Anthony T. Lee, Esq.
TABLE OF CONTENTS
II. QPRT Requirements
III. Estate, Gift and Income Tax Considerations
IV. Other Planning Considerations
QUALIFIED PERSONAL RESIDENCE
A. Estate Planning Opportunity
The transfer of a personal residence to a qualified personal residence trust (“QPRT”) can provide substantial estate tax savings while preserving the grantor’s use and enjoyment of the residence. The opportunity in using a QPRT is to eliminate a substantial portion of the value of the personal residence (including future appreciation) from the grantor’s gross estate if the grantor outlives the term of the trust.
B. Internal Revenue Code §2702
1. Personal residence trusts were sanctioned by Congress in 1990 under §2702 and the regulations thereunder. A personal residence trust is a specific exception to the general valuation rule of §2702 which provides that the value of an interest retained by a grantor in connection with a gift of property in trust for the benefit of a family member is zero. If the personal residence trust requirements are met, the value of the gift of the remainder interest in the residence is determined under traditional gift tax rules by subtracting from the total fair market value of the residence (a) the present value of the grantor’s retained income (use) interest and, if the grantor retains a reversion, (b) the present value of the grantor’s reversionary interest.
2. Section 2702 was enacted to address a perceived abuse of common law grantor retained income interest trusts. Congress was specifically concerned that the use of Treasury valuation tables undervalued transferred remainder interests more often than not and determined that these valuation problems were best addressed by valuing retained interests at zero unless they took an easily valued form (i.e., an annuity or unitrust interest). The primary purpose in enacting §2702 was to ensure a more accurate gift tax valuation of the initial transfer of interests in trust to family members.
3. Under §2702, the value of any interest retained by a grantor in connection with a gift of property in trust for the benefit of a family member is zero, unless the interest is a “qualified interest” as provided in §2702(a)(2)(B). If a retained interest is a “qualified interest” then the value is determined under §7520. If a retained interest is valued at zero, rather than under the §7520 tables, the value of the gift for purposes of the gift tax is the fair market value of the property transferred.
4. Section 2702 defines a “qualified interest” to be (i) a qualified annuity interest (a “GRAT”), (ii) a qualified unitrust interest (a “GRUT”), or (iii) a qualified remainder interest (that is, a noncontingent remainder interest if all the other interests in the trust consist of either qualified annuity interests or qualified unitrust interests).
5. Section 2702(a)(3)(A) creates three exceptions to the general valuation rule of §2702(a)(1). (Note that the exceptions are in addition to the rule that transfers of qualified interests fall outside of §2702 for gift tax valuation purposes.)
(a) A transfer that is an “incomplete gift.” The primary purpose of this exception is to exclude a transfer to a revocable trust. §2702(a)(3)(A)(i).
(b) A transfer of an interest in a trust consisting only of “a residence to be used as a personal residence by persons holding term interests in such trust.” §2702(a)(3)(A)(ii). This section is the personal residence trust exception to the general valuation rule of §2702.
(c) The third exception provides for a regulatory exception “not inconsistent with the purposes of [§2702].” (This exception is explained in the legislative history as being available “to except a charitable remainder trust . . . that does not otherwise create an opportunity for transferring property to a family member free of transfer tax.”) §2702(a)(3)(A)(iii).
6. The §2702(a)(3)(A)(ii) exception permits the creation of a trust for a personal residence which, for gift tax valuation purposes, operates like a common law grantor retained income trust or “GRIT” (which continue to be available when the remaindermen are not members of the grantor’s family). The regulations, however, impose a number of requirements that must be satisfied to fit within the personal residence trust exception.
7. The personal residence requirements are contained
in Reg. §25.2702-5(b), applicable to personal residence trusts, and
in Regs. §25.2702-5(c), applicable to qualified personal residence
trusts. Generally, QPRTs are more advantageous than personal residence
trusts since QPRTs offer more flexibility. For example, a personal
residence trust may only hold a personal residence and “qualified proceeds”
(i.e., proceeds payable as a result of damage to or destruction or involuntary
conversion of the residence). Regs. §25.2702-5(b)(1) and (3).
In comparison, a QPRT may hold a certain amount of cash to pay for trust
expenses. Also, the residence cannot be sold by the trustee of a
personal residence trust without disqualifying the trust. Id.
This prohibition does not apply to QPRTs (except with respect to sales
to the grantor, the grantor’s spouse, a grantor trust of the grantor or
the grantor’s spouse, or an entity controlled by the grantor or the grantor’s
II. QPRT Requirements
A. Personal Residence
1. A QPRT may only hold only one residence of the grantor to be used or held for use as a personal residence of the term holder. Regs. §25.2702-5(c)(5)(i). A “personal residence” is defined as either: (i) the principal residence of the term holder (within the meaning of former §1034 – relating to the nonrecognition of gain upon sale of a principal residence – repealed by the Taxpayer Relief Act of 1997, after publication of the §2702 regulations); (ii) one other residence of the term holder (within the meaning of §280A(d)(1) – without regard to §280A(d)(2) – relating to property which is used in part as a residence 2); or (iii) an undivided fractional interest in either of the foregoing. Regs. §25.2702-5(c)(2)(i). Consequently, the regulation s limit a grantor to creating only two QPRTs and, if two QPRTs are created, one must hold the grantor’s principal residence.
