1. General. A qualified personal residence trust ("QPRT") is a trust authorized by Treasury Regulations to hold title to a principal residence or one other residence, typically a vacation home, of an individual for a fixed period of time (the "term" of the trust). After the expiration of the term, title goes to other beneficiaries, or may continue in the trust.
1.1. The tax benefit of a QPRT is that the value of the gift of the home may be substantially discounted. This is because the value of the gift is the fair market value of the home at the date of the gift reduced by what the owner did not give, namely, the right to live rent-free in the home for the term of the trust. If the owner outlives the term of the trust, the home is included in the owner's taxable estate at the discounted value at the time of gift, not the fair market value of the home as of date of death.
1.2. A major advantage of a QPRT, besides gift and estate tax savings, is that it causes minimal lifestyle changes, while avoiding fears that too much is being given away.
1.3. No more than two residences may be placed into QPRT's. Two residences would require two separate trusts.
1.4. A disadvantage of a QPRT is that the remainder beneficiary takes the donor's tax basis in the property instead of receiving the property with a step-up in basis as would occur if the property were included in the donor' gross taxable estate. This will cause an eventual capital gain to be incurred on a portion of the sale price. However, current capital gains rates are substantially less than current estate tax rates.
2. Requirements of a QPRT. A QPRT may hold only one personal residence of the term holder. The Regulations require that the following items be included expressly in the QPRT's governing instrument:
2.1. Mandatory distribution of income. The governing instrument of a QPRT must absolutely require that any trust income be distributed to the term holder at least annually. This will apply if the trust rents the residence for part of the year.
2.2. A prohibition against distributions of income or principal to anyone other than the term holder except for principal distributions on termination. A QPRT must expressly prohibit distribution of income or corpus to anyone other than the term holder during the trust's term. If the trust has any rental or other income, it may be distributed only to the term holder until the termination of the trust's term. There is no exception for hardship or emergency needs.
2.3. A prohibition against the trust's holding cash in excess of certain limitations and a requirement that certain excess cash be distributed. A QPRT may permit the trustee to hold limited amounts of cash. The trustee may be allowed to hold such cash only in a separate account and in an amount that, when added to the existing cash held for these purposes, does not exceed the amount needed: (1) for payment of trust expenses, including mortgage payments, already incurred or reasonably expected to be incurred within the next six months, (2) for improvements to the residence to be paid within six months, and (3) on creation of the trust, to buy a personal residence, or thereafter to buy a replacement residence, within three months, and even then only if the trust prohibits any additions being made to the trust for this purpose unless there is an existing contract to buy the residence. A QPRT that permits the trust to hold cash transferred to the trust for these purposes must also require the trustee to determine the amounts required for these purposes at least quarterly and promptly to distribute any excess cash to the term holder. Furthermore, within 30 days of the termination of a QPRT, the trustee must distribute any cash not required to meet trust termination costs outright to the term holder. A QPRT must require that any cash held by the trust beyond the amounts permitted under the Regulations must be distributed to the term holder at least quarterly and that all cash held by the trust must be distributed to the term holder on termination.
2.4. A prohibition on commutation of the trust. The trust must prohibit any commutation of the interest of the term holder. If not prohibited, commutation would occur when the parties decide to terminate the trust early and to distribute a fractional share of the real estate to the term owner and a fractional share to the remainder owner, based on the actuarial value of their respective interests.
2.5. The required termination or conversion of the trust into a GRAT on the cessation of the trust property's use as a personal residence. A QPRT must provide that the trust will not be a QPRT if the residence ceases to be used or held as the term holder's personal residence. This is the triggering mechanism to a series of options. Several options exist.
2.5.1. Sale or involuntary conversion of the personal residence. If the residence is sold or involuntarily converted (destroyed or condemned), the trustee may hold the proceeds in a separate account. A timely replacement or repair of the property will preserve QPRT status. In the case of a sale, the trust remains a QPRT if the trustee purchases a replacement residence for the term holder within two years from the date of the sale or, if earlier, the date that the term holder's interest terminates. If all the sales proceeds are not used for this purpose, the trust ceases to be a QPRT to the extent of the unused proceeds. In the case of an involuntary conversion, the trust remains a QPRT if the trustee repairs or replaces the residence for the term holder within two years from the date of the conversion or, if earlier, the date that the term holder's interest terminates. If all the insurance or condemnation proceeds are not used for this purpose, the trust ceases to be a QPRT to the extent of the unused proceeds.
2.5.2. Other termination of residence status. A QPRT must contain one of three provisions that will become effective if the trust's property ceases to be the term holder's residence for any reason (such as sale, destruction, condemnation, or cessation or change in use).
