Using Debt to Leverage a Taxable Gift to a QPRT

Editor: Stephen E. Aponte, CPA

A wealthy client recently wanted advice on how the purchase of a vacation home might affect her estate plan. She was 66, a widow, and in good health. She had a large taxable estate and had a little less than half of her applicable unified estate and gift tax credit remaining. The property she planned to purchase was expected to appreciate significantly in the long term, and she was concerned that the property could trigger significant estate taxes. While she wanted to enjoy the property during her life, she also wanted to pass the property on to her adult children. Given her situation, a qualified personal residence trust (QPRT) could help her achieve her goals.

QPRT Basics

A qualified personal residence trust is a trust created to own a personal residence of the grantor for the benefit of the grantor’s spouse, children, or charity. The grantor makes a gift of a personal residence into the trust while retaining a right to occupy the residence for a term of years. Once the term is up, the grantor relinquishes the property to the beneficiaries, and the asset is gone from the grantor’s estate.

When the grantor contributes the property to the QPRT, a taxable gift has been made to the beneficiaries for the remainder interest in the property. To determine the amount of the gift, one has to calculate the value of the retained interest by the term holder. The value of the term has an actuarially determined value that consists of two components: a reversionary interest and an income interest. The reversionary interest is the value of the chance that the property might revert to the estate if the term holder does not outlive the term of the trust. The income interest is the value of the retained right to live in and use the property during the term. Both interests are calculated using the applicable Sec. 7520 rate and valuation tables.

Planning tip: As the applicable Sec. 7520 rate increases, the value of the remainder interest goes down, as does the taxable gift in turn. Similarly, an older grantor decreases the value of the remainder interest, as does extending the term of the trust. A client with a large estate who is in good health and is older (and if the Sec. 7520 rate is favorable) might be a good candidate for a QPRT.

A QPRT can own only one personal residence of the grantor and certain other assets. A personal residence for purposes of a QPRT is one for which the “primary use” is for that of the term holder when occupied by the term holder (Regs. Secs. 25.2702-5(b)(2)(iii) and (c)(2)(iii)). Primary use is satisfied provided that the property transferred to the trust meets the residence definition under Sec. 280A(d)(1), where the grantor must use the residence for the greater of 14 days or 10% of the days rented.

Certain other assets a QPRT can hold include appurtenant structures used for residential purposes and adjacent land that can reasonably be attributed to the residence. It can also hold other property such as cash to pay for expenses, improvements, or the purchase of the initial or a replacement residence.

There are several other restrictions that must be adhered to within the governing instrument for a QPRT to maintain its status.

• The trust must cease to be a QPRT if the residence is no longer a personal residence or if it is damaged or destroyed and not replaced within two years;
• The trust must pay all income and excess cash to the term holder annually and quarterly, respectively;
• The trust must not allow for distributions of corpus to nonterm-holder beneficiaries;
• The trust cannot sell the residence to the grantor or the grantor’s spouse at any time during or after the QPRT term; and
• The trust must prohibit the exchange of the term holder’s interest (Regs. Sec. 25.2702-5(c)).

The agreement may also allow for improvements to be made to the residence, but this would create additional taxable gifts.

A QPRT converts to a grantor retained annuity trust if the residence is sold and the proceeds are not reinvested in another residence within the shorter of two years or the remaining term of the trust. If the QPRT loses its QPRT status or the term holder dies within the term, then the trust comes back into the estate. However, adjusted taxable gifts are also reduced for any gifts brought back into the estate, so the individual is no better or worse off as a result.

Leveraging the Taxable Gift to the QPRT

As mentioned earlier, the ideal client for a QPRT is someone with a potential estate tax problem, good health, advancing age, and a desire to pass on his or her wealth.

Example: J fits all of the above criteria. J is 66 at the time of the creation of the QPRT, in excellent health, has a large taxable estate, and wishes to pass her wealth on to her adult children. The one complication is that she has only $160,000 of applicable credit remaining, and the vacation home she wants to purchase costs $1.675 million. She has the funds to purchase the vacation home outright and gift it into the QPRT, but the value of the remainder interest would use up all her remaining applicable credit and generate a large gift tax liability.

To solve this problem, J should take out a $1.35 million 10-year interest-only loan and structure the term of the QPRT over 10 years. The remainder interest is calculated based on the $325,000 equity in the vacation home, the prevailing Sec. 7520 rate, her age, and the 10-year term. The gift of the remainder interest in the QPRT is approximately $140,000 and is much less than her remaining applicable credit. By utilizing the debt, J is able to leverage the gift to the QPRT and get a highly appreciating asset out of her estate at a very low gift tax cost.

Planning tip: It is important that the debt be structured as an interest-only loan. If the debt is a typical mortgage, then each payment of principal is considered a taxable gift.

J‘s adult children will ultimately inherit the debt, but they will also inherit all the appreciation the house accumulates over the course of the term of the trust. However, in true leverage fashion, the rate of return on the initial equity will be much larger than it would have been had debt not been used. Therefore, this is an excellent technique to maximize one’s applicable credit.

In addition, the mortgage interest and the property taxes J pays are expenses of the income beneficiary of the trust (J), so she can pay these expenses without any gift tax consequences and still take the income tax deduction for both.

Disadvantages of a QPRT

QPRTs do not come without drawbacks and may not fit every client’s situation. Once the term of the trust is up, the grantor must relinquish ownership of the property or pay fair market value rent to the trust if he or she intends to still live in or use the residence beyond the term. In addition, the grantor’s basis in the residence carries over to the beneficiaries, so there could be adverse income tax consequences to weigh against the potential estate tax benefits.

Having debt on the property can create some severe administrative and gift tax complications. If the debt is not an interest-only loan and the grantor is making principal payments on the mortgage, an additional gift is made each time a principal payment is made and new QPRT calculations will have to be performed every time a payment is made. Therefore, it is advisable to carry interest-only debt on the property, pay off the debt before gifting the property, or structure the mortgage payments as a loan to the QPRT.

EditorNotes

Stephen E. Aponte is senior manager at Holtz Rubenstein Reminick LLP, DFK International/USA, in New York, NY.

Unless otherwise noted, contributors are members of or associated with DFK International/USA.

For additional information about these items, contact Mr. Aponte at (212) 792-4813 or saponte@hrrllp.com.