2. One commentator indicates that the IRS has stated unofficially that a second residence must actually be used by the grantor for sufficient time to qualify as §280A property during the calendar year in which the trust is created and satisfaction of the “held for use” requirements in that year will not satisfy the QPRT requirements (although this position seems inconsistent with the regulations). See U.S. Trust – Practical Drafting (April 1999). In any event, it is clear that actual use for any specific number of days in any subsequent year is not required provided that the property is “held for use” by the grantor for the requisite time period.
3. The IRS has ruled that shares of stock in a cooperative apartment qualify as a “personal residence” under §2702 and thus may be transferred to a QPRT. PLRs 944803; 9249014; 9151046. The IRS has also ruled that a taxpayer’s beneficial interest in cooperative apartment stock qualifies as a personal residence under §2702 where the cooperative association does not allow the cooperative stock to be transferred to a trust. PLRs 9447036 and 9433016.
4. Married couples may together create three QPRTs, one to hold their principal residence and two others which may hold second homes. Since the couple shares the principal residence, each would actually be deemed to have only created two QPRTs within the limits set by the regulations under these circumstances.
5. A residence will not fail to qualify as a personal residence merely because the grantor allows a friend (or his or her spouse) to reside there with him (PLR 9249014) or occasionally allows house guests to use the residence rent-free (PLR 9448035). Nor will the leasing of a portion of the property to an unrelated third party result in disqualification, provided the residence continues to remain the grantor’s personal residence (PLRs 199916030 and 199906014).
B. Additional Property
1. A personal residence may include appurtenant structures used by the term holder for residential purposes and adjacent land not in excess of that which is reasonably appropriate for residential purposes (taking into account the size and location of the residence). Regs. §25.2702-5(c)(2)(ii). The IRS has held, in numerous private letter rulings, that a personal residence may include guest houses and other appurtenant structures provided no part of the property is used for rental purposes (to the extent that the residence or any appurtenant structure no longer continues to remain the grantor’s personal residence), no individual other than the owner has any rights of continuing occupancy with respect to any appurtenant structure, and the entire property is not in excess of what is reasonably appropriate for residential purposes. See, e.g., PLR 9328040 (property consisting of 1.65 acres of land including a large single family vacation home and an adjacent small ranch-style structure used as a guest house qualifies as a personal residence); PLR 9639064 (property consisting of 43 acres improved by a single family residence, swimming pool, pool house, green house, tool shed and barn with attached corral and quarters for a caretaker and housekeeper qualifies as a personal residence); PLR 9645010 (property consisting of 16.6 acres improved by a principal residence with two guest apartments, a swimming pool, and tennis court qualifies as a personal residence where subdivision is impracticable or impossibile and neighboring properties have similar characteristics); PLR 9714025 (three parcel property containing guest house, caretaker’s residence, carriage house, pool building, and storage barn qualifies as a personal residence); PLR 9718007 (property consisting of main residence, separate guest facilities, a caretaker’s house, and other appurtenant structures that has been used by the grantor’s family continuously and exclusively as a vacation residence since 1951 is not in excess of what is reasonably appropriate for residential purposes); PLR 9818014 (property consisting of main house used by spouses and their unmarried children as their residence, a guest cottage and garage apartment used for family guests, a swimming pool with a cabana and pump shed, and two barns used to stable a riding horse and store equipment used to maintain the property, qualifies as a personal residence, where the total acreage is comparable in size to other residential properties in the area and no part of the property is used for farming or rental purposes).
2. A QPRT may hold additions of cash for payment of trust expenses or for improvements to the residence, subject to certain specific requirements (discussed below in section III.A.3.). Regs. §25.2702-5(c)(5)(ii).
3. A QPRT may permit improvements to the residence to be added to the trust, provided that the residence, as improved continues to meet the requirements of a personal residence. Regs. §25.2702-5(c)(5)(ii).
4. A QPRT may permit the sale of the residence (with certain exceptions discussed below in section III.D.2.) and may permit the trust to hold proceeds from the sale of the residence. Regs. §25.2702-5(c)(5)(ii).
A QPRT must prohibit commutation (prepayment) of the term holder’s interest. Regs. §25.2702-5(c)(6).
D. Cessation of QPRT
1. A QPRT must provide that the trust ceases to be a QPRT if the residence ceases to be used or held for use as a personal residence of the term holder. Regs. §25.2702-5(c)(7). If the QPRT permits the trust to hold proceeds of sale of the residence, the QPRT must further provide that the trust ceases to be a QPRT with respect to all proceeds of sale held by the trust not later than the earlier of: (i) the date that is two years after the date of sale; (ii) the termination of the term holder’s interest in the trust; or (iii) the date on which a new residence is acquired by the trust. Regs. §25.2702-5(c)(7)(ii).
