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FEATURE STORY
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Great News: Home Values Are
Dropping
Owners should start
thinking about qualified personal residence trusts
By Donald H. Kelley
The housing market is tanking. Interest rates are rising. As things
get worse, home owners will have a wonderful opportunity—to put their
property into trusts that’ll freeze the value at a low point and help
them leave more to heirs.
The qualified personal residence trust (QPRT) is a very popular tool for
estate tax planning. But it has non-tax uses and benefits, as well.
The QPRT may be used as a will substitute for designated residential
property and provides a way to pass this property to a specified family
member (or family members) at the end of a trust term.
In these times of depressed residential property values, it’s
particularly useful to transfer a principal residence, or vacation home,
to a QPRT, because it freezes the estate tax value of that property at
the current market rate. That is, the estate tax value will be the
current gift value of the remainder interest, assuming the grantor
outlives the term. Lower interest rates, as we’ve been experiencing,
make QPRTs less effective. But interest rates are rising. Even with
the low rates, QPRTs can be a tax bargain—as Natalie Choate discussed
in her February 2005 Trusts & Estates article, “The
Beauty of QPRTs.” (Choate also outlines the QPRTs’
generation-skipping tax implications.)
A QPRT may hold a personal residence and an amount of cash dedicated to
the payment of expenses attributable to maintaining the residence,
paying trust expenses, making improvements to the residence, and
enabling the trust to purchase a replacement residence. Under Treasury
Regulations Section 25.2702-5(b)(2)(i) the QPRT can include a
vacation home, if certain requirements are satisfied, or an undivided
fractional interest in an otherwise qualified residence.
For a quick review of QPRT requirements as well as their pros and cons,
see James King’s “The ABCs of
QPRTs,” in the October 2006 issue of the Journal of
Accountancy and Marilyn Sullivan’s “Qualified
Personal Residence Trust” on her website. Internal Revenue
Service sample provisions for a QPRT, including the required language
regarding conversion to a grantor retained annuity trust (GRAT) upon
total or partial disposition of the residence held by the trust, are set
forth in Revenue
Procedure 2003-42. QPRT conversion to a GRAT is discussed by Philip
Michaels and Laura Twomey in “Estate
Planning for Qualified Personal Residence Trusts,” in The CPA
Journal (Nov./Dec. 2003).
(Article continues below advertisement.)
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(Article continues here.)
Planning for a QPRT
What’s the best QPRT term for a grantor? That depends on (1) his or
her willingness to risk estate tax inclusion if he or she dies during
the term; (2) how much control he or she wants over gift tax value; and
(3) how long he or she wants to have the right to live on the property.
If the grantor wants to continue to reside on the property after the
trust term ends, his or her spouse can be made the initial beneficiary
and share the occupancy of the property with the grantor. The people
receiving the property after the trust term (or the trust, if continued
as a grantor trust) may rent it back to the grantor, as well.
To avoid estate taxation, the rent must be for the full fair market
value (FMV). Such rental removes more property from the grantor’s
estate, even if the rent is paid to the people receiving the property at
the end of the trust term, so long as their income tax rate is less than
the grantor’s estate tax rate. Given that there’s effectively no
tax on the rent paid to the continuing QPRT (as a grantor trust), the
result is even more property moved out of the grantor’s estate, both
as to the rent amount and the accumulated reinvestment of that money.
See Revenue
Ruling 85-13, 1985-1 C.B. 184. Properly done, rental back to the
grantor should not make the trust property includible in the grantor's
estate (see Private Letter Ruling 9448035 and the preamble to T.D. 8743).
And such rental should not affect the trust's status as a personal
residence trust (see PLR 9249014). This technique could be used to
offset the gift value increase resulting from a shorter trust term.
If the trustee sells the trust property during the trust’s term, the
QPRT’s estate tax benefit may be preserved by converting the QPRT into
a GRAT within two years of the sale. Of course, being a gift, the basis
of the trust property is not stepped up to the value at the date of the
grantor’s death.
Estate and Gift Taxability
The actuarial value (based on the applicable federal rate (AFR) on the
date the trust is created) to the recipients of the remainder interest
after the trust term is the gift value of the transfer. If the grantor
survives the trust’s term, only this gift value (as an adjusted
taxable gift) will be taxed to the grantor’s estate. If the grantor
fails to survive the term, the trust property’s FMV as of the date of
the grantor’s death is included in the grantor’s gross estate. Of
course, the shorter the term, the greater the likelihood that the
grantor will survive it. The possibility of the grantor not outliving
the trust term can, of course, be hedged by the purchase of life
insurance to cover the estate tax difference.
The remainder interest, being a future interest, has no gift tax annual
exclusion and will use up the grantor’s gift tax exemption to the
extent of its value at the time the trust is created.
