The Qualified Personal Residence Trust (“QPRT”) is an effective means of transferring one’s residence to one’s children or other beneficiaries at a reduced transfer tax cost. But what happens if the trust is revoked or subject to early termination?
In this article, we take a look at what happens to a QPRT if revoked or terminated.
Table of contents
Background
The goal of the QPRT is for the owner of a personal residence to transfer it to a trust but retain the right to live in the home for a certain period.
At the end of that period, the designated beneficiaries (usually the children) will become the residence owners. After that, the residence will no longer be a part of the former owner’s taxable estate.
The tax advantage of the QPRT technique comes primarily from how the value of the gift to the trust is calculated for gift tax purposes. The value of the gift itself is not the full value of the residence on the date of the gift. Instead, the taxable gift is only the value of the children’s right to take possession of the home at the end of the specified period of years, which can be far less than the property’s current value.
For example, let’s assume a $1,000,000 is gifted to a QPRT, which removes $1,000,000 from the donor’s taxable estate, but the taxable gift may be as little as 10 or 20 percent of the residence value. By keeping the gift value of the transfer below the donor’s remaining lifetime federal gift tax exemption amount, the donor can avoid paying federal gift tax on the gift.
The question of what will happen to the home at the end of the QPRT term can be handled in several ways. In the simplest situation the home will then be owned by the grantor’s children, and the grantor can arrange at that time to rent the home for a fair market rental from the children. Alternatively, the home can continue in a further trust for the children’s benefit for the life of the grantor and spouse after the QPRT term, and the grantor can enter into a rental arrangement with the trustee, which will also under current law avoid the children recognizing taxable rental income because it will be a DGT.
Lastly, until recently the grantor could buy the home back from the QPRT for its then fair market value just before the end of the term, without causing a capital gain to be realized. However, under recent regulations, every QPRT is required to contain a provision explicitly prohibiting the repurchase of the residence by the grantor.
If the home is sold during the term of the trust, the trustee may or may not purchase a replacement residence. Any net proceeds not reinvested in a replacement residence will be returned to the grantor or automatically be converted into a grantor retained annuity trust (“GRAT”) of equivalent actuarial value to pay an annuity to the grantor as discussed below.
Can a QPRT be Revoked?
There are two options upon early termination. The trust agreement may allow that the trust will terminate and the property or its sales proceeds be given back to you. From a tax perspective, this is unattractive because the cash proceeds are distributed to you, and therefore all of the tax advantages are lost.
Another option is that the trust agreement can allow the property to be sold and either (a) a new home purchased for you, or (b) the cash may be invested, in which case you will receive a cash distribution as an annuity. The grantor will receive an annuity for the remaining QPRT term (thus lowering but not necessarily terminating the tax benefit). After the term, the remaining trust assets will be distributed to the beneficiaries.
Early Termination of QPRT Example
Let’s look at an example. Assume the proceeds are $2,000,000 from the sale. You could elect to receive $200,000 annually until the trust termination. This will continue to provide the required tax shelter and may serve your estate planning needs.
Remember that if the home is sold during the QPRT term, another property may be purchased. Suppose a replacement home of equal value is not purchased. In that case, the cash proceeds must be distributed back to the grantor, which will revoke the tax benefit. Alternatively, the cash can be invested.
