence,
April
2001 Transfer, 4% Annual Appreciation, 55% Estate
Tax Bracket
|
|
QPRT Term
|
Current Value
of Gift
|
Future Value at End of
Term
|
Potential Estate
Tax Savings
|
|
3 years
|
$790,920
|
$1,124,864
|
$183,669
|
|
6 years
|
$615,350
|
$1,265,319
|
$357,483
|
|
9 years
|
$467,840
|
$1,423,312
|
$525,510
|
|
12 years
|
$346,060
|
$1,601,032
|
$690,235
|
|
15 years
|
$247,070
|
$1,800,944
|
$854,631
|
|
18 years
|
$167,390
|
$2,025,817
|
$1,022,135
|
7.
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 year 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. For example, Mary, age 50, creates a
QPRT with a 15 year term and transfers her $1,000,000 house to
the QPRT. Mary dies 14 years and 11 months later when the
residence is valued at $1,800,944. The value of the residence
is included in Mary's estate at $1,800,944. However, she does
receive a credit for the initial gift to the QPRT.
8.
How Is the Term Of The QPRT Determined?
The term is selected by the
client/donor. Because of the negative tax consequences of
dying before the expiration of the QPRT term, we will
typically review the actuarial tables and life expectancy of
the client and use approximately 2/3 of the client's life
expectancy. For example, an average individual age 65 has a
life expectancy of 17.2 years. As a result, we will use a QPRT
term of no greater than 12 years. Obviously, we discuss any
known health problems and family history with the client and
may make adjustments to the QPRT term, as appropriate, based
on those discussions.
9.
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 obligation 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. IRS Private Letter Rulings have sanctioned QPRTs
which included mandatory fair market lease provisions at the
end of the QPRT term.
10.
Can I Place My Vacation Home in a QPRT?
Yes. You are allowed to transfer
your principal personal residence and one vacation home to a
Qualified Personal Residence Trust. You are allowed to have
only one principal residence, but you can have two personal
residences (one of which is your principal residence).
11.
Can I Create Multiple QPRTs?
Yes. If you own two
personal residences, you can transfer each residence to a QPRT.
In addition, you can transfer fractional interests in your
personal residence to multiple QPRTs. This can be used to
hedge against the possibility of a premature death. For
example, Steve creates four QPRTs with terms of 4, 8, 12, and
16 years. Steve transfers a 25% interest in his residence to
each of the QPRTs. If Steve dies after 14 years, only the 25%
interest in the last QPRT (with the 16 year term) is included
in his estate.
12.
Is It Possible To Take Advantage Of Valuation Discounts With A
QPRT?
Yes. It is not uncommon for a
husband and wife to own their property jointly or as tenants
by the entirety with the right of survivorship. In this case,
we will divide the property into two 50% tenant in common
interests. Each spouse will create a QPRT and will transfer
his or her 50% interest to the QPRT. The Court have
consistently upheld valuation discounts for fractional
interests in real estate and it is not uncommon to receive
discounts of 20% or more. Under these facts, each of the 50%
interests valued at $500,000 would be discounted to $400,000
and would produce an even better tax result. The chart below
compares the tax savings of the transfer of 2 50% interests
with a 100% interest.
|
12 Year
QPRT for Husband and Wife Both Age 65, $1,000,000
Residence,
April
2001 Transfer, 4% Annual Appreciation, 55% Estate
Tax Bracket,
20%
Valuation Discount for Fractional Interest
|
|
Initial Value of Asset
|
Current Value
of Gift
|
Future Value at End of
Term
|
Potential Estate
Tax Savings
|
|
$1,000,000
|
$346,060
|
$1,601,032
|
$690,235
|
|
$800,0001
|
$276,848
|
$1,601,032
|
$728,301
|
1
Two 50% interests each valued at $500,000 and discounted by
20%. 2 x ($500,000 x (1 – 20%)) = $800,000
13.
I have an Estate-Type Residence, Comprising of the Main
Residence, a Guest Cottage, and Several Outbuildings on 35
Acres. Can I Transfer all of the Properties into a QPRT?
