A Qualified Personal Residence Trust ("QPRT") is an estate planning technique that allows you to remove the full value of your primary residence and/or a second residence from your estate for estate tax purposes. Depending on the value of your residence and the size of your estate, it is possible to save a significant amount of estate taxes, thereby allowing more of your assets to pass to children and other named beneficiaries.

A QPRT is a special type of trust designed to hold the residence of the trust's creator (called the "Settlor"). The Settlor makes a gift of his or her residence to the QPRT and retains the right to live in and to use the residence for a specified number of years chosen by the Settlor (the "Fixed Term"). The Settlor may even be the Trustee during the Fixed Term. At the end of the Fixed Term, the property in the QPRT passes to further beneficiaries specified by the Settlor at the time of trust creation. The Settlor may specify that the residence is then held for the benefit of the Settlor’s spouse for the rest of his or her life, and is then distributed to (or in trust for the benefit of) the Settlor's children. Because the children must wait until the end of the term to benefit from the transfer, the present value of the gift is substantially lower than the value of the residence. If the Settlor outlives the Fixed Term, the full value of the residence plus all future appreciation thereon is out of the Settlor's estate at a substantially lower gift tax value.

Both a primary personal residence and any vacation home are eligible to be held in a QPRT, but a Settlor may only create two QPRTs. The IRS also permits the QPRT to hold limited amounts of cash needed to maintain the residence, pay real estate taxes, etc. Finally, the Trustee of the QPRT is authorized to hold (i) the proceeds of sale of a residence pending purchase of a replacement residence, (ii) insurance proceeds in case of damage to the residence (for a limited period of time up to two (2) years), and (iii) other monies planned to make improvements or repairs to the residence (up to ninety (90) days).

A QPRT is irrevocable. Since the Trust is irrevocable, the Settlor will not have the power to alter, amend, revoke, or terminate the Trust after it is created. It is established for the sole purpose of holding a personal residence for the Fixed Term and thereafter transferring the residence to the individual or individuals specified in the trust agreement. Although there are several planning opportunities discussed in this memorandum involving the Settlor’s spouse, the QPRT provides substantial tax savings whether or not the Settlor is married.

The Advantage of a QPRT — Estate Tax Savings:

The estate tax savings from use of a QPRT can be substantial. As an example, assume that an individual, as the Settlor (age 60) transfers his home worth $500,000 into a QPRT with a fifteen (15) year Fixed Term. First, the value of the retained right to live in the home is computed by the use of a formula set forth in the Tax Code. In this example assume the value of the retained right is $320,000 under the formula. Next, the value of what the children will receive (and, therefore, the amount which is considered to be gifted for gift tax purposes) is computed. This is accomplished by subtracting the value of the retained right to live in the residence (in this case $320,000) from the current value of the residence ($500,000). Therefore, in this example, the value of the gift to the children would be $180,000 ($500,000 - $320,000). Because the gift will not be received by the children until some time in the future, the Settlor of the trust uses a portion of his or her Unified Credit Exemption Equivalent ($1,500,000 in 2005, $2,000,000 in 2006, and additional increases scheduled for later years) to avoid current gift tax, or if the Settlor has previously utilized his or her entire Unified Credit, a gift tax is computed on the discounted gift value.

Assume that, at the end of the Fixed Term, the residence has risen in value to $900,000 and the Settlor owns other property (which does not include the residence) equal to the amount of the Unified Credit Exemption Equivalent. The entire $900,000 ($500,000 value plus $400,000 appreciation) has been removed from the Settlor’s estate and will not be subject to estate tax at the death of Settlor or Settlor’s spouse. Had the QPRT not been used and the Settlor and his or her spouse passed away shortly thereafter, the combined estate tax burden would equal $405,000. With the use of the QPRT, however, the combined estate tax burden would equal $81,000. Under these facts, the use of a QPRT transfers $324,000 to the Settlor's children or other named beneficiaries that would otherwise be lost to taxes.

Additional Leverage Through Fractionalized Ownership:

It is possible for a husband and wife to obtain additional tax savings by fractionalizing ownership. This would be done by deeding one-half of the residence into the husband’s name and one-half into the wife’s name.  The husband and wife would then each create a separate QPRT.  Because the fair market value of an undivided one-half interest in a residence is worth less than fifty (50%) percent of the value of the entire residence, fractionalizing ownership in this manner would reduce the total value of the gift to the trust beneficiaries.  In addition, the husband and wife could select different fixed terms for their respective QPRTs so that if one of them should survive the fixed term selected but the other does not they would at least realize the tax savings on the QPRT of the spouse who survives.

During the Fixed Term:

The Settlor has the right to use the residence during the Fixed Term; the law ignores the fact that the Settlor’s spouse will also live in the residence. In addition, during the Fixed Term, the Settlor retains complete control over the use and occupancy of the residence and has sole responsibility for real estate taxes, general maintenance, and repairs. In this manner, the Settlor will decide how the home is used and will also make all decisions regarding whether to sell the home and whether to buy a replacement home. This includes the power to decide the price and terms of any sale and purchase.

