Estate Planning
Short Term Qprt

Short Term QPRT

Background

Estate planning regarding Florida homesteads is often a difficult problem because Florida law requires that if the decedent is survived by a spouse or minor child, the homestead must pass as a life estate to the surviving spouse with the remainder to the decedent’s descendants. Most clients simply do not want their homestead to pass in that fashion. The fundamental problem cannot be solved via a transfer of the homestead to a revocable trust.

Accordingly, whenever the Florida restriction on devise of homestead may apply and there is a desire to control the passage of the homestead on death, Florida law practically forces the estate planner to recommend the gifting of a remainder interest in the homestead to an irrevocable trust. But unless the gift is incomplete for gift tax purposes or the homestead is held in a trust that meets the technical requirements of the regulations under IRC §2702 (i.e., a QPRT), the taxable gift equals the entire value of the homestead without reduction for the value of the interest retained by the donor.

QPRTs in General

A qualified personal residence trust (QPRT) is a well-known and often used estate planning device. The purpose of the QPRT is to achieve a valuation discount for a gift of the owner’s homestead or another personal residence (or both). Usually the gift is made to a trust in which the donor retains a possessory right to the residence for a term of years, after which the residence either continues to be held in trust for the benefit of other family members or title shifts to such donees.

From a gift tax perspective, the benefit of a QPRT is that the gift is measured by subtracting the value of what the grantor retained from the value of the gifted interests in the residence, all measured at the time of transfer. If the grantor survives the term, title shifts to the remainderman without additional gift tax. If the grantor fails to survive the term, the net effect is essentially the same as if the QPRT had not been established. Since there is no “downside” if the grantor fails to survive the term, the technique fits into the category of “heads I win, tails we’re even.”

The Remainder Interest

The above discussion is well-known and noncontroversial in the estate planning community. The difficulties arise when planning for the remainder interest.

The primary question is how the grantor can continue to reside in the residence after the term expires. The usual answer is that the residence can be rented to the grantor. Since losing control is not particularly palatable to many clients, many estate planners recommend naming a trust for the benefit of the children (or other beneficiaries) as the remainderman—and with careful drafting, there is no reason why the grantor(s) could not be the trustee(s) of the remainder trust.

The benefits of such an approach are significant. Since the remainder trust can be drafted to be a grantor trust for income tax purposes, the grantor can continue to be treated as the owner of the residence for income tax purposes (but without being treated as the owner for estate and gift tax purposes). A lease of the residence by the grantor as tenant is then considered a lease by the owner to himself—a nonevent. Thus the grantor can lease the residence from the trust after the term expires without adverse income tax consequences, and can still take the same mortgage interest and ad valorem deductions as before, as well as qualify for the exclusion from gain on sale.  Moreover, the rent payments are not considered gifts.

The Short-Term QPRT

Suppose the QPRT is for only two years, instead of the typical ten to fifteen year period. Besides the real-world effects, there are two obvious tax effects. First, the remainder interest—and thus the taxable gift on formation—is much larger. For example, with a $1 million residence, the remainder interest with a two-year QPRT might be valued at $867,430 as compared to $391,270 for a twelve-year QPRT. Second, the risk that the grantor will die during the term (and thus lose the transfer tax benefits) is much less. One effect is good and one is bad; you must “crunch” the numbers to see if the tradeoff makes sense.

Illustration (12-Year Term):

Assume (i) 60-year-old spouses own a $1,000,000 residence with no mortgage, (ii) they divide their interests into an equal tenancy in common without rights of survivorship to achieve a 20% valuation discount, (iii) they each transfer their half interest to a separate QPRT with a twelve-year term, (iv) the §7520 rate is 6%, and (v) each spouse retains a reversionary right if he or she dies during the term. The combined value of the gifted remainder interests is only $313,016. If they each survive the term and the residence is worth $2,000,000 at that time (i.e., appreciates at 6% compounded annually), the net gift tax effect is the transfer of a $2,000,000 asset for a gift tax value of $313,016.