Maybe. Only a personal residence
can be transferred to a QPRT. The additional land and
buildings may not qualify as a QPRT. The IRS has ruled in
several Private Letter Rulings that estate-type residences and
the attendant outbuildings, guest cottages, and acreage may
qualify as a personal residence. The rationale is that a
person who purchases an estate type residence normally expects
to have the attendant acreage, outbuildings, etc. and, thus,
gave these favorable rulings. Each property should be
determined on a case by case basis.
14.
My Residence Has A Mortgage. What Are The Tax Consequences Of
Transferring The Residence, Subject To The Mortgage, To A QPRT?
Ideally, property contributed to
a QPRT should not be subject to a mortgage. We recommend that
our clients pay off the mortgage before transferring the
residence to the QPRT.
If property subject to a mortgage
is transferred to a QPRT, there are two possible tax
treatments. First, the transfer may be treated as a net gift
of the difference between the fair market value of the
property and the amount of the debt. For example, if a
residence, valued at $500,000 is encumbered with a $150,000
mortgage, the value of the underlying property gifted to the
QPRT is only $350,000. The gift tax consequences are based on
a value of $350,000. However, each time a mortgage payment is
made and a portion of the principal loan balance is reduced,
the client is treated as having made an additional gift to the
QPRT. This can create an accounting, tax, and administrative
nightmare.
Another approach is to include a
provision in the QPRT Trust Agreement in which the
client/donor agrees to indemnify the Trustee of the QPRT for
any liability associated with the mortgage. Arguably, only the
value of the underlying residence should be taken into
consideration, the value of the mortgage is excluded, and
additional payments on the mortgage are not taken into
consideration.
15.
How Are Real Estate Taxes, Hazard Insurance Premiums, Repairs,
And Capital Improvements Paid While The Residence Is In The
QPRT?
Ordinary and recurring expense
associated with the residence, such as real estate taxes,
hazard insurance premiums, and minor repairs may be paid by
the client/donor. The client 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 client/donor can deduct the real
estate taxes paid on his or her personal income tax return.
In the event a capital
improvement is made to the residence by the client/donor, 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.
16.
Can The Residence Be Sold While It Is In The QPRT?
Yes. 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 the $250,000/$500,000
exclusion of gain from the sale of a principal residence,
provided all of the other Code § 121 requirements are met.
The exclusion of gain does not apply to the sale of a personal
residence that is not a principal residence, such as a
vacation home.
If the proceeds of sale are not
reinvested in a personal residence, the QPRT will convert to a
Grantor Retained Annuity Trust or "GRAT" and will
pay an annuity to the client/donor for the balance of the QPRT
term. GRATs are discussed below.
17.
What Happens If The Property Ceases To Be Used As A Personal
Residence?
If the property ceases to be used
a personal residence, the trust ceases to be a QPRT and the
Trustee must convert the QPRT to a GRAT. GRATs are discussed
below.
18.
What Is A GRAT?
A GRAT is a Grantor Retained
Annuity Trust. It provides for the payment of an annuity for a
fixed term with the balance passing to the remainder
beneficiaries at the end of the term. If a QPRT converts to a
GRAT, it will pay a fixed annuity amount to the client/donor
for the balance of the Trust term and will distribute the
balance to the remainder beneficiaries. The amount of the
annuity must be based, at a minimum, on the Code § 7520 rate
in effect in the month the QPRT ceases to be a QPRT.
For example, Paul, age 50,
transferred a personal residence worth $1,000,000 to a QPRT in
a month in which the Code § 7520 rate was 8.4%. The trust
instrument provided that Paul retained the right to use the
residence for a 10-year period or until his death if death
occurs before the expiration of the 10-year period. The
approximate value of Paul's retained interest was $591,650.
Five years later, the personal residence is sold for
$1,500,000 and Paul's interest is converted to a qualified
annuity interest in a GRAT. Under the formula contained in the
regulations, the annuity payable to Paul must be $92,726
annually. The annuity amount is computed by dividing $591,650
(the lesser of Paul's retained interest or the value on the
conversion date) by 6.3806 (the annuity factor at 8.4% for the
shorter of 10 years or the life of a person age 50).
