I am a firm believer that disadvantages of any proposed estate planning structures needs to be carefully examined. The upside will take care of itself, but make sure you can live with the downside.
While we are a big fan of QPRTs, you should carefully examine the downside to make sure that a plan fits what you are looking to accomplish. QPRTs can be an excellent strategy to lock in an estate value for a primary residence (or vacation home). It results in an estate “freeze” and can remove future appreciation of the home out of the estate.
In this guide, we will address the top 10 downsides (or cons) of setting up this trust structure.
Table of contents
- #1 – No Step Up in Basis
- #2 – Term Survival Requirement
- #3 – Capital Improvements Result in a Gift
- #4 – Low Interest Rate Environments
- #5 – Lack of Annual Gift Exclusion
- #6 – Inability to Buy Back
- #7 – No Gain Exclusion Upon Expiration
- #8 – Rental at Lease Term
- #9 – Costs and Fees
- #10 – Complexity
- Conclusion – QPRT Disadvantages
#1 – No Step Up in Basis
Stepped up basis is one of the best benefits of our estate tax code. When someone passes away, the value of the assets is increased to fair market value and no gain is realized.
You want to take advantage of stepped up basis as much as possible. Unfortunately, QPRTs do not offer step ups. You transfer the property to the trust at your carryover basis and that basis carries on through the trust ownership.
So at the end of the term, your heirs will get carryover basis in the property. When the home is subsequently sold, capital gains will be assessed.
#2 – Term Survival Requirement
There is no minimum or maximum QPRT term. The general approach is as follows: you want the term to be as long as possible so as to minimize the initial gift. But if the term is too long and the grantor dies during the term, the full value of the home must be included in the grantor’s estate.
So it is critical that the grantor survives the established term. If the grantor passes away during the term, the home will either be returned back to the grantor’s estate or it is subject to the grantor’s general power of appointment. We have even seen this issue with suicide.
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When the grantor dies during the term, the strategy has failed and the estate is be taxed as if the structure was never implemented. So make sure you carefully determine the initial term.
#3 – Capital Improvements Result in a Gift
Let’s assume for example that you established a QPRT then decided to do some capital improvements. Maybe you are building a pool, installing new cabinets, or even putting on a new roof. Because the trust legally owns the home, how are these capital improvements accounted for from an estate tax perspective?
Capital improvements are typically going to be made over the QPRT term. The treatment is rather straightforward.
These improvements result in an additional gift and a gift tax return will be required to be filed. This will further absorb some of the lifetime gift exemption. In addition, there is the headache and cost of an additional gift return. This should not really be much of a challenge but it is often overlooked in the process.
#4 – Low Interest Rate Environments
Over the last decade or so, we have seen unprecedented low interest rates. Whether the low rates are here to stay is another question.
Low interests rates will reduce the benefits of a QPRT. The goal is to have a rate as high as possible that when calculated results in a low gift value. The lower the gift value, the less of the lifetime exemption that is utilized.
The reason that keeping the gift value low is so important is that you only have so much to go around. So if you are going to dip into the lifetime exclusion you should make it count. But waiting for interest rates to rise is probably not a good idea. If you wait too long tax laws could change or the political tides could swing.
#5 – Lack of Annual Gift Exclusion
The first step in gift tax planning is utilizing the annual exclusion that is currently $15,000 per person. This is available to both a husband and wife. Many people overlook this basic strategy.
But the QPRT gift works a little differently. The gift itself represents a future interest. The annual gift exemption is only available for present interests. These present gifts are usually made in cash, but can also be real estate, stocks, bonds, mutual funds and other personal items like cars and boats.
So unfortunately, the QPRT gift does not qualify for the annual gift exclusion is allowed. This is not a huge disadvantage, but it is important to note.
#6 – Inability to Buy Back
Once the property is transferred to the QPRT, the grantor is unable to buy back the home at any time that it is a grantor trust. The QPRT provisions must include this prohibition in the trust document.
The QPRT is by definition a grantor trust during the initial QPRT term as a result of the grantor’s retained use of the home. Assuming the grantor plans to rent the property from the QPRT after the initial term, many QPRTs are drafted so that they continue to be grantor trusts even after the term ends. This structure is often used for income tax planning.
As a payment from a grantor to a grantor trust is not considered taxable for income tax purposes, maintaining the grantor trust structure after the term ends can be very appealing to eliminate any tax on the rent payments.
#7 – No Gain Exclusion Upon Expiration
We all know that the best real estate tax break is the primary residence gain exclusion. It has been around (in one form or another) for many decades. I don’t think it will be going away anytime soon.
The exclusion is currently up to $250,000 in gain on the sale of a primary residence. This is increased to $500,000 for a married couple. Fortunately, since the QPRT is a grantor trust the grantor will qualify for the exclusion.
But is that still applicable after the term expiration? Unfortunately, if the home is sold subsequent to the QPRT term the property does not qualify for the gain exclusion.
#8 – Rental at Lease Term
At the end of the trust term, you will become a tenant and you are required to pay rent. You should also have a lease agreement in place that spells out the rental amount and the lease terms.
The rental is required to be at fair market value. This is critical if you don’t want the IRS to challenge the trust and potentially pull the property back into the estate.
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It might sound strange or awkward to be leasing your home. But remember that your rental payments will reduce your estate. So this could actually be an advantage rather than a disadvantage.
But the issue still must be considered. Many don’t follow through on the rent payment formalities and they can run a risk if ever confronted by the IRS.
>>MORE: QPRT Example: The #1 Strategy
#9 – Costs and Fees
Estate planning isn’t cheap and QPRTs are no exception. There is the cost involved in setting up the trust, calculating the gift value and filing the gift tax return. The fees can add up.
How much does a QPRT cost? Of course it depends on a few variables, including where the grantor lives. But fees can run a few thousand dollars up to $10,000 and more.
The good news is that you don’t have to spend much on annual maintenance. You may want to have the trust updated for changes in the law. You may also want some CPA advice on the application of the QPRT basics. But in theory, this should not cost you that much.
Certainly, it pays to shop around. But it’s not like there are necessarily a lot of options in the market. Many attorneys set up basic revocable trusts and living wills. Very few estate attorney’s have the experience to set up QPRTs and give guidance.
#10 – Complexity
QPRTs are actually not the most complex structure. But they are certainly more complex than a traditional revocable trust.
The trust formalities need to be followed during the term and also after expiration. The rental payments need to made based on fair market value and administering them can often be a challenge.
Conclusion – QPRT Disadvantages
There are many advantages of QPRTs. But it is the disadvantages that I wanted to highlight here.
In the right situation, these trusts work great and you will find that the disadvantages may be something that you can live with. Talk to a tax or legal professional to see if a trust is right for you.