A Qualified Personal Residence Trust (QPRT) is a specific type of irrevocable trust that in certain circumstances can reduce estate and gift taxes by transferring a residence to a trust. Importantly, it is a strategy that is meant to be deployed during your lifetime while allowing you to protect assets for your heirs.
How a QPRT Works
A QPRT is designed to remove a residence from the estate of the grantor (i.e. the person creating the trust) so it is not subject to estate tax. It can also minimize gift tax incurred when transferring the house to beneficiaries.
The grantor gifts the residence to the irrevocable trust, retaining an interest for a designated term. At the end of the term, the grantor no longer has any interest in the property. During the term, the grantor may live in the residence but once the term is over, the grantor must rent from the trust at fair market value if they wish to continue to reside in the residence.
In order for the gift to the trust to be complete and the property to be removed from the grantor’s estate, the grantor must survive the term. If the grantor fails to do so, the gift will fail and the property will be included in the grantor’s estate.
Valuing the Gift to the QPRT
Since the grantor retains an interest for a period of time, the value of the gift, as is calculated for tax purposes, is lower than the residence’s fair market value, thus potentially reducing taxes.
The value of the gift is determined based on the length of the term, the life expectancy of the grantor, and the applicable federal rates (AFR). The AFR for the trust is based on Internal Revenue Code § 7520 which provides tables to calculate the value of the gift and the retained interest.
Generally, the longer the term (i.e. the length of time that the grantor retains an interest in the residence), the lower the value of the gift for gift tax purposes. Once the term ends, the IRS assumes the property will appreciate in value every year for the remainder of the life expectancy of the grantor thus increasing the value of the gift. However, the IRS also applies a discount in order to calculate the present-day value of the appreciated gift. The discount is based on an interest rate set by the IRS (currently 5%). The interest rate changes monthly and the higher the interest rate, the greater the discount applied to the value of the gift, resulting in a lower value gift.
A lower valuation is desirable because the grantor uses up less of their federal estate and gift tax exemption, thus preserving exemption for other gifts and/or lowering the amount of gift and estate taxes paid.
Maximizing the Benefits of a QPRT
The current high federal estate and gift tax exemption ($12.92 million in 2023) coupled with the high interest rate the IRS is using to discount the value of a QPRT gift (5% in September 2023) are a perfect combination for taking advantage of a QPRT. The gift is valued at the time of the gifting, and the high exemption enables grantors to try to maximize their gifting now, while the high interest rate generates a bigger discount.
When creating the QPRT, the grantor can select a term that minimizes to the greatest extent the value of the gift. For example, a younger grantor might gamble on a longer term (10 or even 20 years) which will greatly lower the value of the gifted property assuming the grantor survives the term. Further, once the term is over, the rent paid to the trust to live in the residence functions as a tax-free gift to the beneficiaries.
Note that the age and health of the grantor and how much of their exemption has been or will be used up in other ways are important considerations in determining what length term makes sense for the QPRT.
Selling the Residence in a QPRT
The trust can sell the residence and any increase in the value of the property is not subject to gift or estate tax. However, the trust must either buy another house or pay the grantor an annuity. Annuities can be problematic since they must be calculated correctly.
If another home is purchased, ideally, it should be for the same amount. If a less expensive home is purchased, the trust may need to provide an annuity to cover the difference. The trust may be able to put aside some cash for maintenance of the home, but the rules are stringent. If the new home is more expensive, the trust may need to obtain financing which may be difficult to come by.
Certain jurisdictions allow for self-settled irrevocable trusts, which when coupled with the QPRT framework would allow a grantor to gift their residence to a trust of which they are also the beneficiary, thus removing the property from their estate while retaining use and enjoyment of the property indefinitely.
Mortgage Considerations with a QPRT
Mortgages are personal obligations, so if a mortgaged property is conveyed to a QPRT, the original mortgage debtor remains liable for the mortgage debt, even though they no longer own the property. Accordingly, it is important to check with the mortgage company or bank to determine if it will allow the transfer to a QPRT or other irrevocable trust. Failure to obtain the lender’s approval, if it is required, may be considered a default under the mortgage.
Estate planning is not just about disposing of assets after you pass. There are creative options to take advantage of during your lifetime that can protect your assets presently and preserve assets for future generations. QPRTs are one option to consider as part of a lifetime estate plan and should be discussed with your attorney to determine whether it is the right choice for you.
If you need assistance with your estate plan, our attorneys can help. We work with clients to develop a comprehensive plan that is tailored to their needs and goals. Contact us today.