2.5.2.1. First, the trust may require that the trustee distribute all the trust assets to the term holder. This option is the least desirable because it forfeits entirely the estate tax benefits the term holder sought to obtain, returning the entire trust fund (the residence) to the term holder's estate.
2.5.2.2. Second, the trust may require the trustee to convert the trust into a qualified grantor retained annuity trust ("GRAT"). The GRAT created in this situation must meet all the requirements of a qualified annuity trust.
2.5.2.3. Third, the trust may give the trustee the option to convert the trust into a GRAT or to terminate and distribute all the trust funds to the term holder.
3. Selecting the Term of a Qualified Personal Residence Trust. The duration of the grantor's interest in a QPRT depends on several factors. The term of the grantor's use of the residence should be short enough that the grantor is likely to survive it. On the other hand, the longer the term of the trust, the greater the valuation discount.
4. The Remainder Interest in a Qualified Personal Residence Trust. The remainder interest in a QPRT can be distributed outright or held in continued trust. The trust can continue after the expiration of the initial term, for the benefit of persons other than the initial term holder.
5. Selecting the Trustee of a Qualified Personal Residence Trust. The grantor can serve as the trustee without any automatic income, gift, or estate tax problems. However, the grantor should not serve as trustee if the grantor can alter the remainder owner's interests through any actions taken as trustee. Also, it is necessary that not only the trust agreement and funding be correct, but also that the trust must also be operated as a trust in accordance with the agreement and IRS rules.
6. Generation-Skipping Transfer Tax Issues. A QPRT permits the donor to make a relatively large gift of a personal residence at a reduced gift tax cost, but the leverage of the retained personal use term is not available to reduce the amount of the transfer subject to generation-skipping transfer (GST) tax. A transfer of a remainder interest in a QPRT to grandchildren or other "skip persons" occurs for GST purposes only when the retained interest terminates. Until that date, an estate tax inclusion period exists, and the grantor cannot allocate any of his or her GST exemption to the trust. When the retained interest terminates, the grantor may allocate some of his or her GST exemption to the trust, but the allocation will be based on the value of the assets in the trust valued as of that time without any discount for the grantor's retained interests.
7. Mortgaged Property in a Qualified Personal Residence Trust.
7.1. A QPRT may hold a residence subject to a mortgage. However, such debt can cause income and gift tax problems for the grantor. Normally, a donor recognizes a gain on a gift of encumbered (mortgaged) property if the property is subject to a debt that exceeds the donor's adjusted basis. Recognition of this gain will be deferred or possibly avoided entirely because a QPRT is a grantor trust. Although there is no deemed disposition on the creation and funding of the trust, there is a deemed disposition when the grantor's retained personal use interest terminates and the trust ceases to be a grantor trust. At that time, if the trust's basis in the real property is still less than the outstanding debt, the grantor will recognize a gain.
7.2. A grantor who makes principal payments on a loan secured by a mortgage on the trust assets may be treated as having made a gift to the remainder beneficiaries at the time of each payment.
8. Continued Possession of the Residence After the QPRT's Initial Term. A grantor may wish to continue to use a personal residence after the stated term of the QPRT has ended. A lease from the remainder beneficiaries back to the grantor is a suspect transaction. The IRS may contend that the lease is, in effect, a retained life estate causing the entire at death value to be included in the grantor's taxable estate. To counteract such an argument, any lease of the residence back to the grantor should provide (1) the lease term, including extensions, should not be as long as the lessee's life expectancy, (2) the rent, initially set by appraisal, should be adjusted annually and should be at least the fair market rent, and (3) a security deposit and first month's rent should be required at signing.
9. Jointly Owned Residences. Many personal residences are owned by married couples as joint tenants or tenants by the entireties. Such joint ownership may offer opportunities for additional estate tax savings. The regulations provide that spouses who each hold an interest in the same residence may give their interests to a single personal residence trust. The regulations require that the trust instrument prohibit anyone other than one of the spouses from holding a term interest in the trust concurrently with the other spouse. Thus, the interests of the spouses cannot be freely assignable. Another approach, however, is for the spouses to convert their joint tenancy (or tenancy by the entireties) into a tenancy in common (with no rights of survivorship). Each spouse should then transfer his/her interest to a joint QPRT or create their own separate QPRT. An undivided one-half interest as a tenant in common, even when the other one half is held by one's spouse, should be valued for gift tax purposes at a discount from its fractional share of the value of the undivided property to reflect properly the lessened marketability of such partial interest. Therefore, in addition to reducing the value of the gift of the property on account of the retained interest, the donor may also receive an additional discount for the lack of marketability of the partial interests created in the property.