Determining the Fixed Term:

In deciding what the appropriate "Fixed Term" should be, two factors need to be considered. First, the longer the Fixed Term the lower the value of the taxable gift, and therefore, the less Unified Credit absorbed and/or gift tax paid. Second, in order to benefit from the use of a QPRT, the Settlor must survive the Fixed Term. Therefore, it is necessary to weigh the probability of survival against the potential gift tax benefit. This will obviously differ from person to person based on a number of factors such as the value of the home, the likelihood of significant appreciation, the value of the Settlor's total estate, the age of the Settlor, the health of the Settlor, and genetic tendencies or patterns of the Settlor’s family. We can assist with the Settlor's determination of the optimum Fixed Term by providing actuarial life expectancies and potential estate and gift tax savings under various scenarios; however, the ultimate decision as to the proper Fixed Term is determined by the Settlor.

Another advantage to the QPRT is that it has little downside risk. In the event the Settlor dies prior to the expiration of the Fixed Term of the trust, the property is included in his or her estate just as though the QPRT was never created. Hence, the sole risk is to put the Settlor in the same place he or she would have been had he or she not elected to create a QPRT. The only real downside is perhaps an alternative use of the Settlor's Unified Credit or gift tax paid.

Termination of the Trust Term:

It is important to understand that at the end of the Fixed Term, the Settlor no longer owns the residence; rather the trust owns it for the benefit of the Settlor’s designated beneficiaries, generally the Settlor's spouse and/or children. The most frequently asked question, therefore, is whether the Settlor can continue to live in the residence at the end of the trust term. The answer to this question depends on several factors. These factors and various options are discussed below.

1. Life Interest Granted to Spouse. The QPRT is typically (but is not required to be) drafted to grant the Settlor’s spouse the right to live in the residence for the rest of his or her life beginning after the expiration of the Fixed Term. The fact that the Settlor’s spouse allows the Settlor to live with him or her in the residence has not been held by the IRS to disqualify the tax benefits of the QPRT. Hence, so long as the Settlor and his or her spouse each choose to live together, the QPRT design is intended to provide significant estate tax savings as well as the continued use of the residence by the Settlor for life. In the case where the Settlor’s spouse dies before the Settlor, there are alternatives (listed below) by which the Settlor may arrange to continue using the residence.
   

2. Residence passes to children. One option is to create the trust to provide for the residence to pass to the younger generation family members with no strings attached. In this case, the Settlor would not have any right to live in the residence after the Fixed Term. Of course the children may always choose to rent the residence to the Settlor and his or her spouse, but there is no guarantee. This option may not be desirable if this is a concern. Moreover, if any of the Settlor's children have creditor problems this may be an unattractive option. In some situations, however, the Settlor and his or her spouse may be willing to move out or plan to sell the residence, particularly if they will be older at that time and are planning to downsize.
   

   
   

3. Parent Rents the Residence. Under this option, the Settlor rents the residence from the trust at the home’s fair rental value. There are benefits to using this option which are not immediately apparent. First, the trust may be drafted so that the rent paid to the trust will not be taxable. Second, by making rental payments, the surviving spouse can remove assets from his or her taxable estate (in addition to the $10,000 per year per person annual exclusion gifts) without paying gift tax. So, the rental payments are like tax-free gifts to the trust beneficiaries.  The rental of the property cannot be assured in any written document entered into prior to the end of the Fixed Term due to the fact that a pre-arranged rental agreement could jeopardize the tax savings provided by the use of a QPRT. However, since the residence will continue to be held in trust after the Fixed Term, there is more assurance to the Settlor that he or she will be able to rent the residence.
   

4. Parent Buys the Residence. Under this option, the Settlor may purchase the residence from the trust after the expiration of the Fixed Term. If the purchase is elected, then the Settlor must buy the residence at its fair market value. When the Settlor purchases the home from the trust, the trust must pay tax on any capital gain resulting from the sale and unlike the sale of most personal residences, there is no $250,000/$500,000 exemption available to shelter any capital gain resulting from such a sale. Remember, however, that absent a change in the law, capital gains are currently taxed at rates far lower than under the estate and gift tax regime. The sale proceeds from any such sale would then be held under the terms of the trust agreement for the benefit of the Settlor’s spouse and/or children as specified by Settlor at the time of creation of the trust. This purchase option allows the Settlor to maintain control over the residence and is particularly attractive if the residence has a cost basis reasonably close to its fair market value.
   