2. A QPRT must provide that,
within 30 days after the date on which the trust has ceased to be a QPRT
with respect to certain assets, either: (i) the assets be distributed
outright to the term holder; or (ii) the assets be converted to and held
for the balance of the term holder’s term in a separate share of the trust
meeting the requirements of a GRAT. Regs. §25.2702-5(c)(8).
III. Estate, Gift and Income Tax Considerations
A. Gift Tax Considerations
1. If a trust qualifies as a personal residence trust under §2702(a)(3)(A)(ii), the transfer to the trust is not valued for gift tax purposes under the special valuation rules of §2702. In other words, the transferor’s retained interest is not treated as having a value of zero. Instead, the value of the gift is determined under traditional gift tax rules by subtracting from the total fair market value of the residence (a) the present value of the grantor’s retained income (use) interest and, if the grantor retains a reversion, (b) the present value of the grantor’s reversionary interest.
2. Computation of the taxable remainder interest in a QPRT is determined using the IRS valuation tables prescribed by §7520 and takes into consideration several factors, including the term of the trust, the applicable interest rate (120% of the federal mid-term rate for the month in which the valuation date falls – rounded to the nearest 2/10 of 1%), and the grantor’s age (as of the grantor’s birthday which is closest to the date of the transfer of the residence to the QPRT). The IRS valuation tables are found in Publication 1457, Actuarial Values Alpha Volume.
3. Gifts to a QPRT occur when: (a) the residence is initially transferred to the trust; (b) later contributions of cash are made to the trust; and (c) the grantor (or other person) pays for capital expenses (i.e., expenses allocable to trust principal) or improvements directly.
(a) Although contributions made after the initial transfer of the residence to the trust should fall within the personal residence trust exception to the valuation rule of §2702(a)(1), such contributions will constitute additional gifts that are valued using different actuarial factors, that is, the term, ages, and rates applicable to the date of contribution, rather than those applicable to the initial transfer of the residence to the trust. The grantor’s retained interest will make up a smal ler portion of the total value of a later contribution than it did of the original transfer (all other factors being equal) because the grantor’s retained term at the time of the additional contribution will be shorter than it was at the creation of the QPRT.
(b) A QPRT may permit additions of cash to the trust and may permit the trust to hold additions of cash in a separate account, in an amount which, when added to the cash already held in the account for such purposes, does not exceed the amount required (i) for payment of trust expenses (including mortgage payments) already incurred or reasonably expected to be paid by the trust within six months from the date the addition is made to the trust, and (ii) for improvements to the residence to be paid by the trust within six months from the date the addition is made. Regs. §25.2702-5(c)(5)(ii)(A)(1)(i) and (ii). The gift tax consequences of contributions of cash for trust expenses may differ from those for improvements to the residence. Contributions for expenses that are allocable to trust income should not be gifts to the trust because they are for the benefit of the term holder (i.e., the grantor) rather than the remaindermen. See PLR 9249014 (grantor’s payment of mortgage interest payments, taxes, maintenance, utilities, repairs, and any other costs properly chargeable to a grantor’s life tenancy under the trust agreement and applicable local law – citing New York EPTL §11-2.1 3 – will not result in a gift to the remainderman). The payment of expenses allocable to trust principal, however, should constitute gifts to the trust, at least in part. For example, the principal portion of a mortgage loan payment should be treated as a contribution for an improvement to the property and, therefore, as a gift. (On the other hand, if the grantor retains a reversionary interest, the grantor is deemed to own a portion of the trust corpus and, to that extent, the principal payment of a mortgage loan should not be treated as a gift. The IRS, however, has not issued guidance on how to compute the gift tax value of a mortgage payment under these circumstances.)
(c) The trustee of a QPRT is required to determine, not less frequently than quarterly, the amount of cash held by the trust for payment of expenses in excess of the amounts permitted to be held by the trust under Regs. §25.2702-5(c)(5)(ii)(A)(1), and the excess cash, if any, must be distributed immediately to the grantor. Regs. §25.2702-5(c)(5)(ii)(A)(2). The gift tax consequences of the grantor’s right to receive the excess cash are not clear. Arguably, the gift is not complete until the expense or improvement is paid for because of the grantor’s retained right to receive excess cash held by the trust.
Example: Joe contributes $100,000 to Joe’s existing QPRT to pay for the cost of an improvement to the residence. If the improvement only costs $80,000, the trustee is required to distribute the $20,000 excess cash to Joe. This may cause an adverse gift tax result if Joe had used a portion of his unified credit or paid gift tax on the value of the remainder in the $100,000 contribution. It may be, however, that Joe receives the excess cash distribution prior to the date on which the gift tax return relating to the $100,000 contribution is due, in which case it seems arguable that no completed gift of the excess $20,000 was made.
