Article written by Jonathan Osler, Esq.
The qualified personal resident trust (QPRT; pronounced “Q-Pert” in estate planning parlance) is a technique that is used to reduce the size of a taxpayer’s estate. With a QPRT, the grantor creates an irrevocable trust and places property—usually a primary residence or vacation home—into the trust. The grantor retains the right to use the property for a predetermined number of years, which is established in the trust agreement. After that period of time has expired, the property passes to the trust’s beneficiaries (typically the grantor’s children), or the property remains in trust for their benefit.
Right off the bat, one should know that the grantor must survive the full term of years specified in the QPRT—if not, the entire value of the property is included in the decedent’s estate, which negates any benefits of establishing the QPRT. However, the full market value of the property, including appreciation, is removed from the grantor’s estate if the grantor lives through the full term. Determining whether the QPRT is worth the gamble requires careful planning on the part of the grantor and his or her estate planning attorney.
The above describes the QPRT in a nutshell, but a little more detail is necessary to explain what makes the QPRT tick. First, the transfer of the residence to the beneficiaries after the term of years expires actually constitutes a completed gift under Internal Revenue Service rules. To attain the maximum benefit for gift tax purposes, it is important to minimize the value of the gift to the greatest extent possible. However, minimizing the gift tax value requires a fairly complex song-and-dance, which involves calculating the value of the grantor’s remainder interest, which is based on the number of years set in the trust, along the with the grantor’s life expectancy and the applicable interest rate—as set by Internal Revenue Code Section 7250—at the time the QPRT is created. If you’re still with me after all that, here’s the long story short: A longer term of years and a higher interest rate lowers the value of the gift, and vice-versa (we’ll leave life expectancy out of it for now). And the lower the value of the gift, the greater the benefit of the QPRT for estate tax purposes.
A positive attribute of the QPRT is that it remains a grantor trust throughout the years that the grantor retains an interest in the property. Because it is classified as a grantor trust, the grantor may continue to take the mortgage interest deduction (prior to 2018 the grantor could take a full deduction on property taxes as well; currently, the grantor may deduct a maximum of $10,000 in property and state and local taxes, combined) if there is a mortgage on the property. The beneficiaries have no tax or other liability with respect to the property during the years that the grantor retains an interest in the property.
You may be asking yourself, “What happens when the term of years set in the trust agreement expires?” That’s a good question, and here’s the answer: At the end of the term, the ownership of the residence transfers to the beneficiaries. Commonly, the grantor will continue to live in the house by paying rent—at full market value—to the beneficiaries. The upside is that the grantor, by paying rent to remain in the property, can move more money out of his or her estate to further reduce estate tax exposure.
An important income-tax consideration with the QPRT relates to capital gains taxes for the remainder beneficiaries. The beneficiaries will not get a “step up” in cost basis to the grantor’s date-of-death value if they take ownership of the house under the remainder terms of the trust. In other words, if the grantor outlives the term of years, and the transfer to the beneficiaries is a completed gift for tax purposes, the beneficiaries take the property with the same cost basis as the grantor. On the other hand, if the property is in the grantor’s estate at the time of death and the beneficiaries take the property by inheritance, capital gains liability is erased because the beneficiaries take the property subject to its new, stepped up cost basis. In that case, if the beneficiaries turned around and sold the house the very next day, they would owe nothing in capital gains. Therefore, when considering the QPRT as an estate planning tool, the attorney and the client must discuss the estate tax/capital gains tradeoff. If the tax basis of the property has increased markedly since the grantor’s initial purchase, or is expected to rise significantly due to market appreciation, alternative options for reducing estate tax exposure may be well worth exploring.
If you have a QPRT, or you may be interested in setting up a QPRT, please contact our offices—we would be delighted to schedule you for a complimentary, one-on-one consultation to review your estate plan. Additionally, if you are interested in learning more about estate planning in light of the recent changes to state and federal laws, please join us at one of our seminars.