Qualified Personal Residence Trusts
A qualified personal residence trust or QPRT (pronounced "cue-pert") is a special type of trust that can provide a significant savings in transfer costs. A taxpayer creates a QPRT by transferring a personal residence to an irrevocable trust and retaining the right to live in the residence for a fixed term of years. Although a taxable gift is made when the property is transferred to the trust, If the taxpayer survives until the end of the trust term, the residence will go to the beneficiaries the taxpayer has named (typically the taxpayer's children) with no further tax consequences.
Tax Savings. The tax advantage of a QPRT stems from the fact that when the residence is transferred, the taxpayer does not pay gift tax on the full fair market value of the property. Instead, the gift is computed on the value of the property reduced by the value of the interest the taxpayer has retained. Suppose for example, that Susan Taxpayer owns a personal residence with a fair market value of $1,000,000 and is in the 50 percent marginal tax bracket for gift and estate tax purposes. If Susan makes an outright gift of the property, she will pay a gift tax of $500,000 on the transfer. If she leaves the residence to her children at death, she will pay a 50% tax not only on the current $1,000,000 value, but also on any appreciation on the property between now and the time of her death.
If Susan transfers the property to a 15-year QPRT instead, and survives until the end of the trust term, the result is quite different. Rather than paying tax on the full $1,000,000, she pays a 50% tax on $1,000,000 minus the value of the 15-year retained interest. At a 4% interest rate, the value of a 15-year interest is just over 41% of the total value of the property. This means that the value of the interest passing to the children is only about 59% percent of the total, or $586,290 as shown in Figure 1.
The bottom part of the illustration shows what the value of the home might be worth at Susan’s death in 30 years, using an annual growth rate of 3%. When you compare the value of the residence in 30 years to the cost of a current transfer, the transfer cost savings can be very dramatic!
Retaining a Reversion. One drawback to a QPRT is that if Susan should die before the end of the 15-year term, the value of the residence is brought back into her estate for death tax purposes at its then fair market value. However, we can turn this potential adversity into opportunity by having Susan retain a reversion, which is a right to recover the property from the trust if she dies within the term. With the reversion, Susan’s gifts to the children is not $586,290 as shown above, but is only $450,110 -- reducing the gift tax cost even more!
After Expiration of the Trust Term. Despite the large reduction in gift tax, many taxpayers may have reservations about using a QPRT because they are concerned about having to give up their residence at the end of the trust term. Prior to enactment of regulations in 1997, taxpayers could solve this problem by repurchasing the residence from the trust before the end of the trust term. Now, the governing instrument of a QPRT must prohibit the trust from selling or transferring the residence, directly or indirectly, to the grantor, the grantor's spouse, or to an entity controlled by the grantor or the grantor's spouse.
Fortunately, an alternative strategy is available. After the end of the term, the donor can lease the residence back from the children. The lease must provide for payment of a fair rental amount to avoid unintended gifts from the children to the parent (or worse, having the residence included in the donor’s estate due to the IRS treating the transfer as a sham). However, such lease payments offer an additional avenue for transferring value to the children at no transfer cost (although the children will have to pay income tax on the rent received).
Other Rules. Although the most frequent application for a QPRT involves the donor’s primary residence, a secondary residence or even a vacation home can be placed into a QPRT. However, a taxpayer may not create a QPRT for more than two residences.
If the home is sold or destroyed during the term of the trust, a new home must be purchased or rebuilt within one year. Alternatively, the proceeds of the sale (or insurance proceeds where the residence is destroyed) can be turned into a Grantor Retained Annuity Trust (GRAT), which will distribute an annual annuity to the donor for the balance of the trust term.