The huge estate tax benefit from a Qualified Personal Residence Trust (QPRT) can be a home run for many. But what is the best QPRT exit strategy?
In this article, we will examine the QPRT exit strategy and take a look at a few tips to make sure do it right. Let’s get going.
Table of contents
Unwinding a QPRT
But what happens at the end of the QPRT term, and the couple still wants to use the property? In theory, the answer to this question is straightforward. All you have to do is enter into a lease agreement that pays fair market rent.
After the QPRT expiration term, the grantor must pay rent if they continue to reside in the property. If the couple decides not to live there, the home’s fair market value on the date of death will be included for estate tax purposes.
Generally, after the QPRT term expires, it typically makes sense to have the property still retained in the QPRT.
If the house is distributed outright to the children, it will lose the asset protection trust benefit. Then upon the death of a child, the ownership interest becomes fractionalized among the beneficiaries.
As a result, distributing the property may result in adverse tax consequences and should typically be avoided.
This will completely unwind the QPRT and is in most situations not something you want to do. So the next step is to complete a lease agreement between the trust and the grantor.
But if the property continues to remain in trust, there can be some considerations. As an example, let’s assume that when the QPRT term expires, the trust was divided among the couple’s children into separate trust shares. As a result, each separate trust would, in theory, be the lessor for its proportional interest in the home. The problems posed by this issue may be mitigated if the trust is treated as a grantor trust for tax purposes.
Rental Rules & Regulations
Now that we understand that a lease agreement must be executed, certain questions arise:
- Who are the lessor and lessee?
- How is fair market rent determined?
- Who is in charge of administering rent payments?
- How is the rental income treated for tax purposes?
During the QPRT term, the grantor pays all property expenses. If these payments are converted to rent under a lease, it would typically not increase the financial burden. The rent must be based on fair rental value.
To minimize the risk that the property is included in the estate, the rental amount should be determined by an independent appraiser or, at a minimum, an experienced realtor. The rental amount should also be adjusted annually or periodically to reflect the current market amount. Assuming the grantor performs maintenance duties on the property, the rental amount might be reduced by the value of services performed.
But be careful with valuing services provided. If they are overvalued, the IRS may have an issue. One option is for the grantor to issue a promissory note (at the applicable federal rate for interest) instead of paying rent. The principal and accrued interest would be payable at the grantor’s death. Ensure that the lease is drafted to ensure that the QPRT is taxed only when the note instrument is paid.
(3) How are rental payments administered between the parties?
When there is a single lessor, the administration of rental payments is relatively straightforward. A simple checking account should be opened under the QPRT, and rental payments should be deposited into the account.
However, the administration is more complicated when more than one lessor exists. For example, let’s assume that at the end of the QPRT term, the trust requires division into separate trust shares between the children. This highlights a few other issues.
Sale of Residence
The problem is then compounded with a married couple who have identical QPRTs. If the married couple has four kids, then arguably, there are eight interests. Do you need to set up eight bank accounts and deposit fractional rent payments into each account? The administration would be easier if the QPRTs can continue to operate as grantor trusts. This can complicate the QPRT exit strategy.
(4) Are the rental payments considered taxable income?
The QPRT is generally treated as a grantor trust for tax purposes, so tax compliance is straightforward.
Let’s take a look at two options:
- Non-grantor trust treatment
- Grantor trust treatment
Irrevocable QPRT
Here are the issues to consider with a non-grantor or irrevocable trust:
• The QPRT becomes a taxable entity and must have its tax ID number. If sub-trusts are created under the “main” or “umbrella” QPRT, each trust will be separate taxpayers and require its tax ID number. A separate tax return is required for each trust.
• Rental payments are then taxable income to the trust. This, of course, is offset by expenses related to the property such as insurance, property taxes, maintenance, and depreciation. Because of the depreciation, there will most likely be depreciation recapture when the property is finally sold.
• The lessor trusts would need to have a separate bank account to collect the rental payments.
• If the home is the grantor’s primary residence, no capital gains tax exclusion is available when it is sold. The capital gains resides in the trust and are paid when the tax return is filed.
Revocable QPRT
Grantor trust treatment for income tax purposes has the following benefits:
• The QPRT and the subsidiary trusts are not taxable entities and do not need separate tax ID numbers. Tax return filings are not required.
• Rental payments are not considered taxable income. This is because the grantor cannot be taxed on income that is treated paid to himself. In addition, the property cannot be depreciated.
• Technically, the property can be owned by multiple “sub-trusts” because they are disregarded entities (not taxable). The QPRT can open a single bank account and deposit the rent checks. All the subtrusts own the bank account, but it uses the grantor’s social security number.
• Assuming the property is the grantor’s primary residence, the capital gains exclusion is available. Since the grantor is responsible for paying any capital gains tax, the payment would further lower the grantor’s estate. The result is a tax-free gift to the children or other beneficiaries.
Most people realize that the effectiveness of a QPRT in reducing estate taxes far outweighs the administration tasks once the QPRT term expires.