Sale of the Residence:

As explained above, the Settlor may sell the residence at any time during the Fixed Term and reinvest the proceeds in a new residence. The replacement residence must be purchased within two years from the sale. If the trust agreement provides for a life interest in the Settlor's spouse with the spouse to act as Trustee, he or she may also direct the sale of the residence after the expiration of the Fixed Term and the reinvestment of the sales proceeds. If the sale takes place after the expiration of the Fixed Term, the sales proceeds do not need to be reinvested by the trust in a replacement residence and can even be held for the benefit of Settlor’s spouse without being taxed in his or her estate. In both cases, the trust agreement can be drafted to allow the Settlor or his or her spouse to use their $250,000/$500,000 exemption to shelter capital gains stemming from the sale of a personal residence, so long as the sale is to an unrelated third party. If the sale is to a child or certain other family members, the exemption will not be available.

If the residence is sold during the Fixed Term and a replacement residence is not purchased, the trust typically provides for an annuity payment to be paid to the Settlor for the remainder of the Fixed Term. In this manner, the tax savings attributable to the use of a QPRT can be in large part maintained.

Income Tax Consequences:

The trust can be drafted in such a manner so that it will not be considered a separate taxpayer for income tax purposes. In this manner, no separate income tax return will need to be filed by the trust. Any trust income is reported directly on the Settlor’s annual U.S. Income Tax Return, Form 1040. There may be certain instances, however (i.e., if the Settlor wishes to purchase the residence from the trust after the expiration of the Fixed Term) where it may be desirable for the trust to be treated as a separate taxpayer. In that instance, the trust would then need to file its own tax return.

It is important to note that there is no basis "step-up" for the gifted residence. Rather, the ultimate beneficiaries will receive the Settlor's basis in the residence. If the beneficiary later sells the property at a price higher than the Settlor’s basis in the property, the beneficiary will recognize a capital gain. Under present law, the tax on long-term capital gains is 15% for property held in excess of 12 months, while the federal estate tax rate is currently 45%. Even though greater capital gains taxes might be paid by the Settlor’s children in the future, the differential of up to 30% [45% minus 15%] will provide substantial estate tax savings. If the Settlor dies within the Fixed Term, the estate tax savings is lost because the residence will be included in the Settlor's estate, but the beneficiary will receive the full basis step-up provided by law.

Benefits of Making Gifts In Trust:

In addition to considerable tax savings, the use of a QPRT, as with other trusts, offers other potentially valuable benefits. First, upon the death of the Settlor, no change in ownership has occurred because the trust owns the residence (only now with a new Trustee). The assets are, therefore, exempt from probate. Second, the assets in the QPRT (the residence or reinvested sales proceeds) do not become a matter of public record thereby increasing the privacy of the decedent and his or her family. Third, the QPRT and any trust created for the benefit of the Settlor’s spouse and children are "spendthrifted" which means that creditors of the surviving spouse and family members generally cannot reach an asset held in the trust. Fourth, the terms of the trust can be drafted to give the Settlor as much or as little control over how the assets pass to his or her spouse and children to ensure that their needs are met, their education is paid for, and the money is not squandered by a spendthrift child. Finally, competent management through a professional Trustee is available, if desired.

Creation of the Trust:

The steps to creating a QPRT are summarized below:

1. Determination of Fixed Term. After the Settlor has reviewed the actuarial life expectancies and potential estate and gift tax savings under various scenarios, the Settlor needs to decide on the Fixed Term.
   

   
   

2. Trust Agreement. We will discuss the details of the trust agreement with the Settlor, including his or her choice of Trustee and the manner in which the Settlor wishes to have the property pass to his or her spouse, children, or other named beneficiaries. The trust agreement is then signed by the Settlor which states that the Settlor is irrevocably transferring the residence to the trust and is retaining the right to live in the home for the Fixed Term
   

   
   

3. Deed. There is a legal deed equivalent included as Schedule A to the trust agreement. While this might transfer the ownership of the residence to the QPRT, the preparation and recording of a deed will allow the transfer to be put onto the public records without recording a complete copy of the Trust. We can prepare the deed and see to its proper recordation.
   

4. Gift Tax Return. When the Settlor deeds the real estate to the QPRT, the Settlor will be making a gift. Due to the nature of the gift, the Settlor will be required to file a U.S. Gift Tax Return, Form 709. This return must be filed by April 15th of the year after the gift. If the value of the gift (discounted as explained above) is less than the Settlor’s Unified Credit, no gift tax will be due.
   

5. Appraisal. The discounted value of the gift will depend on the fair market value of the residence. In order to properly determine and memorialize the residence’s fair market value on the date of the gift, it will be necessary to obtain an appraisal of the property. This appraisal will be attached to the Gift Tax Return discussed above. We recommend using an MAI appraiser to avoid any challenge to the appraised value by the IRS at a future point in time.
   

6. Insurance and Mortgage Holder. The insurance company issuing the home owner’s policy needs to be notified so the policy can be updated to reflect the trust as the new owner of the residence. Likewise, if the residence is secured by a mortgage, the bank must be notified of the transfer of the home into the QPRT so the mortgage documents can be properly amended.
   

Conclusion: