A qualified personal residence trust (QPRT) is a statutory estate freeze technique that generally has a grantor making a gift of a remainder interest in a personal residence (often to children) while retaining an interest in the home for a term of years (Sec. 2702; Regs. Sec. 25.2702-5(c)). The gift to the QPRT is a completed gift for federal gift tax purposes. Further, if the grantor survives the QPRT term, the property is not included in the grantor's estate for federal estate tax purposes.
Treasury regulations set forth several requirements for a trust to qualify as a QPRT. Among those requirements, the trust is generally prohibited from holding any asset other than the principal or one other residence to be used or held for use by the grantor, or an undivided fractional interest in either (Regs. Secs. 25.2702-5(b)(1) and (c)(2)(i)). What then happens if the residence is sold during the QPRT term?
Sale of residence and reinvestment of all of the proceeds in a new residence
Despite the requirement that the QPRT must hold a residence, QPRT status will not necessarily be terminated if the residence is sold during the QPRT term. In fact, Regs. Sec. 25.2702-5(c)(7)(ii) provides that a QPRT may continue as such and hold the proceeds from the sale of the residence until the earliest of: (1) two years after the date of sale; (2) the QPRT term ends; or (3) the QPRT acquires a new residence. The trust agreement must permit the trust to hold sale proceeds (Regs. Sec. 25.2702-5(c)(7)(ii)). If the trust agreement does not, the trust will cease to be a QPRT even if the proceeds are otherwise held in compliance with the regulations.
If the QPRT reinvests all of the proceeds from the sale of the house by purchasing a new residence of equal or greater value and does so before the earlier of (1) two years from the date of sale or (2) the date the QPRT term ends, the trust's QPRT status will continue. The replacement residence must meet the same requirements as the original residence. That is, the replacement residence must be used or held for use as the primary or one other residence of the grantor (Regs. Secs. 25.2702-5(b)(1) and (c)(2)(i)).
Because a QPRT usually qualifies as a grantor trust under Secs. 677 and 673, the grantor may exclude up to $250,000 ($500,000 if married filing jointly) of gain on the sale of a principal residence in the QPRT, provided the requirements of Sec. 121 are met—including that the residence was used as the grantor's principal residence for at least two of the preceding five years.
Sale of residence and reinvestment of some, but not all, of the proceeds in a new residence
Of course, the replacement residence does not always have a value equal to or greater than the sales proceeds. Often, a grantor looks to downsize and purchases a smaller home, leaving the QPRT with a replacement residence and excess cash. Here, the QPRT status will continue for the replacement residence, but the excess cash will not qualify as an eligible QPRT asset. Within 30 days following the date in which some or all of the trust loses its QPRT status, the trust agreement must provide for, or give the trustee the discretion to choose between, one of the following options:
- The nonqualifying assets (here, the excess cash) are distributed outright to the grantor; or
- The nonqualifying assets are segregated, and that portion of the trust is converted to a grantor retained annuity trust (GRAT) for the remainder of the QPRT term (Regs. Sec. 25.2702-5(c)(8)(i)).
For those QPRTs where the grantor is also serving as trustee and the trust agreement requires the distribution of the excess cash outright to the grantor, the initial gift of the remainder interest will be an incomplete gift (Regs. Sec. 25.2511-2). Further, all of the excess cash will be brought back into the grantor's estate for federal estate tax purposes. On the other hand, a conversion to a GRAT will at most lead to only some of the excess cash going back into the grantor's estate. Consequently, only the second option is sometimes drafted into the QPRT document. In fact, the IRS's sample QPRT form includes the GRAT conversion as the sole option for the trustee following the termination of QPRT status for some or all of the trust's assets (Rev. Proc. 2003-42).
The GRAT conversion requirements are set forth in Regs. Sec. 25.2702-5(c)(8)(ii). Of particular note is the annuity start date. The grantor's right to receive the annuity begins on the date the original residence was sold, known as the "cessation date." Recall that sale proceeds may be retained by the QPRT for up to two years before needing to be reinvested, distributed outright, or converted to a GRAT. This timing difference may lead to an accrual of annuity payments deferred during the time between the date the residence is sold and the date the QPRT status ceases for the excess cash. Any deferred annuity payments must bear interest during the deferral period at a rate not less than the Sec. 7520 rate (Regs. Sec. 25.2702-5(c)(8)(ii)(B) and Rev. Proc. 2003-42). If permitted by the trust agreement, the trustee may reduce the aggregate deferred annuity payments by the amount of any income actually distributed to the grantor during the deferral period (Regs. Sec. 25.2702-5(c)(8)(ii)(B)).
While the mechanics of a GRAT annuity calculation are beyond the scope of this item, note that the annuity calculation for a partial conversion of the QPRT is simply the annuity calculation for a full conversion of the QPRT to a GRAT (discussed below), multiplied by the ratio of the non-QPRT assets to the total value of all assets in the trust.
Sale of residence and no reinvestment of the proceeds in a new residence
The sale of the residence without any reinvestment of the proceeds in a new residence will cause the QPRT status to terminate as to all of the assets. The complete termination works much the same as described above for a partial termination—the QPRT assets must be distributed in total to the grantor, or the entire QPRT must be converted to a GRAT. This, of course, defeats the QPRT's intention of removing the trust assets from the grantor's estate. Timing is a significant factor in reducing the negative impact of a sale of the residence during the QPRT term—a sale at the beginning of the QPRT term will cause a longer annuity stream to the grantor, and subsequently more assets going back to the grantor's estate, than would a sale at the end of the QPRT term.
While a QPRT can be a valuable estate freeze technique, to maximize the intended benefits, grantors should be committed to retaining the residence for the duration of their retained interest or reinvesting all of the sale proceeds in a replacement residence.
Kevin Anderson is a partner, National Tax Office, with BDO USA LLP in Washington.
For additional information about these items, contact Mr. Anderson at 202-644-5413 or email@example.com.
Unless otherwise noted, contributors are members of or associated with BDO USA LLP.