By: Randall A. Denha, J.D., LL.M.
A qualified personal residence trust (QPRT) is an estate-planning vehicle that allows a homeowner to transfer his home to a trust, while retaining the right to live in it for a term of years. This technique allows the individual to transfer the house to beneficiaries at a reduced gift tax cost and remove an asset expected to appreciate in value from his estate. A QPRT is an irrevocable trust into which a Trustor or Grantor transfers ownership of either a primary residence, vacation home or an undivided fractional interest in either a principal residence or vacation home. A vacation home is defined, according to the Internal Revenue Code pertaining to this planning, is a property used the greater of fourteen days annually or 10% of the days rented to others annually.
When the estate lifetime exclusion was lower and there was no portability of each spouse’s exemption, the use of QPRTs gained in popularity. Many of these trusts are just now approaching their termination date and will require proper planning to ensure a smooth transition for everyone involved.
Because there’s no limit on how long the QPRT must run, it’s not uncommon to see QPRTs that were created 10 to 15 years ago finally expire today. Much strategic planning needs to be done to develop a plan that takes into account the economic and tax issues of the beneficiaries, as well as those of the grantor, at the time the initial trust term expires.
A few benefits of a QPRT are:
1. The QPRT’s main benefit to the Grantor and the Beneficiaries is the eventual reduction of estate taxes.
2. A QPRT allows the Grantor to transfer the property to children at a reduced gift tax value. Because the gift is of a “future interest” in the property (meaning the beneficiaries can only actually own it at some future date) the value is discounted for gift tax purposes.
3. If the Grantor or Grantors live beyond the term of the trust, the full market value of the property, including any appreciation during the term of the trust, is removed from the Grantor’s estate.
4. The Grantor or Grantors can continue to use and enjoy the possession of the property during the term of the trust. If the Grantors live beyond the term of the Trust, the beneficiaries can “rent” the property back to the Grantors for fair market rent and this will keep the property from reverting back to the Grantor’s estate for estate tax purposes.
5. The Grantors can serve as Trustees of the QPRT and thereby control the property during the term of the Trust.
Looking ahead to the expiration of the QPRT initial term and mapping out a successful transition will not only prevent unforeseen consequences for the grantor and the new owners, but also ensure that the original intent of this valuable estate-planning vehicle is achieved.
What options, decisions and considerations need to be made when the QPRT term ends? Here are a few to consider.
If Grantor Dies During Term
As a brief overview, if the grantor dies within the QPRT period, the fair market value (FMV) of the trust will be included in the grantor’s estate for tax purposes. If the Grantor dies during the term of the trust, the property is brought back into the Grantor’s estate as if the QPRT never existed and all tax savings are lost. It’s important to note, however, that we would have had the same result had the Grantor never established the trust. As such, you are no worse off than trying!
Scenarios at QPRT Termination
One of the most fundamental reasons for planning what to do once the QPRT expires is that, at the end of a QPRT term, the grantor is no longer the owner of the home and loses control of the property. Prior to the end of the fixed term, you must review the trust document for the QPRT to determine what happens to the property at the QPRT’s termination. Does the property transfer outright to the kids, in trust for the kids or provide a period of time for the grantor’s spouse the right to use the property for life, rent fee, thereby allowing the grantor of the QPRT the use of the residence as long as they’re married.
Another scenario that is occurring more often is the Grantor’s unwillingness to continue with the QPRT at the expiration of the QPRT. With an increase in the available estate tax exemption (and possible repeal of the estate tax under current proposals, the need for the QPRT may no longer be of interest to the Grantor.
Given the state of the economy, it’s not uncommon for real estate that has been transferred to a QPRT to have experienced less than anticipated appreciation or even depreciation. Consequently, one of the purposes of the QPRT–removing future appreciation from an estate–may go unachieved. Some grantors in this position may be inclined to “unwind” (undo) the QPRT. That, however, may not be the best option.
If you unwind the QPRT, you will have wasted any payment of federal gift tax or gift tax exemption that you may have used on the original transaction. You will have squandered that amount because you won’t get that back when you unwind the QPRT.
Additionally, when the QPRT terminates, you will have to pay the remainder beneficiaries fair market rent. These payments will reduce your estate even further. That said, if you still want to unwind the QPRT, what options exist:
1. Live in the house rent free which will cause estate tax inclusion
2. Remainder interest holders assign their interests back to you
Beneficiaries of the QPRT may not know how to manage the property or may not want to take on the responsibility. Part of the pre-termination planning should include determining who’ll be responsible for paying the bills for the residence, continuing homeowners insurance on the property, making improvements to the property, collecting the rental income if the property is rented or arranging for a sale if the property is to be sold. A checking account needs to be set up in the name of the new owner(s) as well.