(d) In order to avoid the stringent requirements contained in the regulations regarding additions of cash to a QPRT, a grantor may wish to pay for trust expenses and improvements directly rather than by adding cash to the trust. For gift tax purposes, however, direct payment of trust expenses should be analyzed as though cash were contributed to the trust.
4. As discussed in more detail in section IV.D. below, whether the residence is subject to a mortgage is a factor that will determine the value of the gift upon contribution of the residence to the trust. The value of the gift generally must take into account the mortgage on the property.
5. By retaining a contingent reversion, a grantor of a QPRT can lower his or her taxable gift of the remainder interest, since the reversionary interest itself has an actuarial value which is added to the value of the grantor’s income (use) interest, thereby further reducing the value of the remainder interest. If the grantor does not retain a reversion and dies prior to the end of the trust term, the residence will still be includible in the grantor’s estate for estate tax purposes under §2036(a)(1) because the grantor has retained an income (use) interest for a “period which does not in fact end before his death.” Consequently, since the value of a retained reversionary interest results in a lower taxable gift of the remainder interest, there is no downside to providing for a reversionary interest in a QPRT.
6. Examples of tax savings
with and without retained reversionary interest:
(b) Exhibit II: Same facts as in Exhibit I except that Jean retains both the right to use the residence for 10 years and a reversionary interest (that is, the right to have the residence distributed to her estate or in accordance with a power of appointment which includes her estate as a permissible appointee should she die prior to the end of the trust term). If the gift tax valuation rate is 7.4%, the value of the taxable gift is $408,540 (representing a 59.15% discount). By retaining a reversionary interest, Jean has increased the discount factor by 11.44%. In this case, Jean’s estate tax savings will be $589,437. By retaining a reversionary interest, Jean has increased her potential estate tax savings by $62,898.
7. The longer the term of a QPRT, the greater the value of the retained income (use) interest and, thus, the lower the value of the taxable gift of the remainder interest. For this reason, it often makes sense for a relatively young grantor to create a QPRT. For example:
(a) Exhibit III: A personal residence worth $1 million is transferred to a QPRT by Betsy, a 35-year old grantor, who retains both the right to use the residence for 35 years and a reversionary interest. The property is distributable to Betsy’s estate if she does not survive the term of the QPRT. If the gift tax valuation rate is 7.4%, the value of the taxable gift is $60,890 (representing a 93.91% discount!). If the annual rate at which the property appreciates in value is assumed to be 4%, the residence will have appreciated in value to $3,946,089 after 35 years and the potential estate tax savings (assuming Betsy is in the top marginal federal estate tax bracket of 55%) will be $2,136,859.
8. Under §6501(c)(9), a gift of a remainder interest in a QPRT must be adequately disclosed on a gift tax return (Form 709) in order to prevent any potential adjustment of the value of such gift after the statute of limitations for assessing a gift tax (under §6501(a), generally three years after a return is filed) has expired. In other words, unless the gift is adequately disclosed on a gift tax return, the three-year statute of limitations will not begin to run and the value of the gift is subject to adjustment at any time. The adequate disclosure rule was made applicable to QPRTs in 1990 when §2702 was enacted. The Taxpayer Relief Act of 1997, §506(b), extended the adequate disclosure rule to all types of gifts. The amendment is effective for gifts made after December 31, 1996. On December 3, 1999, the IRS issued final regulations (Treasury Decision 8845) on adequate disclosure of gifts. The final regulations are applicable to gifts of remainder interests in QPRTs as well as to all other types of gifts.
B. Estate Tax Considerations
1. If the grantor of a QPRT dies prior to the expiration of the term during which the grantor retained the right to use the personal residence, the trust property is includable in the grantor’s gross estate under §2036(a)(1), because the grantor will have retained an interest that did not in fact end before the grantor’s death.
2. If the grantor dies prior to the expiration of the QPRT term, the residence held by the QPRT is includable in the grantor’s gross estate at its value as of the grantor’s date of death (or at the alternate valuation date, if elected). The estate, however, is entitled to a credit for any gift taxes paid which are computed on the value of the gifted remainder interest as of the date of the transfer to the QPRT, but using the gift tax rate in effect as of the grantor’s date death. See PLR 9249014. If the grantor did not pay any gift tax but instead used a portion or all of his unified credit upon creation of the QPRT, the unified credit used is restored at the grantor’s death.
3. Obviously, to avoid inclusion of the personal residence in the grantor’s estate, it is necessary to choose a retained term which, based on the grantor’s life expectancy, is likely to end prior to the grantor’s death. However, the need to restrict the length of the retained term in order to avoid the risk of inclusion of the residence in the grantor’s estate must be weighed against the fact that the value of the taxable gift of the remainder interest decreases as the length of the retained term increases.
4. As a hedge against the risk of inclusion of the residence in the grantor’s estate, it may be appropriate to acquire insurance on the grantor’s life for the term of retained use and to structure the ownership of the policy in a manner so that the proceeds will not be includable in the grantor’s estate (for example, through use of an irrevocable life insurance trust).
