What is a qualified personal residence trust? It’s a special type of irrevocable Trust that allows you to remove your home from your personal, taxable estate. Sound enticing? We thought so too! Keep reading to find out exactly how a QPRT works, important factors to consider, and when you might choose to use one.
What is a Qualified Personal Residence Trust?
A qualified personal residence trust (QPRT) is an irrevocable trust that allows the Trustor, the creator of the trust, to move a real primary or secondary home out of their personal estate. This is done for the key benefit of transferring the home to a future beneficiary with gift tax savings.
A QPRT allows the homeowner to remain in the residence with “retained interest” until a specified date. After this date, the remaining interest and thus the ownership of the home is transferred to the beneficiary of the trust.
During the length of the trust, the value of the property may increase. This value is calculated using Internal Revenue Service (IRS) federal rates, which represents minimum market rates. Because the homeowner retains partial interest in the property, the gift value of the property is calculated at a lower rate than the fair market value. Thanks to this, the value at which the gift tax is calculated is lowered. The gift tax may also be lowered through a unified credit, which sets a dollar amount that an individual can give to beneficiaries before any estate-related taxes are applied.
How Does a Qualified Personal Residence Trust Work?
Let’s use an example to help illustrate how a qualified personal residence trust works. Let’s say that you own your home and would like to eventually have your daughter inherit it. You know that its value could be subject to gift taxes if it continues to increase in value any longer, but you’re not ready to move out.
You get the bright idea to set up a QPRT so that you can continue holding on to the house but reduce the impact any increase in value could have on the size of your taxable estate.
Your home is currently worth $1 million. You set up a QPRT with a term length of ten years and transfer the home to it. You name your daughter as the beneficiary such that when the Trust expires, the home will pass to her.
Over the course of ten years, the home increases in value by $500,000. Luckily, however, this increase in value is tax-free because the home is in your QPRT. When the house passes to your daughter, any potential gift and estate tax will be assessed at the original $1 million value.
How Long Can the Term on a QPRT be?
There is no set limit on the term of a QPRT.
Setting the term length is one of the most important aspects of the Trust. It should be set up such that it expires before you pass away. Otherwise, the property goes back into the estate and will be subject to estate taxes, including gift taxes. The QPRT is set up with the intention that you will still be alive when the trust expires.
The inherent risk lies in determining the length of the trust agreement. Longer-term trusts help create greater reduction in the gift tax for beneficiaries. However, you must ensure that you have a low possibility of passing away before the trust expires. It is not uncommon for QPRTs to be set up for 10, 15, 20 years or longer.
What Are the Benefits of a Qualified Personal Residence Trust?
Grantors typically seek out the qualified personal residence trust (QPRT) for the key benefit of reducing their estate taxes. By removing the home, often one of the Grantor’s most valuable assets, out of the estate and into the trust, they are able to reduce the taxable estate by that much. However, there are some additional benefits that might ultimately help a Grantor choose between a QPRT and other types of trusts.
Here is an overview of QPRT benefits:
Utilizing a QPRT reduces estate taxes for the Grantor and their Beneficiaries.
QPRTs allow Grantors to pass property to heirs with a reduction in the value for gift tax purposes. Because the property can only be owned by the heirs at a future date, the property value is discounted by the IRS. (This rule essentially “freezes” the property value to its value at the time it was transferred to the trust.)
If the Grantor lives past the expiration of the trust, then the full market value of the property is removed from their estate. (This includes any appreciated value of the property.)
The Grantor maintains partial interest in the property placed in the trust, meaning that they can still possess, use, and enjoy the property throughout the trust term. When the trust expires, the beneficiaries have the option to rent the property back (at a fair market rental rate) to the Grantors to keep it out of the Grantor’s estate.
The Grantor can also name himself or herself as the Trustee of the QPRT such that they control the property throughout the trust term.
What Are the Drawbacks of a Qualified Personal Residence Trust?
There are also some disadvantages of establishing a qualified personal residence trust to consider:
A QPRT is irrevocable. This means that you cannot cancel the trust or change its terms once it is put into effect. The QPRT can only be terminated prematurely upon your death. This is a big commitment that should be carefully thought over.
Setting up a QPRT is inherently a gamble. This is because you must set an arbitrary trust term and be sure that you do not pass away before the term expires. If you do pass away before the trust expires, then the tax benefits you intended to benefit from are lost. The property ends back up in your estate and will be subject to estate taxes.
If you have an outstanding balance on your mortgage, know that any mortgage payments are considered “gifts” that reduce your gift tax exemption. You also can no longer refinance the property or use it as a collateral since you are no longer the technical owner of the home. It’s recommended that you utilize a QPRT only if you own your home outright.
The Grantor is responsible for any QPRT income and expenses for tax purposes.
Other Common Questions About Qualified Personal Residence Trusts
Deciding whether or not to utilize a qualified personal residence trust is a big decision. Earlier, we pointed out several benefits and drawbacks associated with using a QPRT. When the conditions are right, it can be a powerful tool that removes one of your most valuable assets, your home, from your estate. Ultimately, this should reduce your estate and gift taxes that could impact your beneficiaries. However, there are some inherent risks involved. The key risk is the possibility of passing away before the trust expires. If this happens, the house goes right back into your estate and your strategy essentially fails.
