Trust Your House

By Michael Mingione

One way to reduce the value of a taxable estate is to transfer a home into a qualified principle residence trust (QPRT). The author explains the estate, gift, and income tax consequences of such a transfer. He also warns tax planners of the requirements of a new proposed regulation that now must be
considered.

There are a number of ways that a taxable estate can be reduced. One technique is the use of a qualified principal residence trust (QPRT) or grantor retained income trust (GRIT) under IRC Sec. 2702 and related regulations. There are a number of requirements, however, that must be satisfied for these trusts to qualify to achieve the desired results.

GRITs

A major estate planning device used prior to 1990 was the GRIT. A grantor could transfer property to an irrevocable trust and retain the right to the property's income for a fixed term or his or her lifetime. For gift tax purposes the donor was able to reduce the value of the property by the present value of the retained income. Depending on the grantor's age and the income retained, the value of
the property transferred could be reduced to a small fraction of the
property's actual value.

As you might expect, the IRS convinced Congress that it should stop this transfer technique since it is perceived as potentially abusive. So Congress, after several unsuccessful attempts to curb these benefits during the late 1980's, finally created new Chapter 14 of the IRC effective in 1990, which is comprised of IRC Secs. 2701-2704, dealing with special valuation rules with respect to transfers of property between family members when
utilizing trusts.

IRC Sec. 2702 basically states that the value of the retained income interest shall be valued at zero unless the retained rights are "qualified" retained rights. Trusts that retain these qualified characteristics are known as grantor retained annuity trusts (GRATs) and grantor retained unitrusts (GRUTs). In addition, Congress exempted transfers to trusts for property that consists of a qualified personal residence or second residence defined under IRC Sec. 280A, dealing with vacation homes and related rental rules. Thus, the continued use of the QPRT and certain types of GRITs remains a very effective method of reducing the value of a taxable estate when dealing with these qualifying
properties.

Establishing a QPRT

To establish a QPRT, the taxpayer transfers his or her home into an irrevocable trust. Each grantor is permitted to have two qualifying trusts (presumably one for the principal residence and one for a second home). The terms of the trust provides that the grantor retain the right to live in the home without paying any rent for a specified period of time. The term of the trust can be as short or as long as desired. The longer the term the lower the value of the gift. If the grantor dies before the term of the trust expires, however, the property will revert back to the estate of the deceased and be subject to estate taxes at its current value. Therefore, a term should be picked that the grantor believes he or she will outlive for the benefits of the QPRT to be effective. If the grantor outlives the trust, the corpus could then be distributed directly to children or continue in a new trust for their future benefit. The new or successor trust may be desirable since the continuance of the trust may also provide the children with asset protection from potential creditors as well as unexpected marital disputes. The creation of a QPRT results in complex and overlapping income, gift, and estate tax consequences.

Income Taxes

For income tax purposes, the creation of a QPRT is considered a grantor trust governed by IRC Sec. 677. Accordingly, the grantor is treated as the owner of the income portion of the trust's property. As such, the trust's income and deductions for real estate taxes and mortgage interest are attributed to the grantor since the trust is ignored for income tax purposes. Therefore a parent in a high tax bracket will still obtain a deduction for mortgage interest and real estate taxes provided he or she continues to pay for them.

The grantor should also retain a reversionary interest under IRC Sec. 673, which is the right for the grantor's estate to receive the property back if the grantor dies during the trust term, so that the property will qualify for the unlimited marital deduction and limited administrative rights such as the ability to change trustee(s) and beneficiary(s). These additional limited powers also make the grantor the owner of the corpus for income tax purposes. This results in the following advantages:

* Sale of the residence can qualify
for the $125,000 exclusion under IRC
Sec. 121.

* Sale of the residence can qualify for the deferral of gain if a new residence is purchased within two years under IRC Sec. 1034. If a replacement residence is not purchased, the trust converts to an annuity trust thus providing the grantor with an income stream for the remainder of the trust term.

* The trust document may provide that the grantor's spouse shall be a subsequent income beneficiary, thus providing the spouse with the right to live in the house until death without paying rent. This provision should not result in the residence being included in the spouse's estate upon his or her death, since he or she was not the original grantor.

* The grantor may sell or purchase property to or from the trust without recognizing any taxable income or loss. Under new proposed regulations as discussed below, repurchases will cause the trust to become disqualified.

* The grantor may transfer a residence with a mortgage in excess of basis without triggering gain, provided the grantor remains personally liable for debt.

Gift Taxes

For gift tax purposes, the creation of a QPRT will not result in a gift qualifying for the $10,000/$20,000 annual gift tax exclusion since it is not a gift of a present interest. However, the $600,000 unified lifetime exemption does apply to this type of gift. The value of the gift is determined by the current market value of the residence, less the present value of the grantor's retained rights, i.e, the right to live in the house rent free during the term of the trust. The present value of the retained interest is determined by valuation tables established under IRC Sec. 7520, based on mortality, trust term, and interest rate. The interest rate used to determine the present value must equal 120% of the mid-term applicable Federal rate in effect during the month of transfer. The result is a high discount for gift tax purposes. The final regulations dealing with QPRTs do not require the retained interest factor be valued with reference to the grantor's life expectancy as is the case with GRATs and GRUTs. Therefore Table B of the IRS valuation tables (Publication 1457) may be used, although IRS may try to assert table H should be used, which would result in a slightly larger gift value. The higher the interest rate, the greater the value of the retained interest, and accordingly, the lower the value of the current gift.