5. Another technique that may be used as a hedge against the risk of inclusion of the property in the grantor’s estate is to create several QPRTs of varying lengths, funding each with an undivided interest in the residence. For example, in PLR 9714025, the grantor transferred a 50% undivided interest in his residence to each of two QPRTs. QPRT1 had a three-year term and QPRT2 had a five-year term. The IRS ruled that if the grantor survived until the end of QPRT2’s five-year term, the entire residence would not be included in the grantor’s gross estate. If, however, he died during the fourth year, the 50% undivided interest held by QPRT2 would be includable in his estate but the 50% undivided interest transferred to QPRT1 would not be included. In this scenario, the fractional ownership may also prove advantageous because the grantor’s estate should be able to claim a discount in valuing the includable fractional interest for estate tax purposes.
6. The grantor of a QPRT may lease the residence from the remaindermen for fair market value after the expiration of the retained use term without causing the residence to be included in the grantor’s gross estate under §2036 because the grantor’s retained economic enjoyment of the property ceases when the grantor begins paying rent. PLRs 9829002; 9626041; 9448035; 9249014. The lease arrangement may be provided for as an option in the governing instrument or may be entered into following the expiration of the term of the QPRT. PLR 199916030.
C. Generation-Skipping Transfer Tax Considerations
1. A QPRT is not an effective
mechanism to reduce generation-skipping transfer (“GST”) taxes, for the
following reasons. Section 2642(f) provides that no allocation of
GST exemption may be made to inter vivos transfers of property that would
be includable in the transferor’s gross estate (under any section other
than §2035) if the transferor were to die immediately after the transfer
until the end of the “estate tax inclusion period” (“ETIP”). Because
QPRT assets are includable in the grantor’s estate under §2036(a)(1)
if the grantor dies during the retained term, the grantor cannot make an
effective allocation of GST exemption under §2642 until the r etained
term during which the grantor may use the residence ends (i.e., the end
of the ETIP).
Example: Jean creates
a QPRT and funds it with a residence worth
Example: Assume the same facts as in the preceding example, except that Jean provides that the trust will distribute per stirpes to Jean’s descendants living at termination, and that Jean’s two children are alive at the creation of the trust, but one child dies with surviving issue before the term ends. Although §2651(e) now allows the use of the predeceased ancestor exception in the case of taxable terminations, the exception is available only if the predeceased ancestor was deceased at the time that the transfer was first subject to estate or gift tax. In this case, since both of Jean’s children were alive at the time the QPRT was established (i.e., at the time the transfer of Jean’s residence was first subject to gift tax), the predeceased ancestor exception would not apply and the distribution of a portion of the residence to the issue of Jean’s child who predeceased the trust term would be subject to GST tax. Furthermore, under the separate share rules contained in the regulations, which require (for irrevocable lifetime trusts not includable in the transferor’s gross estate at death) that separate trusts or shares must exist from and at all times after the creation of the trust to be recognized for GST tax purposes, it may not be possible in this case to direct the allocation of GST exemption to the portion of the trust passing to the skip person at termination, since the skip person’s share did not exist from and at all times after the creation of the trust. Regs. §26.2654-1(a)(1)(i). Rather, any allocation of GST exemption will apply with respect to the entire trust and thus, in Jean’s case, ½ (or $500,000) of the distribution made to the skip person will be subject to GST tax.
3. Several planning opportunities exist for minimizing the GST tax that could occur if a child of the grantor dies during the retained use term.
(a) If a QPRT at termination provides for distribution only to living children, the taxable termination will be avoided but the descendants of the deceased child will not have received a share of the QPRT assets. In this case, the transferor or his or her spouse could provide for equalizing gifts to the descendants of the deceased child, assuming that other assets are available to make such gifts.
(b) A separate QPRT may be created for each child which will allow the transferor to allocate GST exemption only to the share of any deceased child at the end of the ETIP. (As noted in section III.C.2. above, the separate share rules require that the separate trusts or shares must exist from and at all times after the creation of the trust to be recognized for GST purposes.) If this option is utilized, the grantor may also benefit from discounting the value of the fractional interests in the residence that are transferred to each separate QPRT.
(c) The grantor of a QPRT may provide for payment of the deceased child’s share to the deceased child’s estate at termination. GST taxes may be completely avoided in this way because no distributions from the trust will be made to a skip person. See PLR 9534004. The desirability of this option is questionable, however, since estate taxes will be owed by the deceased child’s estate without access to the taxable remainder interest in the residence for reimbursement; provided, however, that under §6163 the payment of taxes could be deferred (with interest) until six months after the grantor’s retained use term ends. In addition, the value of the includable remainder interest could be high, particularly towards the end of the term of the grantor’s retained use when the value of the remaining use and contingent reversion will be relatively small.
(d) Transfer taxes may
be saved if the portion of the QPRT that would otherwise pass to the skip
person instead reverts to the grantor, or the grantor’s spouse, who then
gifts that portion to the skip person. The GST direct skip tax is
always less than the GST taxable termination tax, if the transferor survives
the gift by three years, because of the tax exclusive nature of the gift
tax. This option, however, entails risks – the transferor may not
be competent at the end of the term to be able to make the gift or may
not survive the gift by three years.
