Americans have enjoyed historically high estate tax exemption rates for most of the last twenty years. Such high exemption amounts have kept many of them from needing to seek out more advanced estate planning strategies to avoid estate taxes, which have been as high as 60 percent during those same years. However, it is uncertain what the estate tax exemption amounts and rates will be in the future. The current federal administration may decide to reduce the estate tax exemption amounts in an effort to raise revenue to fund many of the high-cost government programs being implemented today. Even if the current federal administration does not act, the current high estate tax exemptions are scheduled to sunset (be cut in half) at the end of 2025. Additionally, Minnesota residents face estate tax exposure if their total estate exceeds $3 million. Therefore, for individuals and families whose wealth is significant enough that their estates could be subject to estate taxes, it can be important to be aware of some of the tried-and-true strategies for reducing their taxable estate’s value to avoid paying more tax at death than absolutely necessary. One strategy is the qualified personal residence trust (QPRT).
The Benefits of Qualified Personal Residence Trusts
A QPRT is a specific type of irrevocable trust that is designed to own a taxpayer’s personal residence. If a QPRT is designed and implemented correctly, it offers the taxpayer a number of benefits:
- The transfer of the home to the trust beneficiaries during the taxpayer’s life can be made for significantly less tax liability than if it were transferred at the taxpayer’s death.
- The appreciation in the home’s value over subsequent years is removed from the taxpayer’s taxable property.
- The taxpayer can continue to live in the home rent-free for a period of time.
- The taxpayer can further reduce their taxable property’s value by paying rent to the trust after a specified period of time.
- The QPRT can hold the residence in continuing trust for the beneficiaries, thereby providing robust asset protection from the beneficiaries’ creditors, divorcing spouses, bankruptcies, etc.
Requirements of a QPRT
Generally speaking, the way a QPRT works is that the taxpayer who owns a personal residence must transfer the property by recording a deed with the local property registry retitling the residence in the QPRT’s name. Within the terms of the trust, the grantor (the taxpayer) retains the right to reside in the home for a specific number of years (term). As a result of the taxpayer reserving the right to live in the property, the taxable value of the gift to the QPRT can be discounted under federal tax law. The longer the term, the greater the gift’s valuation discount. When the term ends, the grantor’s right to live in the home terminates, and the trust beneficiaries (usually, the grantor’s children) receive the residence either outright (if the trust is designed to terminate at the end of the term) or in further trust for asset protection purposes. If the grantor wishes to continue to live in the home, they can rent it at fair market value, which allows the grantor to make additional transfers of cash to the trust, transfer tax-free, for the benefit of the beneficiaries.
For the taxpayer to realize the above benefits, a QPRT must be carefully designed and implemented. For the trust to qualify as a QPRT under federal tax regulations, the following terms must be included[1]:
- All income generated by the trust must be distributed to the trust’s grantor at least annually.
- The QPRT cannot allow the distribution of trust principal to any beneficiary other than the grantor before the term expires.
- The trust can hold only one residence with a reserved right of occupancy during the specified term and cannot hold any other type of property (with some limited exceptions to help maintain and insure the home).
- The QPRT must prohibit termination of the trust and distribution of trust property among the beneficiaries prior to the expiration of the trust term.
- The trust must require that if the residence is no longer being used as the grantor’s personal residence, the trust will cease to qualify as a QPRT.
- The trust must provide that if the home is damaged or destroyed to the degree that it becomes uninhabitable, the trust will cease to be a QPRT unless the home is repaired or replaced before the earlier of two years after the damage occurs or the expiration of the grantor’s residency term.
- The QPRT must not allow the trust to sell or transfer the residence to the donor, their spouse, or an entity controlled by either of them at any time during the grantor’s residency term or at any time after the grantor’s residency term that the trust remains a grantor trust.
In addition to the property, the QPRT can hold cash for a short period of time to allow for the payment of trust expenses such as mortgage payments or home improvements or to allow the trust to purchase a replacement residence should the residence be sold with the intent of replacing it.
Possible Downsides of QPRTs
As with most things tax related, whenever you get a tax benefit, there are going to be trade-offs that must be considered, and the same holds true for QPRTs. Before you decide to use a QPRT in your estate planning, consider the following:
- There are legal and professional fees associated with the formation, funding, and tax reporting of a QPRT.
- In some states, holding a personal residence in a QPRT can result in reassessment of property tax liability and higher property taxes or a loss of certain property tax exemptions or abatements.
- After the QPRT’s term ends, the grantor must give up the right to occupy the residence and, if they desire to continue living there, they can do so only by renting the property from the QPRT beneficiaries, which can create an awkward situation in some families.
- Transferring the residence to the QPRT causes it to have a carryover basis in the hands of the beneficiaries, resulting in potential taxes if they choose to sell the property after the term ends.
- Transferring a residence that has a mortgage on it may complicate proper accounting for the tax aspects associated with mortgage payments and deductions. It is generally recommended to transfer only homes that are not encumbered by a mortgage.
Who Should Consider Using a QPRT?
A QPRT is a sophisticated estate tax planning tool that can allow a homeowner to transfer their property to the next generation with significant tax savings, both on the transfer and by removing the home’s future appreciation from the grantor’s estate. Those with an already high net worth who may be facing estate taxes upon their death, and who anticipate high appreciation in their personal residence may want to consider using a QPRT in their estate planning. Nevertheless, because of the many tax and nontax considerations associated with this tool, it is important to use an attorney and tax professional who can help you weigh the benefits against the downsides of using a QPRT to determine if it is an appropriate tool for your own situation. If you would like to learn more about this strategy for yourself and your loved ones, we are ready to assist you.
[1] Treas. Reg. § 25.2702-5(c)(1).