The value of the gift may be further reduced by gifting less than 100% of the residence into a trust. For example, if two undivided 50% interests were transferred into two separate trusts with identical terms, the 50% undivided interest may qualify for a minority interest and lack of marketability discount when determining the current market value of each interest. Great care needs to be exercised in this area.

If the property being transferred is subject to a mortgage, the grantor should remain personally liable on the mortgage. It is still unclear as to how the IRS will treat mortgaged property. The value of the residence should not be reduced by the outstanding mortgage when creating a QPRT, so that future principal payments made by the grantor are not treated as additional gifts. If the value of the residence is reduced by the mortgage, the principal portion of the mortgage payments may be treated as additional gifts that may not qualify for the $10,000/$20,000 annual exclusion, since IRS may take the position these mortgage payments are not gifts of a present interest. Due to the current uncertainty, it is generally not advisable to transfer highly mortgaged property to a QPRT, since there are no apparent benefits to do so. However, it can be done without disqualifying the trust.

At the end of the trust's term, the property generally passes to the intended beneficiaries. There is no additional gift tax due regardless of how much the residence has appreciated in value over the years. This is a very powerful tool for transferring wealth between generations. As with any gift, the beneficiary will assume the same tax basis of the grantor. Therefore, when the property is ultimately sold, gain will be computed based on the grantor's tax basis. Currently, capital gains tax rates are significantly lower than estate tax rates and if capital gains rates are reduced further in the future, the overall benefits of a QPRT will become even greater. The overall tax burden of capital gains tax and potential gift taxes (if any) upon creation of a QPRT should still be significantly lower than the estate tax rate that would be imposed if the property passed at death. If gift taxes are due, these taxes will further reduce the grantor's estate subject to tax, whereas estate taxes do not reduce the value of the gross estate.

Estate Taxes

The estate tax consequences of a QPRT are relatively simply. If the grantor should die during the term of the trust, the property will be included in the estate of the deceased at the current market value on the date of death. For this reason, the trust document should contain a reversionary clause as discussed earlier. If the grantor survives the term of the trust and wishes to continue living in the home, he or she must pay rent at the current fair market value. If rent paid is below market value or no rent is paid, the residence may be included in the grantor's estate under IRC Sec. 2036, since the grantor would be considered retaining an implied life estate. If no planning is done, the value of the residence(s) will be included in the deceased estate. If a QPRT is created and the grantor dies before the trust term expires, the value of the residence(s) will also be included in the estate. From a tax standpoint, you have nothing to lose by creating a QPRT and everything to gain.

A planning option available to hedge the risk of estate taxes in the event of premature death is to purchase a term life insurance policy to cover the potential estate taxes in event of death. Furthermore, the creation of a QPRT should provide asset protection from claims of future creditors.

Since the creation of the QPRT will require giving up ownership of a residence(s) during lifetime, the options available upon the termination of the trust should be considered. The grantor can lease the residence for its fair market value. This will result in taxable income to the children and a reduction in taxable estate of the grantor, who's estate tax bracket may be higher than the children's income tax bracket.

Prior to May 16, 1996, the grantor had an opportunity to purchase the residence near the end of the trust term at the current market value. This transaction would not result in a taxable event because, as discussed above, transactions between the trust and grantor would not be taxable. The IRS had privately ruled this transaction will not disqualify the QPRT. In Letter Ruling 9441039, the IRS also allowed a QPRT to qualify where the trust document required the trustee to provide the grantor with a first option to purchase the residence in the event of a sale; this ruling made creating these trusts very favorable to the grantor. The grantor could purchase the residence with a note or cash. Utilizing a note enabled the grantor to retain cash needed for living expenses. A major benefit of repurchasing the house is that the grantor exchanges an asset (cash or note) that receives no step up in basis for an asset (house) that may benefit from a stepped-up tax basis upon the death of the grantor, while not increasing the value of the estate.

Proposed Regulation

As discussed earlier, on April 16, 1996, the IRS issued Proposed Regulation 25.2702-5 that is effective for any trust created after May 16, 1996. The proposed regulation provides that if a trust document did not specifically prohibit a grantor, spouse, family members or controlled entity from directly or indirectly acquiring the residence, the trust would not qualify as a QPRT. Accordingly, the overall tax benefits resulting from a repurchase is currently suspended and lost. If the trust were to be disqualified, the results would be disastrous since a gift tax would be due on the entire value of the transferred property, presumably many years before the trust would be deemed disqualified. A potentially large deficiency including interest and penalties would also be due. The IRS has also vowed to examine transactions for trusts created prior to May 1996 and may challenge any repurchase under the substance-over-form doctrine. This result could also be disastrous since taxpayers may have created QPRT's relying on existing regulations, letter rulings, and other interpretations of the tax laws. Although these new rules are in the form of proposed regulations, practitioners must rely on them until additional guidance is issued. The proposed regulation may be challenged and ultimately invalidated, or new code sections may be added as part of proposed tax legislation.

Alternate Strategy

Alternatively, the trust document may provide that upon termination of the grantor's initial term, the property shall continue in trust with the surviving spouse having the right to live there rent free. This will not cause the inclusion of the residence in the nongrantor spouse's estate as the benefit of enjoyment ceases upon his or her death with no further rights. The grantor can presumably continue to have use of the residence as the spouse's guest without any adverse tax consequences. As discussed earlier, the trust property (whether cash, notes or the house) may further be retained in trust solely for the future benefit of the children, which could provide important asset protection from children's creditors and potential marital disputes. The children can receive the trust's income as well as its principal for health, education, support, and maintenance while protecting the underlying asset value until a much later date. *