Qualified Personal Residence Trust

My wife and I want to transfer our personal residence to our children. We retired last year, and want to remain in our family home for another five years or so, and then move to a retirement community in Florida. Our accountant tells us it would be a mistake to include the house in our will or a living trust because the house and property have appreciated significantly and the estate taxes on it would be exorbitant. He keeps telling me to look into “grits”, but I haven’t been able to find any information other than recipes for a southern dish. Can you help me out here?

Would you like cheese on those grits? Just kidding. The term “GRIT” is an acronym for Grantor Retained Interest Trust. A Qualified Personal Residence Trust (QPRT) is a type of GRIT that allows a gift to the trust by you (the settlor) of your personal residence at a discounted rate. The beneficiary is usually the child or children of the settlor. This removes the asset from the settlor’s estate thereby reducing estate taxes when the settlor dies.

It's important to recognize up front that QPRT's are irrevocable. Once you put your home in a QPRT, you have effectively given it away at that point (subject, of course, to the retained interest we'll talk about). And, this brings up another key point which is there really is no reason to even think about using a QPRT (or QTIP for that matter) unless you have an estate tax "problem." And you only have an estate tax problem if your estate is large enough to pay estate taxes. You can get more information about this at estate tax.

A QPRT will work for you if you want to transfer your personal residence to your children (or other family members) at some time in the future. You can reserve the right to live in the house for a specified period of time when you create the trust. At the end of the specified period, the ownership transfers to your children.

If properly done, it will reduce the overall transfer tax cost (estate and gift taxes) of the transfer. You will not pay rent, but you are responsible for all of the expenses of the home (repairs, taxes, maintenance fees, etc) while living there. The residence must be used as your primary residence; you can use the residence secondarily for business activities.

In terms of gift tax, the value of the remainder is calculated by 1) determining the fair market value of the property 2) subtracting the value of the retained interest. The retained interest is the length of time you will remain in the house and its valuation is calculated by by using rates published by the IRS (actually the Dep't of Treasury) for making present value calculations. If you want some light reading you can find the rules explaining all this is at Section 25.2702-5 of 26 CFR (Code of Federal Regulations). Relevant tables with rates can be found at 26 CFR Sections 1.642 and 1.664.

Obviously, the calculations involved are rather complex. But to give you a general idea: If a 55 year old transfers a home worth $800,000 to a QPRT for a term of 10 years, depending on the valuation rates at the time, the value of the current gift might be about $300,000. If the residence appreciates at 3% per year, the house would be worth $1,075,000 at the end of 10 years. If the house were gifted to the children at the end of the 10-year term INSTEAD of using the QPRT, the gift tax value would be based on the $1,075,000 value of the house at that time; rather than the $300,000 QPRT valuation 10 years earlier. So, you would potentially pay a gift tax on 300k rather than either a gift tax on 1.075 million or potentially estate tax on that amount if the house simply passed as part of your estate. So, by using a QPRT, there would be a substantial tax savings (gift or estate tax) in the range of $270,750 (using the lowest marginal estate tax rate).

A QPRT affords the greatest transfer tax savings when the settlor is young and the trust term is long. This is because the retained interest will be valued higher (longer trust term in which the settlor retains use of the property); the remainder interest lower (because there's a longer time to wait to receive the property). Also, odds are the property will appreciate in value; yet the value will be set at the much earlier time of transfer for purposes of gift tax -- so another advantage to a long trust term. However, a long trust term runs the risk of the settlor dying before the trust term ends and thus dies with the property still in his or her estate. If this were to happen it would defeat the purpose of the QPRT.

For an older settlor, the risk of death before the trust term expires is obviously greater. And, again, if the settlor dies before the trust terminates, the residence will be included in the taxable estate because the settlor retained the use of the property that did not end before his/her death. If the settlor outlives the term of the trust, the property will be distributed to the children without further transfer tax (gift tax was already paid -- assuming no exemption).

Advantages and Disadvantages of Qualified Personal Residence Trusts (QPRT's)

We've talked about the potential tax advantages of a QPRT and touched on the risk of dying before the QPRT term ends. But, there are other possible disadvantages to consider as well. One of the biggest potential disadvantages of a QPRT is the loss of the stepped-up basis that would otherwise happen if the property passed at death. To use an example:

Let's say the house is worth 500k when transferred into the QPRT. Let's say the remainder interest was valued at 250k. So, we have a gift of 250k to potentially pay gift taxes on. Let's further assume the term of the trust was 10 years and during that time the value of the house rose to 750k. So, we end up with a 750k house transfer with payment of only gift tax on 250k. BUT, if we simply had kept the house in the estate, and if the estate was small enough to avoid having to pay estate taxes, then we would have been better off since the house would have been passed at the stepped-up basis of 750k (so no capital gains tax on that) and there would have been no estate tax or gift tax -- so no tax at all.

So, that gives you a flavor of the considerations that must be taken into account. Ultimately, the potential tax benefit has to be weighed against the expenses of the trust, risk of possibly dying before the end of the trust term, loss of stepped up basis, etc. Like everything else, there are pros and cons to QPRT's and they are not right for everyone. It will depend on your unique situation; your assets; your age; your health; the current and prospective estate tax exclusion amount and many other things. This is why you really should get advice from a professional before deciding whether to put a residence in a QPRT.

A QPRT is an irrevocable trust. It must keep its own records and file annual federal and state income tax returns. You cannot expect to regain ownership of the residence unless the trust ceases to qualify as a qualified personal residence trust. When the trust term expires the residence will automatically pass to the remaining beneficiaries. When the trust term expires, it will be unavailable to you as a residence or as an asset that can be sold if financial circumstances change. You could stay in the house at the end of the trust term if you agree to pay rent to your children at the going, fair market value, rate for such rentals.

Other QPRT Considerations

If, during the term of the trust, you sell the residence it can be replaced with another residence. If it is not replaced, the proceeds from the sale are returned to the settlor. Since the QPRT is considered a “grantor trust” it can take advantage of the settlor's $250,000 capital gains exclusion.

Another option, rather than returning the proceeds to the settlor would be to convert the QPRT into another typ of GRIT (Grantor Retained Interest Trust -- discussed earlier); namely, either a GRAT (Grantor Retained Annuity Trust) or GRUT (Grantor Retained Unitrust). Doing so would allow for payments from the trust to the original owner or settlor. The difference between the two is that a GRAT pays a set amount each year that is established at the beginning of the trust. A GRUT pays a fixed percentage of the trust value each year (so the payment goes up and down as the value of the trust goes up and down).

A few additional notes:

A QPRT can be a great way to provide some asset protection since you don't "own" the home once it is transferred to the irrevocable QPRT. Of course, this is a complicated issue and depends on your situation, but know that it is a possible benefit of a QPRT.

Also, a husband and wife who own a home jointly could take advantage of both of their gift tax exclusions to lesson any gift tax by each making a one-half interest transfer to separate QPRTs.

Finally, a vacation home may also potentially qualify for a QPRT if certain requirements are met.

This article is obviously just a brief overview of a very complex topic. So, if you are considering -- GRITS, GRUTS, GRATS or QPRTS -- you need to talk to a good living trust attorney. You can read about a similar trust at QTIP Trust.

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