Planning for Life after a QPRTBy Laura E. LaForgia | Kathi Mintzer | August 3, 2017 | Download PDF
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. 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.
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.
Let's explore the decisions, choices and considerations that need to be made when the fixed term ends.
If Grantor Dies During Term
As a brief overview, if the grantor dies within the QPRT fixed period, the fair market value (FMV) of the trust is included in the grantor's estate for tax purposes.1 The value of the gift is determined by subtracting the value of the retained interest from the FMV of the residence.2 Under Internal Revenue Code Section 7520, the terms of the trust, the life expectancy of the grantor and the "7520 rate'' in effect for the month of the transfer all factor into the computation. Hence, the longer the term of the trust, the greater the gift tax discount.
No Repurchase by Grantor
Many complex rules govern the creation of a QPRT, and it's important that QPRTs follow the technical requirements of Treasury Regulations Section 25.2702- 5(c), such as the provision that the grantor may not repurchase the residence at the end of the QPRT initial term. Treas. Regs. Section 25.2702-5(c)(9) also prohibits the grantor, grantor's spouse and any entity benefitting the grantor or grantor's spouse from repurchasing the residence either during the trust term or afterward. Following the regulations set in place is vital to gleaning the benefit of this estate and gift tax planning tool.
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. Typical scenarios are:
- It might be distributed outright to one or more individual beneficiaries, often the children of the grantor.
- It might pour into another trust for the benefit of the children, in which case the client must determine if this has been structured as a grantor trust.3
- It might provide that a t rust for the grantor's spouse is the initial beneficiary, giving the spouse the right to use the residence for life, rent free (and indirectly allowing the grantor the use of the residence as long as they're married).
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? See "Schedule of lncome,” p. 20.
Transfer of Interest
The new individual owners may want to contribute their interests in the residence to a limited liability company (LLC) or to a trust to make administration of the property simpler. 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, and the residence doesn't go to a trust for the spouse, the grantor must pay to the remainder beneficiary, at FMV, rent for the use of the residence to avoid operation of IRC Section 2036(a)(1), which would bring the transfer back into the grantor's estate. 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. A provision requiring renters insurance is often included in leases. All of this also applies if the property is rented to someone other than the grantor.4
There's an advantage to the grantor staying in the home and paying fair market rent while value is being removed from the grantor's estate. If the beneficiary of the QPRT is a trust that's been set up as a grantor trust, the rental payments paid by the grantor aren't taxable to the beneficiaries, nor are these payments taxable to the grantor, who's deemed to be paying rent to himself. Because this is disregarded as a rental activity, there will be no depreciation deduction, but the grantor will be able to deduct real estate taxes as an itemized deduction. These rental payments aren't treated as gifts.
Otherwise, the rental payments are considered income to the recipient. Of course, the recipient will be able to use rental expenses and depreciation to reduce e 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.
Sale of Property
Should the grantor want to sell the property during the fixed term Treas. Regs. Section 25.2702-S(c)(7) (ii) stipulates that the sale proceeds must be invested into a new home to preserve the QPRT. If there's no desire to replace the property, the sale proceeds will be converted into a qualified annuity interest within 30 days after the sale, with payments going back to the grantor or distributed outright.5 These rules are complex and must be permitted by the governing instrument.
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 101S(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 homeowners 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.
GST Tax Considerations
Look for any generation-skipping transfer (GST) tax issues in the QPRT document. QPRTs aren't generally used in planning for GST because the GST tax exemption won't be effective until the end of the initial QPRT term.6 GST will come into play if: (1) the remainder beneficiaries are the grantor's children "per stirpes,” and a child dies before termination of the QPRT initial term, or (2) the remainder beneficiary is a GST trust. Rules governing the estate tax inclusion period, during which the residence would be included in the grantor's estate if he died,7 require that the property be valued at FMV on the termination date of the QPRT and a U.S. Gift Tax Return (Form 709) be filed for the year the QPRT ends. In the case of the property being distributed to a GST trust, your client must decide whether to allocate the GST tax exemption or to elect out of the automatic allocation of the GST tax exemption. Best practice is to make a definitive election and not rely on the automatic allocation rules of GT as a default election.
1. Internal Revenue Code Section 2036(a).
2. See Treasury Regulations Sections 1.7520-1(a)(1) and 20.2031-7(d)(2)(iii).
3. In a grantor trust, the grantor retains control to such extent he's treated as owner of all or a portion of trust. Income of a grantor trust is taxed to the grantor. A spousal interest or the right to add charitable beneficiaries after the initial qualified personal residence trust (QPRT) term might qualify the successor trust to be treated as a grantor trust. IRC Sections 671-679 cover the grantor trust rules
4. What happens if the grantor resides in the residence after the expiration of the QPRT term, but dies prior to the execution of the lease or the payment of rent? Records showing that the grantor knew she would have to pay rent and having the new owner(s) consult with an attorney about drawing up a lease and making arrangement to determine the fair market rent prior to the expiration of the QPRT may be sufficient to keep the residence from being included in the estate. In re Estate of Sylvia Riese v. Commissioner, T.C. Memo. 2011-60 (March 15, 2011).
5. See Treas. Regs. Section 25.2702-5(c)(8).
6. IRC Section 2642(f)(3); see Treas. Regs. Section 26.2632-1(c)(2), (c)(3), (c)(5) Example 1.
7. Section 2642(f)(3).
This article was originally published in the August issue of Trusts & Estates.
About Laura E. LaForgia
Laura E. LaForgia, CPA, MST, AEP®, is a Partner at Marks Paneth LLP and a member of the firm's Private Client Services Group. Specializing in complex tax issues for high-net worth individuals and their families, Ms. LaForgia helps her clients manage, preserve and transfer their wealth through strategic income tax planning and compliance, trusts and estate planning, business management solutions and financial planning. Ms. LaForgia also provides guidance on matters related to gift tax, multi-state... READ MORE +
About Kathi Mintzer
Kathi Mintzer, CPA is a Director in the Tax Department at Marks Paneth LLP. She has over 30 years of tax experience with expertise in trusts and estates, as well as working with family groups. She is licensed to practice in New York and is a member of the New York State Society of Certified Public Accountants. Ms. Mintzer is the co-author of The Everything Money Book: Learn How to Manage, Budget, Save and Invest Your... READ MORE +