The Qualified Personal Residence Trust (QPRT)

This is an irrevocable Trust, similar in concept to a GRAT, with a confusing name. It is a good method of shifting the value of the family home out of your estate, for the purpose of lowering the ultimate estate tax.

The house is placed into Trust for the future benefit of the children. The value today of this remainder interest is a taxable gift. As with a GRAT, the Grantor accepts some federal gift tax liability now, to save more on federal estate tax later. What is retained here by the Grantor is not income, but the right to live in the house for a term of years. If the Grantor outlives that term, the value of the house-plus any property appreciation since it was transferred to the Trust-passes to the children with no additional federal estate tax. As with a GRAT, if the Grantor does not survive the term of the Trust, it has no tax effect.

The QPRT does, however, have two significant drawbacks: First, the children will have received the house by lifetime gift, not inheritance, so there is no step-up in the tax basis of the property. For homes purchased decades ago at a fraction of today’s price, this means that income tax (at the 20% capital gains rate) must be paid on the increase in value-if the property is ever sold by the children. (Recall that, because the basis of inherited assets is “stepped up,” a lifetime of value appreciation can totally escape income taxation.) The Grantor should crunch the numbers to see which scenario will most likely result in the lowest total tax. Secondly, if the Grantor does survive, he/she must start paying the children fair market rent, or the IRS might look at this as a sham transaction. Payment of rent can be viewed as a further opportunity to pass wealth to the children, while decreasing the size of the taxable estate. A long term lease can provide the security they seek, if the payments are real and reasonable in amount. But this adds an element of insecurity to the arrangement and is difficult to accept psychologically for many people.

Note that a new tax regulation-applicable to QPRT’s created after May 16, 1996-has eliminated the common technique of permitting the Grantor the right to buy back the residence for his continued occupancy at the end of the Trust term. Now, the Trust document must specifically prohibit such a buy back. Indeed, this area is a good example of how the IRS looks at the “substance” of an arrangement over its “form,” scrutinizing “creative” transactions and changing the rules in the middle of the game, when necessary. So even if one has a QPRT created prior to the regulation’s effective date, the “buy back” technique should be used only with great caution, if at all.

Note, finally, that even if your state has an inheritance tax, it might well have no gift tax. If not, the QPRT (and the GRAT, above) can also save state death tax. If the Grantor outlives the Trust, the house would be considered a gift, not subject to the state tax, if any, on inheritances.