The Qualified Personal Residence Trust
By Stuart G. Schmidt, Esq.

A Qualified Personal Residence Trust ("QPRT") is an irrevocable trust which allows an individual to structure a gift of a principal residence or vacation home from one generation to the next, while significantly minimizing estate and gift taxes. A person can transfer a residence to a QPRT, retain the right to live or use the residence for a number of years (this term of years or "trust term" is chosen by the "Grantor" of the residence) and name one or more family members as the beneficiaries of the property. At the end of the trust term, the property can remain in trust for the beneficiaries or be distributed outright to them.

The Value of a QPRT Gift

The gift of a residence to a QPRT trust will not be valued at the full fair market value of the property. Instead, the value of the gift will be the value of the residence reduced by the value of the Grantor's retained interest (i.e. the Grantor's right to live in the home during the trust term) and the value of the reversion (i.e. the possibility that the residence will revert to the Grantor's estate if he or she dies within the trust term). Determining the value of the gift requires a complex calculation based on the length of the trust term, the current Federal Mid-Term Interest Rate and the Grantor's age.

The estate and gift tax savings from the use of a QPRT can be substantial. For example, if a 65 year old Grantor transfers a residence with a current value of $1,000,000 to a QPRT and retains the right to live in the home for eleven years, the gift will only be valued at approximately $339,000. If the property appreciates in value to $1,500,000 at the end of the eleven year trust term, the Grantor will have transferred an asset worth $1,500,000 while paying gift tax on the transfer as if the asset were only worth $339,000. Utilizing a QPRT in this situation results in a minimum tax savings of $344,500.00. If the Grantor owned other assets, the tax savings would be even greater.

While a transfer of a residence to a QPRT is an immediate gift, requiring the filing of a gift tax return, no gift tax is usually due. As long as the Grantor has not previously made substantial gifts and used his "unified credit" or "applicable exclusion amount" (a tax credit given by the government which equals $650,000 for 1999 and increases to 1 million by 2006), the Grantor would not pay gift tax to the Internal Revenue Service (IRS). The gift would simply reduce the Grantor's tax credit available for future transfers.

Specific Requirements of the Trust

QPRTs are specifically authorized by Internal Revenue Code § 2702 and accepted by the IRS, provided the trust meets specified requirements. One requirement is that the Grantor must spend at least some time in the residence. Because family members or even tenants are not precluded from using the residence, this rule will often be easy to satisfy with a rental/vacation property. The federal government recognizes that excessive use of QPRTs can reduce the estate and gift tax revenue; consequently, each individual may only establish two QPRTs. Generally, this is adequate for most people in that it allows for a QPRT to be used for a person's primary residence and a vacation home.

Grantor's Control During the Trust Term

A QPRT is irrevocable. Therefore, the Grantor will not have the power to alter, amend, revoke, or terminate the QPRT after it is created. It is established for the sole purpose of holding a personal residence for the trust term, and thereafter retaining the residence in trust for the beneficiaries or transferring the residence outright to the individual or individuals specified in the trust agreement.

The Grantor has the right to use the residence during the trust term, may retain complete control over the use and occupancy of the residence, and has sole responsibility for real estate taxes, general maintenance, and repairs. Not only may the Grantor decide how the residence is used and or managed, but whether the home should be sold. The Grantor may sell the residence at any time during the trust term and reinvest the proceeds in a new residence. However, the replacement residence must be purchased within two years from the sale and must be held in the QPRT.

The End of the QPRT Term

In order to gain the tax savings of the QPRT, the Grantor must survive the trust term. If the Grantor dies during the trust term, the full value of the residence will be included in the Grantor's estate and the estate and gift tax savings will not be realized. However, there are no adverse consequences; the Grantor will merely be in the same position as if the QPRT was never created.

If the Grantor survives the trust term, the Grantor will no longer be the beneficial owner of the residence. Rather, the property will be owned by the trustee, which can be the Grantor if the property is to remain in trust, or the beneficiaries. When initially creating the QPRT, the Grantor must decide whether the property will remain in trust at the end of the trust term and be controlled by the trustee or whether the property should be given outright.

The most frequently asked question, therefore, is whether the Grantor can continue to live in the residence at the end of the trust term? While it is risky to give the Grantor a legal right, he or she can enter into a lease with the legal owner of the property to continue to live in the residence at the fair rental value. Such an arrangement actually has the added advantage of further reducing the value of Grantor's estate through monthly rental payments to the owners of the property (the beneficiaries).

The Income Tax Consequences

Because a QPRT is a gift during life, the beneficiaries will receive the property with the same income tax basis as the Grantor. If the Grantor holds the property until death, the property would receive a step-up in basis which would result in no income tax on an immediate sale by the beneficiaries. While a QPRT forfeits the advantage of a step-up in basis, it is important to keep in mind that the estate and gift tax rates of 37% - 55% are much higher than the income tax rates for long term capital gains on real property which are 20%.

Conclusion
The Qualified Personal Residence Trust is an excellent tool to achieve significant estate tax savings. If you have any questions and/or would like me to calculate your estate and gift tax savings that can be achieved through the use of a QPRT, please call me at (408) 356-3000. You may also contact me via e-mail at sschmidt@smwb.com.