D. Income Tax Considerations
1. During the term for which the grantor retains the right to use the residence transferred to a QPRT, the grantor is treated as the owner of the accounting income portion of the trust under §677(a)(1). In other words, during the retained use term, the QPRT is treated as a grantor trust for income tax purposes to the extent of the accounting income portion of the trust. The grantor may also be treated as the owner of the corpus portion of the trust under §673(a) if he retains a reversionary interest in the trust corpus and if, as of the inception of the trust, the value of the reversionary interest exceeds 5% of the value of the trust.
2. Under Revenue Ruling 85-13, 1985-1 C.B. 184, the existence of a QPRT is entirely ignored for income tax purposes if the trust is treated in its entirety as a grantor trust with respect to its accounting income and corpus. Consequently, the grantor is treated as owning the underlying assets of the trust directly, and no transaction between the grantor and the trust is recognized for income tax purposes. The advantages of this treatment are:
(a) The grantor is entitled to all allowable mortgage interest, tax and other deductions applicable to the personal residence during the retained use term.
(b) If the trustee sells the residence, the QPRT should have the benefit of §121 which allows the exclusion of gain on the sale of a principal residence (up to $500,000 for married individuals filing jointly and $250,000 for other individuals).
(c) No income tax return (Form 1041) is required to be filed for a grantor trust.
(d) Caveat: Regs.
25.2702-5(c)(9), effective for QPRTs created after May 16, 1996, require
the trust instrument to prohibit the sale or transfer of the residence
to the grantor, the grantor’s spouse, a grantor trust of the grantor or
the grantor’s spouse, or an entity controlled by the grantor or the grantor’s
spouse, at any time during the original retained term or at any time after
the original term interest during which the trust is a grantor trust.
Note that before this regulation was issued, a sale of a residence held
by a QPRT to the grantor was advantageous where the QPRT was wholly treated
as a grantor trust since no taxable gain would be realized on the sale.
The regulation was adopted to foreclose this planning opportunity which
took advantage of the differences between the income tax and estate and
gift tax rules. However, the enhanced capital gain exclusion under
§121 (enacted as part of the Taxpayer Relief Act of 1997, P.L. 105-34,
§312) now allows a QPRT grantor to accomplish to some extent the same
result he may have wished to accomplish by purchasing the residence from
the QPRT himself.
IV. Other Planning Considerations
A. Disposition of the Remainder
1. When the retained use term of the QPRT expires, the trust can provide that the residence either passes outright to the remaindermen or remains in trust for the benefit of the remaindermen. If the grantor is married, he can provide for a continuing trust which gives his spouse a life use of the residence. This will not result in inclusion of the residence in the spouse’s gross estate and the grantor may continue to reside in the house as his spouse’s guest. Furthermore, such continued use by the grantor will not cause the house to be includable in the grantor’s gross estate, provided there is no agreement, expressed or implied, regarding the grantor’s continued use of the property after expiration of the QPRT. See, e.g ., Gutchiss v. Comr., 46 T.C. 554 (1966), acq. 1967-1 C.B. 2; PLRs 9827037 and 199906014. (Under Revenue Ruling 70-155, 1970 C.B. 189, co-occupancy by the donor with the donee, where the donor and donee are husband and wife, does not of itself support an inference of an agreement or understanding as to retained possession or enjoyment by the donor.)
(a) Caveat: Although there is no precedent or official IRS position on point, at least one commentator (Jonathan G. Blattmachr, Esq.; Milbank, Tweed, Hadley & McCloy; New York, New York) has opined that where spouses sever a joint tenancy and transfer title to their personal residence to one spouse who then creates a QPRT providing for continued use of the residence by the other spouse at the expiration of the trust term, the IRS may be permitted to argue that one-half of the property should be includable in the nongrantor spouse’s estate under 2036(a)(1) on the theory that the nongrantor spouse would not have consented to the termination of the joint tenancy if he or she had not been given the secondary income interest in the QPRT.
Where spouses owning a residence as tenants-in-common create separate QPRTs
with their respective 50% undivided interests which provide for continued
use by each nongrantor spouse at the end of each QPRT’s term, the IRS could
apply the reciprocal trust doctrine and argue that one-half of the property
should be included in each spouse’s gross estate on the theory that the
trusts are interrelated and leave each spouse in the same economic position
they would have been in had they created a trust naming themselves as life
beneficiaries. However, this may be overcome by varying the provisions
of each QPRT in such a way so that they are not reciprocal (even though
each nongrantor spouse is given a secondary income [use] interest in his
or her spouse’s QPRT).
3. There are several ways to structure a QPRT to continue as a grantor trust. For example:
(a) A power can be granted to a third party to add certain individuals to the class of beneficiaries to whom the income or principal of the trust may be distributed since, under §674(a), the grantor is considered the owner of a trust in respect of which the beneficial enjoyment of the income or corpus is subject to a power of disposition exercisable by a nonadverse party.