19.
I Purchased My Residence Many Years Ago And Have A Very Low
Basis. Will My Children Receive The Residence With The Same
Basis At The End Of The QPRT Term?
Yes. Gifts made during lifetime
are subject to a carryover basis. Therefore, the basis of the
residence in your hands will be the same in the hands of your
children when they receive the residence at the expiration of
the QPRT.
20.
Can I Purchase the Residence From The QPRT During The Trust
Term?
No. Several years ago, the IRS
issued regulations which prohibit the client/donor or their
spouse from purchasing the residence from the QPRT. The
benefit of this type of transaction is that
(i) it avoids the
loss of the step up in basis, and
(ii) the client is not
required to rent the residence from his or her
children.
Before the issuance of the
regulations, a client/donor could purchase the residence back
from the QPRT shortly before the expiration of the QPRT term
for its then full fair market value. As a result, the
remainder beneficiaries would receive cash equal to the
purchase price paid and the client/donor would receive the
residence back in his or her own name. The QPRT Regulations
now require that the trust instrument specifically prohibit a
donor or their spouse from re-acquiring the residence.
21.
Is There Any Way To Take Advantage Of The $250,000/$500,000
Exclusion Of Gain From The Sale Of A Principal Residence And
To Provide A Step-Up In Basis To The Remainder Beneficiaries?
It is possible to structure a
sale shortly before the expiration of the QPRT term to give
the remainder beneficiaries a step-up in basis.
Shortly before the expiration of
the QPRT term, the remainder beneficiaries should purchase the
residence from the QPRT at its full fair market value for a
10% cash down payment and a promissory note for the balance.
As a result of the purchase, they will own the residence with
a basis equal to its full fair market value. When the QPRT
terminates, the remainder beneficiaries will receive the cash
and the promissory notes back and the notes will be
extinguished.
The tax consequences to the
donor/grantor are such that, assuming
(i) the gain recognized
on the sale of the property is less than
$250,000/$500,000,
(ii) the residence being sold is the donor/client's principal
residence,
and
(iii) all other applicable requirements for the
Code § 121 exclusion of
gain requirements are met, the
donor/client will be able to exclude
up to $250,00/$500,000 of
gain in connection with this sale.
22.
Who Should Serve As The Trustee Of The QPRT?
The client/donor may serve as the
Trustee of the QPRT during the trust term. This generally
keeps administrative costs and burdens to a minimum. If the
trust will continue after the expiration of the trust term, in
order to avoid any estate tax traps under Code §§ 2036 or
238, the client/donor should not serve as the Trustee.
23.
Do Any Income Tax Returns Have To Be Filed In Connection With
A QPRT?
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.
24. Requirements for a
Qualified Personal Residence Trust
The following is a brief summary
of some of the more critical requirements of the QPRT
regulations:
Personal Residence: Only
a "personal residence" may be transferred to a
QPRT. A residence qualifies if it either is the parent’s
principal residence or is used primarily for residential
purposes (such as a vacation home). The residence may be
rented to other parties, so long as the parent uses the
residence for the greater of 14 days or 10% of the number of
days the residence is rented.
Length of the Parent's Term
Interest: The length of the parent's term interest in
the trust is not limited by the regulations and, of course,
the longer the term interest, the lower the value of the
child's remainder interest (and hence the lower the gift
tax). As a practical matter, however, the term interest
should be kept well short of the parent's life expectancy,
since if the parent dies before the termination of the term
interest, the full value of the residence would be included
in the parent's estate for estate tax purposes (thus
defeating the entire purpose of the trust).
Lease of Residence after
Term Interest: The QPRT may give the parent the right to
lease the residence after the parent's term interest ends,
so long as the rent paid is a "fair market value"
rent. In this way, the parent may continue to live in the
house as long as desired. Moreover, since the child's
marginal income tax bracket is likely to be lower than the
parent's marginal estate tax bracket, the payment of rent by
the parent is a means of transferring wealth to the child at
a lower tax cost.
ESTATE
PLANNING