A possible approach to dealing with the taxability of the residence to
the estate of the grantor is the split-interest purchase of QPRT
property described by Robert Moshman in “QPRT
Variations”.
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(Article continues here.)
What Should Software Calculate?
In planning for the use of a QPRT you will need software that will make
the following computations, in order to evaluate how best to proceed:
• Calculate the remainder interest that constitutes a gift to the
people receiving the residence at the end of the trust, based on the
value of the property, the current AFR, the term and, if appropriate,
the age(s) of the grantor(s).
• Calculate the reduced value of the remainder if the grantor retains
a reversionary interest, that is to say, reversion of the trust property
to the grantor’s estate if the grantor dies during the trust’s term.
• Calculate the estate tax savings from the QPRT transfer.
• Project the inflated value of the trust property for estate tax
purposes as of the date of death, if the grantor dies during the
trust’s term and calculate the resulting estate tax increment to the
grantor’s estate.
• Calculate the trust’s optimum term, taking into account the value
of the gift (based on the term), gift tax savings from a longer term,
the probability of the grantor dying during the term, and the resulting
estate tax.
• Calculate the consequences of converting the QPRT to a GRAT if the
trust property is sold during the trust’s term (meaning, the present
value of the annuity at the beginning of the trust that is equal to the
present value of the interest in the trust retained by the grantor.)
Methodologies for QPRT Calculations
The gift element of the QPRT is the value of the property contributed to
the trust, less the actuarial value of the grantor’s retained
interest, based on IRS factor for the AFR as of the date of creation of
the trust for a fixed term, or the shorter of such a term and the
grantor’s life expectancy.
The “shorter of” calculation is explained in Lawrence
Katzenstein’s, “Running
the Numbers: An Economic Analysis of GRATs and QPRTs,” ALI/ABA
Course Materials Journal (August 2000). For further review of the
application of the federal tables see Thomas Sweeney’s, “Unveiling
the ‘QPRT’ Magic: A close-up of the numbers behind the Qualified
Personal Residence Trust,” in the November 2000 National Public
Accountant.
The value of the trust assets that do not continue as a qualified
personal residence may be used to construct a continuation GRAT. The
annual annuity required under Treas.
Regs. Section 25.2702-5(c)(8)(C) for conversion of a QPRT to a trust
that meets the requirements of a GRAT is computed as the minimum of (1)
the value in the QPRT at the time of conversion or (2) the present value
of the use and reversion to the grantor(s) divided by the "annuity
factor for annual payment." It is not the total amount of annuity
remaining to be paid after conversion.
The GRAT annuity is obtained by dividing the value of the trust assets
(that do not continue as a qualified personal residence) by the annuity
factor for annual payment (either term, life or blended term and life,
depending on the data entries). The annuity factor is the remainder
factor divided by the discount rate. A GRAT annuity for a partial
replacement of trust property sold also may be calculated based on the
fraction of trust property sold.
I know of no software package that does the optimum QPRT
calculation—but it can be worked out with the software packages listed
in this newsletter.
(Article continues below ad.)
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(Article continues here.)
Available Software
Software packages that address the calculations related to QPRTs and the
computations that are specifically done by each package include:
Click here to
view table
* I am the designer of the Intuitive Estate Planner program.
** Each of these programs includes future valuation calculation features
that would enable computation of the aggregate amount of reinvested rent
for a defined period.
Software Procurement
Further information on the programs listed in this newsletter and
procurement information for each may be found at:
BNA Estate Planner: BNA
Software
Intuitive Estate Planner: Thomson/West
ViewPlan Advanced: CCH
Charitable Financial Planner: Leimberg.com
and Brentmark Software
NumberCruncher: Leimberg.com
Tiger Tables: tigertables.com
Bottom Line
While of great practical value not only for estate tax savings but also
for property transmission, the QPRT is a complex vehicle, both with
regard to its legal requirements and the calculations needed for its
implementation. It may be an especially helpful technique while
residential property values remain depressed and estate tax rules are
uncertain.
Trusts & Estates magazine is pleased to present the monthly
Technology Review by Donald H. Kelley—a respected connoisseur of
the software and Internet resources wealth management advisors use to
further their practices.
Kelley is a lawyer living in Highlands Ranch, Colo. and is of counsel to
the law firm of Kelley, Scritsmier & Byrne, P.C. of North Platte, Neb.
He is the co-author of the Intuitive Estate Planner Software,
(Thomson-West 2004). He has served on the governing boards of the
American Bar Association Real Property Probate and Trust Section and the
American College of Tax Counsel. He is a past regent and past chair of
the Committee on Technology in the Practice of the American College of
Trust and Estate Counsel.
Trusts & Estates has asked Kelley to provide his unvarnished opinions
on the tech resources available in the practice today. His columns are
edited for readability only. Send feedback and suggestions for articles
directly to him at dhkelley@qwestoffice.net.
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