(b) A power can be granted to someone, in a nonfiduciary capacity, to reacquire trust corpus by substituting other property of equivalent value since, under §675(4), a grantor is treated as the owner of any portion of the trust in respect of which a power of administration is exercisable in a nonfiduciary capacity by any person without the approval or consent of any person in a fiduciary capacity. (Under §675(4), the term “power of administration” includes the power to reacquire the trust corpus by substituting other property of an equivalent value.)
B. Naming the Trustee
1. During the retained use term of the QPRT, the grantor may serve as sole trustee. At least one commentator (Jonathan G. Blattmachr, Esq.; Milbank, Tweed, Hadley & McCloy; New York, New York) opines that the grantor should not be the trustee if the trust gives the trustee the discretion, under Regs. §25.2702-5(c)(8)(i), to distribute the assets outright to the term holder upon cessation of the trust as a QPRT since, in that case, the transfer may be viewed as an incomplete gift under Regs. §25.2511-2(c). 4 There do not, however, appear to be any IRS rulings which disqualify a QPRT on this basis.
2. After the expiration of the retained use term, where the residence continues in trust, the grantor should cease to serve as sole trustee if the trustee holds powers which, if held by the grantor, would cause the trust assets to be includible in the grantor’s gross estate (e.g., those powers described in §2036(a)(2) or §2038). Although the grantor could continue to serve as an administrative trustee, an independent trustee (i.e., an individual other than the grantor of a beneficiary of the trust) should be appointed as co-trustee to make all non-administrative decisions.
C. Married Couples and QPRTs
1. Where a personal residence is owned by spouses as joint tenants with rights of survivorship, it may be advantageous to either:
(a) Transfer title to one of the spouses who then transfers the residence to a QPRT; or
(b) Change title to a tenancy-in-common, so that each spouse owns an undivided 50% interest in the property with which each spouse then creates a separate QPRT.
2. By transferring title to one of the spouses and having that spouse create the QPRT, it is possible to decrease the taxable gift because the value of the reversionary interest for a QPRT created by one spouse will be greater than the value of the reversionary interest for a joint and survivor QPRT (since the actuarial likelihood of both spouses not surviving the trust term is less than the actuarial likelihood of one spouse not surviving the same term). For example:
(a) Exhibit IV: Jean, age 60, and Joe, age 64, are husband and wife and own a $1 million residence as joint tenants with rights of survivorship. Both Jean and Joe are in extremely good health and lead active lifestyles. Jean and Joe transfer their residence to a 15-year joint and survivor QPRT. If the gift tax valuation rate is 7.4%, the value of the taxable gift is $304,260 (representing a 69.57% discount). If the annual rate at which the property appreciates in value is assumed to be 4%, the residence will have appreciated in value to $1,800,944 after 15 years and the potential estate tax savings (assuming Jean and Joe are in the top marginal federal estate tax bracket of 55%) will be $823,176.
(b) Exhibits V and VI: Instead of creating a joint and survivor QPRT, Jean and Joe transfer title to the property to Jean, and then Jean transfers the residence to her own 15-year QPRT (see Exhibit V). If the gift tax valuation rate is 7.4%, the value of the taxable gift is $242,200 (representing a 75.78% discount). If the annual rate at which the property appreciates in value is assumed to be 4%, the residence will have appreciated in value to $1,800,944 after 15 years and the potential estate tax savings (assuming Jean is in the top marginal federal estate tax bracket of 55%) will be $857,309. Note that if title was transferred to Joe instead of Jean, and then Joe created a 15-year QPRT, the taxable gift would be lower, and the potential death savings higher, than in Jean’s case, since the value of Joe’s reversion is greater than Jean’s due to his older age (as shown in Exhibit VI).