Illustration (2-Year Term):

If each spouse instead sets up a two-year QPRT, the sum of the taxable gifts would be $694,944, a reduction of only $105,056 from the $800,000 discounted value of the residence, and $381,928 more than the $313,016 combined taxable gifts under the two twelve-year QPRTs. Is the “price” worth paying?

Lease-Back Scenario:

Assume each spouse survives the two-year term and both half interests pass to the same trust for the benefit of their children. Assume further that the fair monthly rental value is 1% of the value of the residence (adjusted annually), the residence increases 6% annually, and the rental receipts are invested at a 6% compounded rate. The remainder trust would not only have the residence, but would also accumulate over $2.35 million in other assets (assuming no trust distributions). The additional $2.35 million arrived with a gift tax “cost” of reporting only $381,928 more taxable gifts up front compared to the twelve-year QPRTs—and the grantors avoided the risk of estate inclusion during the additional ten-year lease period.

For comparison, if the spouses had established two twelve-year QPRTs and made additional taxable gifts of $381,928 up front to the remainder trust, and those funds earned 6% compounded annually, the gifted funds would have roughly doubled to about $768,000—far less than the $2.35 million achievable with the two-year QPRT plus ten-year lease.

Fair-Rent Risk:

The obvious risk is that the IRS could assert that the rent paid exceeded fair rental value and treat the excess as a taxable gift. If the issue is not disclosed on a gift tax return, it would likely arise only during an estate tax audit. If properly disclosed on a gift tax return, the exposure would be limited to excess rent within the three-year statute of limitations. Either way, any gift tax paid reduces the gross estate; the net transfer tax outcome may still be preferable to paying a lower rent.

The Loss of Basis Problem

From a global tax perspective, the principal “downside” of a QPRT is the loss of a step-up in basis on the grantor’s death if the residence is not included in the grantor’s gross estate. As is often the case, that risk can be managed once identified.

For QPRTs established before May 16, 1996, the grantor could simply purchase the residence from the remainder trust—eliminating the lease benefits, but allowing the proceeds to be invested. If the purchase price is paid via an installment note, interest (to the extent thereof) replaces lost rent. If interest is substantially less than rent, an ideal time to purchase may be immediately prior to the grantor’s death.

QPRTs established on or after May 16, 1996 must prohibit sales or transfers of the residence to the grantor, the grantor’s spouse, or an entity controlled by either during the QPRT term or any subsequent period in which the controlled entity is a grantor trust. However, if the remainder trust is not a grantor trust at the time of the transfer from the QPRT, the remainder trust need not prohibit a sale to the grantor.  Note that a nongrantor remainder trust can be designed to convert to grantor trust status shortly after receiving the residence.

The Real World

The practical issues with a short-term QPRT stem from the fact that the grantor must pay rent (or mortgage payments) for a longer period. Whether that makes economic sense depends on the rest of the grantor’s estate plan.

A useful way to view a short-term QPRT combined with a longer-term lease (or purchase-money mortgage) is that the rent (or interest) payments act like an increase in available annual exclusions. Many well-crafted gifting programs involve annual transfers to an irrevocable trust for the benefit of the grantor’s children, coupled with withdrawal powers and “Crummey” letters. Rent (or interest) paid to the remainder trust can accomplish the same results without withdrawal powers. The difference is that gifting is voluntary while rent (or interest) is mandatory.

Conclusion

A QPRT efficiently transfers a remainder interest in a residence from a gift tax perspective. If the grantor dies while holding the term interest, the technique yields no tax benefit. Extending the term lowers the value of the remainder interest—and hence the taxable gift on formation—leading many estate planners to engage in a macabre balancing act of guessing when the client will die.

That balancing act is often not optimal. Where the goal is to shift as much as possible to ultimate donees free of transfer tax and without losing control, a short-term QPRT paired with a long-term lease from a remainder trust that is a grantor trust is often far superior to a long-term QPRT—especially where clients already use or contemplate an aggressive gifting program.