Other considerations when there’s more than one individual beneficiary include: Do the individuals want to own the property as a joint venture, with each owner reporting his pro rata share of rental income and expenses (or of sales proceeds) on his individual tax return? If so, who’ll be in charge of the record keeping and informing the other owners of their share? What will the owners do when the rental income doesn’t cover expenses or improvements are needed? How much of a reserve fund will be kept if rental income is in excess of expenses? What will happen if one of the individual beneficiaries dies?
Transfer of Interest
The new individual owners may want to contribute their interests in the residence to a limited liability company (LLC). Proper planning can ensure this transfer occurs simultaneously with the termination of the QPRT. The managing member of the LLC or the trustee of the trust would then be responsible for the property, and the income would flow through on schedule K-1s to the owners. If the property is sold or generates excess rental income, an LLC or trust can make distributions or can be set up so that the funds are invested.
If Grantor Stays or Goes
Additional planning is needed prior to the termination of the trust to decide if the grantor wants to remain in the residence, and if not, whether the residence should be rented to an outside party or sold. In some cases – for example, if the residence is a summer home – the beneficiaries might want to retain the residence for their own use. As previously mentioned, the grantor no longer retains the right to live in the residence once the trust term is up.
lf the grantor wishes to continue to occupy the residence after the expiration of the initial QPRT term, the grantor must pay to the remainder beneficiary, at fair market value, rent for the use of the residence, otherwise risk estate tax inclusion. An independent real estate broker or appraiser should be consulted to determine fair market rent based on the rent for comparable residences. With each renewal of the lease agreement, the rental terms should be reviewed to make sure they’re comparable to market.
The grantor and the new owner should execute a rental agreement before the expiration of the QPRT term. The lease should state who’s responsible for paying for utilities (generally the renter) and maintenance and repair expenses, such as gardening, snow removal and security. The owners are generally responsible for paying the real estate taxes, homeowners insurance, major repairs and improvements.
The rental payments are considered income to the recipient. Of course, the recipient will be able to use rental expenses and depreciation to reduce the tax bite of the rental income. But, let’s suppose that in the future, there’s no estate tax. Will it make sense for the grantor to stay in the residence and pay rent? The grantor may want to consider other living options that would save him cash or generate income tax deductions. For example, the grantor may have less costly alternatives such as senior housing or purchasing a smaller residence. Therefore, to allow for flexibility, there shouldn’t be a lengthy lease agreement in place.
Prior to the end of the initial term, it’s crucial to ensure that adequate funds are available to pay for all property expenses. Unless the grantor intends to rent the property on a long-term basis, thus providing the beneficiaries with an ongoing source of funds to pay for property expenses, the new owners will need to arrange to pay the bills – including real estate taxes and insurance. If funds aren’t readily available, it may be necessary to rent the property on a short-term basis to the grantor or a third party.
Under current law, if someone holds a home in his name until his death, the cost basis for purposes of determining gain on a sale is increased to date-of-death value. This reduces the taxable gain reportable by the heirs when the property is subsequently sold at the expense of being included in the descendant’s estate for estate tax purposes. The ability of QPRTs to transfer property with a carryover basis, not a step-up in basis, makes them ideal for heirs who want to hold on to the property for generations. It’s important to maintain records for basis, as they’ll be needed for computing depreciation if the property is rented or to determine capital gains if the property is sold. Under IRC Section 1015(a), basis of property is the original basis of the grantor plus any improvements made. If the new trust qualifies as a grantor trust, and the residence is the grantor’s principal residence, the capital gains exclusion may be available under IRC Section 121.
One of the most important steps for the trustee to follow at the end of the QPRT term is to transfer title and ownership of the residence into the names of the remainder beneficiaries to ensure the correct titling and insuring of the asset. The homeowner’s insurance policy will need to be adjusted when the QPRT term ends; therefore, the beneficiaries must contact the carrier prior to the termination. A new policy must be put in place naming the new owners (either the new trust or the individual owners) as the insured to cover liability, including for renting the property (even if it’s to the grantor) and for damage to, or loss of, the residence. Because not all insurance companies have the same requirements or processes for insuring property if it’s held in trust, it’s important to contact an insurance broker who understands the complexities involved. The tenant (even if it’s the grantor) will need to obtain renters insurance to cover his personal liability and the contents. If the residence isn’t to be rented, but rather retained by the individual beneficiaries for their own use, they may be able to add coverage for personal liability and contents to the homeowner policy.