A qualified personal residence trust (QPRT) has long been a favored estate tax planning vehicle, given it is simple to establish, its existence is provided for in IRS regulations, and it requires little sacrifice on the donor's part.
Essentially, a donor transfers a personal residence to a trust for remainder beneficiaries, generally children or a trust for children, and retains an interest in the trust (i.e., the right to live in the residence for a term of years). Upon funding the QPRT, the donor has made an irrevocable gift to the beneficiaries, but the value of the residence is discounted for gift tax purposes based on the actuarial value of the donor's retained interest. During the initial trust term (i.e., the period of the donor's retained interest), the donor continues to occupy the residence rent-free, pays normal operating expenses, and claims the relevant income tax deductions on his or her personal return. Not much changes following the gift, which is appealing for donors who are reluctant to part with assets during their lifetime. However, all good things must end, and the end of a QPRT's initial trust term brings with it many potential issues.
What Happens After the Initial Trust Term?
Assuming the donor survives the initial trust term, one must understand what happens to the residence once the donor's interest ends. Typically, the trust agreement will call for the residence to be distributed outright or retained in trust for the beneficiaries. To ensure correct titling of the client's assets, the title should be transferred into the name of the remaindermen, whether that is a trust or individuals.
The form of ownership following the initial trust term will have significant income and estate tax implications, so it is critical to read and understand the trust agreement. If the residence is distributed outright, then each individual beneficiary will own a fractional piece of the property. However, if the property is retained in the trust or distributed to another trust, the income tax status of the trust after expiration of the initial term must be determined. During the initial trust term, a QPRT is a grantor trust under Sec. 677(a) as to the income portion and possibly also Sec. 673(a) for the remainder of the trust, but whether the QPRT remains a grantor trust after the initial trust term depends upon the language in the trust agreement. Generally, the power of substitution under Sec. 675(4) is not available to provide for grantor trust status in a QPRT, but look for other grantor trust language under Secs. 673-677, such as a spousal interest or a power to add charitable beneficiaries. If it is not a grantor trust, the normal fiduciary income taxation rules of Subchapter J would apply.
Regardless of whether an individual beneficiary or a trust owns the property following the initial trust term, the donor must pay fair market rent to continue occupying the property. Failure to do so can result in the IRS's pulling the full value of the residence into the donor's estate under Sec. 2036. Ideally, the donor and the new owner should execute a rental agreement before the initial trust term expires and obtain an appraisal or realtor opinion that sets forth the fair rental value in the agreement. Rent payments from a parent to the next generation allow for additional tax-efficient transfers out of the donor's estate, so a healthy but supportable market rate of rent should be considered.
Income Tax Issues
If the QPRT remains a grantor trust after the initial trust term or distributes the residence to another trust that is a grantor trust with respect to the QPRT donor, then the income tax issues are greatly simplified. A donor paying rent to a grantor trust for which she is treated as the grantor is in effect paying rent to herself under the federal income tax law. As a result, the rental income is disregarded for income tax purposes, and any deductible real estate taxes and mortgage interest expense are reported directly on the donor's individual tax return. If applicable, the Sec. 121 exclusion on the sale of a personal residence may still be available. Given that the trust is a grantor trust, no taxpayer identification number (TIN) or Form 1041, U.S. Income Tax Return for Estates and Trusts, is typically required. Advisers considering establishing a QPRT for a client should plan ahead and consider the income tax implications of the trust after the initial term.
For trusts that are not grantor trusts (or in the case of payments directly to beneficiaries), the rental payments made by the QPRT donor would be taxable rental income to the trust or beneficiaries. A TIN and Form 1041 will likely be required for a trust, and if the residence is owned by individual beneficiaries, they would need to complete Schedule E, Supplemental Income and Loss, to report rental income and related expenses. Available expenses will depend upon the lease agreement in place.
Generally, the lessor (in this case, the trust or children) will deduct depreciation expense and the cost of insuring the property. Other costs such as real estate taxes, normal repair and maintenance expenses, and utilities could be borne by either the lessor or lessee depending upon the lease agreement. The total gross rent paid by the donor including expenses paid by the donor should represent a market rate of rent for similar properties in the area. Assuming a market rate of rent is paid, the related-party rules disallowing certain expenses should not apply (Sec. 280A(d)(3)).
In calculating the depreciation deduction, the beneficiary will need to determine the tax basis in the property. Generally, because the donor originally gifted the property to the QPRT, the beneficiary's tax basis will be the same as it would be in the hands of the donor (Sec. 1015(a)). The donor's tax basis at the time of the QPRT funding plus or minus any required adjustments such as improvements while owned by the QPRT will determine the basis for depreciation purposes as of the end of the initial trust term. Furthermore, the beneficiaries should capitalize and depreciate additional improvements after the initial trust term.
Other Planning Issues
Generally, the regulations prohibit QPRTs from selling or transferring the residence, directly or indirectly, to the grantor, the grantor's spouse, or an entity controlled by the grantor or the grantor's spouse during the retained term interest of the trust, or at any time after the retained term interest if the trust continues as a grantor trust (Regs. Sec. 25.2702-5(c)(9)). However, trusts created before May 17, 1996, are not subject to this requirement (Regs. Sec. 25.2702-7). For grandfathered QPRTs, a repurchase by a donor provides the option to transfer the residence into a new QPRT or bring the residence back into the donor's estate to achieve a step-up in basis at death under Sec. 1014. Because of these potential estate and income tax benefits, a repurchase should be considered in some cases before the end of the trust term, if grantor trust status ends with the initial trust term. If it is not a grantor trust after the initial trust term, then a repurchase after the end of the initial term will result in a taxable event.
For grandfathered trusts, this option to repurchase the property makes decision-making difficult, especially when the property is held until death. A higher rent amount and/or a higher return on the real estate obviously favors retaining the property in the trust and renting it to the grantor. To the extent the client expects additional growth in value in the real estate, it would make sense to leave the property in the trust. If the client thinks that the real estate is fully valued, then it may make sense to lock in that appreciation via a sale. Additionally, a higher expected return on the invested assets from the purchase would favor a purchase with as much cash as possible since a sale in exchange for a note would produce a significant drag on the trust's return. Clients will need assistance in modeling the expected future estate and income tax benefits under multiple scenarios.
Generation-Skipping Tax Provisions
Lastly, QPRTs are subject to the estate tax inclusion period (ETIP) rules, which require the assets of the trust to be included in the transferor's estate during the term of the retained interest (i.e., through the initial trust term). The ETIP rules make QPRTs poor vehicles for generation-skipping transfer (GST) tax planning because upfront allocations of GST tax exemption are ineffective. However, be aware the ETIP ends at the end of the initial trust term, and if the QPRT distributes property to a GST trust, an automatic allocation of GST tax exemption could occur at the fair market value of the property on the date the initial trust term ends. A Form 709, United States Gift (and Generation-Skipping Transfer) Tax Return, should be filed in the year the ETIP closes to report the GST allocation or to opt out of the automatic allocation rules.
Anthony Bakale is with Cohen & Company Ltd. in Cleveland.
For additional information about these items, contact Mr. Bakale at 216-774-1147 or firstname.lastname@example.org.
Unless otherwise noted, contributors are members of or associated with Cohen & Company Ltd.