Here are some answers to popular questions about QPRTs that may help you with your decision.
What happens when you sell a house in a QPRT?
Regulations permit Grantors to sell a house that is owned by a QPRT. Here, there are generally three different scenarios:
When the QPRT home is sold and proceeds are used to purchase a different home of equal or greater value.
When the QPRT home is sold, part of the proceeds are used to purchase a home of lesser value; there are some remaining proceeds.
When the QPRT home is sold and proceeds are not reinvested in another home.
If a QPRT home is sold, then the Grantor has two years to reinvest the proceeds into the purchase of a new home. If this rule is satisfied, then the QPRT status will continue. However, the new home must meet the trust requirements. Further, the trust terms must allow the trust to hold proceeds of a sale. If the trust agreement does not allow this, then the QPRT automatically terminates.
What if the QPRT home is sold, but only part of the proceeds are used to purchase a home of lesser value? This is a common scenario, as Grantors often wish to downsize as they age. The QPRT will continue with the replacement residence. However, the remaining proceeds are not qualified as a QPRT asset. Within 30 days, the Grantor must either distribute the remaining proceeds to themselves or convert the portion of the trust into a grantor retained annuity trust (GRAT).
Last but not least, what if you sell the QPRT home but don’t use the proceeds to purchase another home? In this case, the QPRT will terminate. The proceeds must either be distributed to the Grantor in entirety, or they must convert the QPRT to a grantor retained annuity trust (GRAT).
What type of trust is a QPRT?
For income tax purposes, a QPRT is considered a Grantor Trust. During the term of the trust, the grantor can still claim deductions for any property taxes he or she paid on their annual income taxes.
Does a QPRT file a tax return?
Again, a QPRT is categorized by the IRS as a Grantor Trust for income tax purposes. In general, QPRTs do not generate any income. Therefore, an income tax return is usually not required. In case the QPRT property does generate income in any given tax filing year, then the Grantor may need to file a Grantor Trust Tax Return. It is best to consult your tax professional if you have any tax-related questions for your QPRT.
What happens at the end of a QPRT term?
Before setting up a QPRT, you should be informed that you will no longer be the owner of your residence. The technical owner of the home is the QPRT, although you are allowed to retain possession, use, and enjoyment of the home throughout the trust’s term. Once it expires, however, the property interest passes to your Beneficiary. This means that you are no longer the home owner thus no longer control the property.
Before the QPRT expires, you should review your trust terms to understand what happens to the property:
The property may be distributed in entirety to your Beneficiary or Beneficiaries.
The property may pour over into another Trust for the benefit of your children. You’ll want to know if this pour over Trust was structured as a Grantor Trust that allows you to retain control of the property.
The Trust may provide that the first beneficiary of the Trust is your spouse. When the Trust expires, it gives your spouse the right to use the house until they pass away, and without having to pay rent. This allows you, the Grantor, to use the residence as long as you are married to your spouse. In this scenario, your children are typically named the backup beneficiaries in case your spouse passes away before the Trust expires.
Can a QPRT hold cash?
A QPRT can hold cash in a separate account for the following purposes:
To pay Trust expenses that are incurred, including a mortgage.
To pay for improvements to be made to the property.
The purchase of the initial residence by the Trust.
The purchase of a replacement residence.
To hold proceeds for two years after a Trust residence is sold.
Note that the cash held in the account must be spent within specific time frames for each purpose. Some time frames are as little as three months, while other transactions must happen within six months. Any cash in excess of the qualified reasons must be distributed on a quarterly basis, and then again when the trust expires.
How do you calculate the gift value of QPRT?
Calculating the gift value of a QPRT is tricky and should be made with the assistance of a tax professional.
When you fund the QPRT with a house, you are making a future gift. The value of this gift is the difference between the value of the property (at the time it was transferred to the trust) and the value of the property interest retained by you (the Grantor).
The property value is the fair market value of the property at the time that it is transferred to the Trust. This essentially “freezes” the property value. Any property value appreciation from this date forth is not counted.
The value of this retained interest is calculated by multiplying the present value by the annuity for the number of years the Trust will run.
The difference between these two values is the future gift value of the QPRT.
Update Your Estate Plan to Include Your QPRT Today
A qualified personal residence trust (QPRT) is a great tool if you are planning your estate and realize that your primary or other residence significantly impacts the total value of your estate. Estate taxes, including gift taxes, are assessed using the total value of your estate. There are instances in which you exceed the exemptions or thresholds and would otherwise be subject to these taxes. However, by leveraging a QPRT and removing your home from your estate, you could reduce your exposure to taxes. When using a QPRT, be careful to set a Trust term such that it will expire when you are still alive. Otherwise, if you were to pass away before the QPRT expires, then the home will go right back into your estate.
If you would like to utilize your QPRT, know that it should be included in your Estate Plan. Find out how you can easily create or revise your Estate Plan today through Trust & Will.
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