What is a Qualified Personal Residence Trust?

Americans have enjoyed historically high estate tax exemption rates for the last twenty years. Such high exemption amounts have kept many of them from needing to seek out help from an estate tax professional. However, it is uncertain what the estate tax exemption amounts will be in the future.

With government spending and the national debt constantly increasing, it's a fair assumption that taxes will be going up soon. The estate tax exemption amount will likely be reduced so that more estates will have to pay tax, and more revenue will be raised for government programs. The current individual threshold of having to pay estate taxes when you pass away is $5.25 million. If your estate is teetering on that number, it's important to be aware of tax planning strategies. One tried-and-true strategy is a qualified personal residence trust (QPRT).

The Benefits of Qualified Personal Residence Trusts

A QPRT is a type of irrevocable trust that is designed to hold a taxpayer's home. If a QPRT is designed and implemented correctly, it offers a number of benefits:

  • It's possible to save a lot of money in taxes when the home is transferred to the trust beneficiaries during the taxpayer's life, rather than after his or her death.
  • The appreciation in the property's value over time is removed from the taxpayer's taxable assets.
  • The taxpayer can continue to live in the home rent-free for some time.
  • The taxpayer can further reduce their taxable property’s value by paying rent to the trust after a specified period of time.
  • The QPRT can hold the home in continuing trust for the beneficiaries, thereby protecting it from their creditors, divorcing spouses, bankruptcies, etc.

Requirements of a QPRT

Generally speaking, the way a QPRT works is that the taxpayer who owns the home must transfer it by recording a deed with the local property registry. The owner will also need to retitle the property in the QPRT’s name. Within the terms of the trust, the grantor (the taxpayer) retains the right to reside in the home for a specific number of years (term). As a result, the taxable value of the gift to the trust can be discounted under federal tax law. The longer the term, the greater the gift’s valuation discount. When the term ends, the grantor’s right to live in the home ends, and the trust beneficiaries (usually, the grantor’s children) receive the home either outright or at a time dictated by the trust. If the grantor wishes to continue to live in the home, they can rent it at fair market value, which allows them to make additional transfers of cash to the trust, tax-free, for the benefit of the beneficiaries.

To reap the benefits of a QPRT, it must be carefully designed and implemented. For the trust to qualify as a QPRT under federal tax regulations, the following terms must be included[1]:

  1. All income generated by the trust must be distributed to the trust’s grantor at least annually.
  2. The QPRT cannot distribute trust principal to any beneficiary other than the grantor before the term expires.
  3. The trust can hold only one residence with a reserved right of occupancy during the specified term and cannot hold any other type of property (with some limited exceptions to help maintain the home).
  4. The QPRT must prohibit termination of the trust and distribution of trust property among the beneficiaries prior to the expiration of the trust term.
  5. If the residence is no longer being used as the grantor’s personal residence, the trust will cease to qualify as a QPRT.
  6. If the home is damaged or destroyed to the degree that it becomes uninhabitable, the trust will cease to be a QPRT unless the home is repaired or replaced within two years of the damage occurring, or within two years of the expiration of the grantor’s residency term, whichever is earlier.
  7. The QPRT must not allow the trust to sell or transfer the residence to the grantor, their spouse, or an entity controlled by either of them at any time during the grantor’s residency term.

In addition to the property, the QPRT can hold cash for a short period of time to allow for the payment of trust expenses such as mortgage payments or home improvements. A replacement property is also allowed to be purchased from the trust funds should the home be sold with the intent of replacing it.

Possible Downsides of QPRTs

As with most tax-related things, whenever you get a tax benefit, there are going to be trade-offs that must be considered. The same holds true for QPRTs. Before you decide to use a QPRT in your estate planning, consider the following:

  • There are typically significant fees associated with the formation, funding, and tax reporting of a QPRT.
  • In some states, holding a home in a QPRT can result in reassessment of property tax liability. This could lead to higher property taxes or a loss of certain property tax exemptions.
  • After the QPRT’s term ends, the grantor must give up the right to occupy the residence and, if they desire to continue living there, they can only do so by renting the property from the QPRT beneficiaries. This can create an awkward situation in some families.
  • Transferring a home to a QPRT causes it to have a carryover basis in the hands of the beneficiaries, resulting in potentially high income taxes if they choose to sell the property after the term ends.
  • Transferring a residence that has a mortgage on it can significantly complicate proper accounting and tax reporting. It is generally recommended to only transfer homes that are fully paid off.

Who Should Consider Using a QPRT?

A QPRT is a sophisticated estate tax planning tool that can allow a homeowner to transfer their property to the next generation with significant tax savings. Those with an already high net worth who may be facing estate taxes upon death, and who anticipate high appreciation in their home may want to consider using a QPRT in their estate planning. However, because of the many considerations associated with this tool, it is important to seek the help of a tax-minded lawyer. They can help you weigh the benefits against the downsides and determine if it's an appropriate tool for your own situation.

Greg DuPont at The Law Offices of DuPont and Blumenstiel is a Certified Financial Planner and Estate Planning Attorney. If you would like to learn more about QPRTs, or trusts in general, call our office at 614-389-9711. We are ready to assist you.

 

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[1] Treas. Reg. § 25.2702-5(c)(1).


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