With interest rates as low as they are, many people will choose to maintain a mortgage on the home even though they have adequate cash to pay the home off. This can be a great financial decision as long as you can get a return on your assets that is greater than the mortgage rate.
But is this a good decision from an estate planning point of view? More specifically, can you have a mortgage with a QPRT?
In this post, we will address how a mortgage works with a QPRT and whether it is even allowed. Let’s dive in.
Table of contents
During the initial trust term, the grantor continues to use the residence rent-free and continues to pay mortgage expenses, real estate taxes, insurance, and expenses for upkeep. At the same time, the grantor continues to deduct mortgage expenses and real estate taxes for income tax purposes. At the end of the term, the residence passes either outright or in further trust for junior family members.
Like with a GRAT, the interest in a QPRT may not be commuted. The residence can include appurtenant structures used for residential purposes and additional property not in excess of that reasonably appropriate for residential use.
QPRT Mortgage Requirements
There is no prohibition against using mortgaged property in a QPRT (although the IRS will likely take the position that the original gift is based only on the net equity in the house, with each future mortgage payment by the grantor constituting in part a further gift to the QPRT).
The grantor of the QPRT will also continue to pay taxes, insurance and routine maintenance expenses, and will continue to benefit from all applicable income tax deductions. He will also be subject to capital gains tax on a sale of the residence, but will retain the right to roll over or exclude capital gains upon a sale of the home.
Many people take the position that the home is required to be free and clear. Don’t make this same mistake.
When a property that has been contributed to the QPRT has an existing mortgage, you are technically making additional gifts each time you pay the mortgage. This can be complex to track and require additional gift tax returns.
The problem with having a mortgage on the QPRT residence is that any subsequent mortgage principal payment by the donor constitutes an additional gift to the trust because it reduces the debt to which the property is subject, thus increasing the trust’s equity dollar for dollar.
Most mortgages call for monthly payments of principal and interest. Thus, under the typical mortgage, the donor would be making additional monthly gifts to the trust. To calculate the gift tax value for each such principal payment, the donor would have to go through the same elaborate calculations required for the original QPRT gift, using the § 7520 rate for the month of that payment (12 different rates for a year’s worth of mortgage payments).
His age- nearest-birthday and the remaining term of the QPRT, both determined as of each payment date. This would require a gift tax return to be filed for each year of the QPRT term, reporting the twelve additional gifts during the year.
One potential way to avoid this dilemma is to legally “indemnify” the QPRT from any mortgage obligation and the subsequent payments. In addition to the gift tax problem, an existing mortgage at transfer of title to the QPRT can result in a breach of mortgage instrument which could accelerate the debt. It is possible it could be all due and payable. Make sure that you carefully review the transaction before you initiate it.
If the mortgage exceeds the donor’s basis in the property, transferring the house subject to the mortgage would generally be treated as a partial sale, triggering income taxes, but this should not be a problem with a QPRT so long as the QPRT retains its grantor trust status. For the same reason (grantor trust status), the donor will continue to be entitled to the interest deductions for his mortgage payments. However, upon expiration of the QPRT term, if grantor trust status then ceases and the mortgage has not been paid off, a partial sale could be deemed to have occurred.
Sample Mortgage Language
Here is some sample language that speaks to the mortgage payments:
Payment of Expenses. The Transferor will be solely responsible for the payment of all costs related to the Residence, including certain expenses not limited to mortgage payments, utilities, property taxes, insurance, repairs, and maintenance. The Trustee’s responsibility for the maintenance and care of the Residence and for other related costs associated with the Residence shall be limited to the extent of any specified trust income and additions of cash received by the Trustee under Article II. Should the Trustee have insufficient funds to pay these costs and expenses, the Trustee shall notify the Transferor, responsible for the unpaid balance of these costs, fees, and expenses. In addition, the Trustee may make improvements to the Residence. Still, the Trustee’s authority and responsibility to do so is limited to the extent of any trust income, insurance proceeds, and additions of cash for that purpose received by the Trustee in accordance with this Article II.
Due on Sale Clause
If the mortgage is to stay on the property when it is transferred to the QPRT, you may need the mortgagee’s permission to transfer the property to a QPRT. Most mortgages provide that the entire loan becomes due if the title is transferred without the mortgagee’s consent; this is called a “due-on-sale clause.”
The mortgagee’s permission may not be obtainable if the lender has sold the mortgage to an agency that accepts only mortgages on “owner-occupied” houses. On the other hand, there are certain laws that prohibit mortgage lenders from enforcing due-on-sale clauses for certain trust transfers and intra-family transfers of residences, so the gift of the residence to the QPRT (and even the termination of the QPRT, if the residence then passes to the donor’s children) may not trigger the due-on-sale clause.
Treat donor’s mortgage payments as loan to trust
Another approach is to have the trust instrument provide that any mortgage principal payments made by the donor will be treated as interest-free loans to the trust from the donor, repayable at the end of the QPRT term. The trustee signs a mortgage to the donor, which the donor records, to secure this obligation.
The interest-free (“below-market”) loan rules do not create an income tax problem because this is a grantor trust. There is no gift tax problem because the “donee” of the interest-free use of the money is the donor himself during the QPRT term, and you can’t make a gift to yourself.
If using this approach, eventually, the parties must decide how the trustor remainder beneficiaries will repay the donor at the end of the QPRT term. If the property is sold to a third party, the donor can be repaid from the sale proceeds. Otherwise, the remainder beneficiaries can repay the donor from their funds or (gradually) from the rental income paid to them by the donor or by refinancing the residence.
Interest Only Option
The best way to avoid these problems is for the donor to pay off the mortgage before making the gift. If that is not feasible, determine whether the mortgage could be changed to an interest-only mortgage during the QPRT term, with a balloon payment of principal due at the end of the QPRT term. The donor can continue to pay the interest during the QPRT term.
Such interest payments should not be deemed additional gifts to the trust. The interest payments do not increase the property’s equity value that will pass to the remainder beneficiaries. Mortgage interest is considered a current expense. The donor, as the trust’s “income beneficiary,” is liable for the current expenses, so by paying the mortgage interest, he is merely paying his proper share of the property’s expenses.
At the end of the term, the balloon payment will have to be dealt with. Either the donor can make an additional gift to the beneficiaries to pay off the mortgage at that point (there would be no valuation discount for this gift because the donor’s retained interests will have expired, or the property can be sold or refinanced to pay off the loan.
Loan Forgiveness Option
Another alternative is for the donor to forgive the loan when the QPRT term expires, thereby making an additional taxable gift to the remainder beneficiaries at that time. There would be no valuation discount for this gift because the donor’s retained interests will have expired.
However, if it is agreed in advance that the donor will do this, then the loan is not bona fide—if the parties never intended that the donor’s “loan” to the trust would be repaid, then the donor’s gift occurs in pieces, each time he makes a mortgage principal payment, and you are in a complicated situation.
As you can see, it is acceptable to have a mortgage with a QPRT. But make sure that your net equity is considered when the value of the contribution is determined upfront.