3. By changing title to a tenancy-in-common and having each spouse create a separate QPRT with their respective undivided 50% interests, it should be possible to reduce the amount of the taxable gift due to the fact that a discount would be available for each undivided interest. The courts have consistently held that an undivided fractional interest in property, even when a corresponding fractional interest is held by one’s spouse or other immediate family member, should be valued for estate and gift tax purposes at a discount from its fractional share of the fair market value of the undivided property in order to properly reflect the lessened marketability of such partial interest. See, e.g., Estate of Lee v. Comr., 69 TC 860 (1978); Estate of Bright v. U.S., 658 F.2d 999 (5th Cir. 1981); Popstra v. U.S., 680 F.2d 1248 (9th Cir. 1982); Estate of Andrews v. Comr., 79 TC 938 (1982); Mooneyham v. Comr., 61 TCM 2447 (1991); Estate of Alto B. Cervin, 68 TCM 1115 (1994); Estate of Ellie B. Williams, 75 TCM 1758 (1998). Such valuation discounts generally range from 15% to 35%. In Revenue Ruling 93-12, the IRS acquiesced to the proposition that family attribution should not be considered when valuing fractional interests for gift tax purposes. The IRS has also recognized that discounts are appropriate when valuing undivided fractional interests in property, but has argued that a discount for undivided interests in real estate should be limited to the taxpayer’s pro rata cost of partitioning the property. Tech. Adv. Mem. 93-36-002 (May 28, 1993) and PLR 199943003. Based on numerous court decisions which have allowed fractional interest discounts for lack of marketablility that far exceed the discounts allowed by the IRS’s cost-of-partition approach, fractional interest discounts based upon lack of marketability should be available when transferring undivided fractional interests in real property to a QPRT. For example:
(a) Exhibit VII: Assume the same basic facts as in Exhibit IV above. In this example, however, Jean and Joe change title to their residence to a tenancy-in-common and then create separate QPRTs with their respective undivided 50% interests. Both Jean and Joe transfer their respective 50% interests to separate 15-year QPRTs but do not claim valuation discounts on account of the partial interests. Assuming a gift tax valuation rate of 7.4%, an annual growth rate of 4%, and a top marginal federal estate tax bracket of 55%, the total potential estate tax savings for both QPRTs combined in this case will be $865,722. The total potential tax savings in this scenario are greater than the savings using the joint and survivor QPRT (Exhibit IV) due to the fact that each spouse benefits from a greater reversionary interest (since the actuarial likelihood of both spouses predeceasing the 15-year joint and survivor term is less than the actuarial likelihood of either spouse predeceasing the 15-year term of their own respective QPRTs). Although this scenario does not produce tax savings as great as those in Exhibit VI, where title is passed to Joe who then creates the QPRT, the use of multiple QPRTs has the added benefit of providing insurance against premature death – if either Jean or Joe dies prematurely, only 50% of the residence value is brought back into the decedent’s estate.
(b) Exhibit VIII: In this scenario, both Jean and Joe transfer their respective 50% interests to separate 15-year QPRTs and claim 20% valuation discounts on account of the partial interests. Assuming a gift tax valuation rate of 7.4%, an annual growth rate of 4%, and a top marginal federal estate tax bracket of 55%, the total potential estate tax savings for both QPRTs combined in this case will be $890,681. Because of the discount claimed for the partial interests, this scenario produces the greatest potential estate tax savings.
D. Mortgage Indebtedness
2. Where mortgaged property is transferred to a QPRT, the value of the gift at the time of the initial transfer is called into question. The general principles applicable to gifts of mortgaged property are as follows:
(a) The amount of a gift of property subject to a nonrecourse debt is the value of the property less the debt.
(b) The amount of a gift of property subject to a recourse debt is the entire value of the property if the donee has a right of subrogation against the donor should the creditor elect to proceed against the donee’s property, instead of against the donor directly.
(c) The amount of a gift of property subject to a recourse debt is the value of the property less the debt if the donee has no right of subrogation. However, the donor is deemed to make an additional gift each time he makes a payment on the debt.
3. (a) Usually, mortgage debt on a personal residence is recourse. In most cases, the grantor of a QPRT will both remain personally liable for and actually continue to make mortgage payments for the term of the trust. In order to avoid the necessity of valuing additional discounted gifts of mortgage principal payments each time a mortgage payment is made by the grantor, the grantor should: (i) remain personally liable on the mortgage; (ii) specifically agree in the trust instrument to indemnify the trustee and the beneficiaries for any payments they are called upon to make, at least during the term of the retained use (i.e., give the donees a right of subrogation); and (iii) actually make all debt service payments. In this case, the debt will not be taken into consideration in determining the value of the initial gift of the residence to the QPRT but the grantor will not be deemed to have made additional gifts to the remaindermen each time a mortgage payment is made.
(b) Caveat: The grantor’s agreement to indemnify the trustee and beneficiaries must be enforceable under applicable state law in order to achieve the purpose of avoiding additional gifts to the remaindermen each time a mortgage payment is made. Generally, in New York, a promise must be supported by consideration in order to be legally enforceable.5 It is at least arguable that the consideration in this context is the willingness of the trustee (who would have to be someone other than the grantor) to serve as trustee of a trust holding only a personal residence on which mortgage loan payments must be made. However, the U.S. Tax Court has held that a trustee’s assumption of fiduciary duties is not a substitute for consideration. Morton D. Strimling v. Comr., 46 TCM 211 (1983) and W. Larry Swecker v. Comr., 46 TCM 552.
TOP * HOME * WILLS * LIVING TRUSTS * PROBATE * ESTATE TAXATION * GIFTS * IRA'S/PENSIONS * LIFE INSURANCE * ELDER LAW * FAMILY PARTNERSHIPS * FAMILY BUSINESSES * GRANTOR TRUSTS * PERSONAL RESIDENCE TRUSTS * CHARITABLE TRUSTS * SPECIAL NEEDS TRUSTS * WEBSITE SUMMARY * CHITTENDEN PROBATE COURT * RICHARD W. KOZLOWSKI, ESQ. * LISMAN LECKERLING