Transferring a personal residence to a qualified personal residence trust (QPRT) is a common estate-planning technique used to make an inexpensive gift of a residence to the next generation. QPRTs may be particularly attractive now. The bursting of the real estate bubble and economic downturn make it very tax-efficient to transfer a residence now, while values are depreciated. (See QPRTs Can Be a Good Deal Now)
Pursuant to Internal Revenue Code Section 2702, the QPRT reduces the value of the gift to the remaindermen by the value of the grantor's retained right to live in the residence for a term of years. The value of the gift made by funding a QPRT is further limited by the Internal Revenue Service's particular assumption under the valuation rules of IRC Section 7520 that all QPRT growth is income deemed paid out to the grantor, causing the QPRT remainder interest to be valued as if the residence does not appreciate over time.
As a creature of statute, the QPRT offers certainty — but it's also subject to restrictions and risks.
An attractive alternative to a QPRT is a remainder purchase marital (RPM) trust. We've previously written1 about the RPM trust as an efficient vehicle to transfer wealth to the trust remaindermen free of gift and estate tax. But an RPM income trust also may be used as an alternative to a QPRT to transfer a residence to the next generation even more efficiently — and without the statutory restrictions applicable to a QPRT.
Indeed, there are two significant advantages of using an RPM income trust instead of a QPRT: It eliminates mortality risk (and may even use mortality risk to the remaindermen's advantage instead of disadvantage) and offers greater flexibility.
What They Are
A QPRT is a form of grantor retained income trust that allows a grantor to remove the value of a residence (and all future appreciation on it) from his estate at a reduced gift tax cost if he survives the term of the QPRT. The grantor retains a right to live in the residence for a term of years and gifts the remainder interest in the QPRT to his or her children or a trust for their benefit. The gift made to the remaindermen is equal to the value of the property transferred to the QPRT less the value of the income interest retained by the grantor as determined under the tables in IRC Section 7520. These tables determine the present value of the income interest by using the grantor's age, the term and the Section 7520 rate as the discount rate: the older the grantor, the higher the Section 7520 rate and the longer the term, the smaller the taxable gift to the remaindermen.
An RPM trust is designed to qualify the spouse's interest for the gift tax marital deduction without subjecting the property of the RPM trust to estate tax at the spouses' death. As a result, at the end of the stated term, the trust property passes to the remaindermen (the grantor's children or a trust for their benefit) free of gift and estate taxes.
The RPM income trust works as follows: A grantor transfers property (such as a personal residence) to the RPM trust, gifts to his spouse an income interest in the RPM trust for life or a term of years, and simultaneously sells the remainder interest in the RPM trust to a trust for his children's or other individuals' benefit.
When an RPM trust owns a residence, the “income interest” is the right to live in the residence. Even though the property passes to a recipient other than his donee spouse after the term ends, the bona fide sale exception to IRC Section 2523(b), the terminable interest rule, applies because the transfer of the remainder interest is for “adequate and full consideration in money or money's worth.” Therefore, the transfer qualifies for the gift tax marital deduction.2 Because the purchase exception is relied upon for the gift tax marital deduction, rather than a QTIP election or general power of appointment in the spouse, the RPM trust property is not includable in the spouse's estate.
The price the remaindermen pay for their interest is equal to the present value of what they eventually will receive from the RPM trust. This will be equal to the value of the property the grantor transfers to the RPM trust reduced by the value of the spouse's income interest (the right to live in the residence), determined in accordance with Section 7520 and the tables and interest rates promulgated thereunder. With an RPM income trust, where the spouse receives an income interest, the appreciation in excess of the income paid to the spouse is transferred to the remaindermen free of estate and gift tax.
No Mortality Risk
If the grantor of a QPRT survives the term, the residence is not included in his taxable estate. But if he doesn't survive the term, the residence is included in his taxable estate pursuant to IRC Section 2036, eliminating any estate tax benefits.
Therefore, in constructing a QPRT and choosing an appropriate term, the practitioner must balance the size of the grantor's taxable gift to the remaindermen with the significant risk that the client will not survive the QPRT's term. Although this mortality risk can be reduced by employing shorter terms, it can never be fully eliminated and the cost of reducing the term is increasing the taxable gift to the remaindermen.
In contrast to the QPRT, the RPM income trust may be structured to eliminate all mortality risk to the grantor. With an RPM income trust, the income interest is gifted to the grantor's spouse and the remaindermen (or a trust for their benefit) purchase their interest from the grantor for “adequate and full consideration in money or money's worth.” Because the grantor has not retained any interest in the trust, Section 2036 does not apply to bring the value of the gifted or sold property back into his taxable estate if he does not survive the trust term.
In addition, not only can the mortality risk be eliminated with an RPM income trust, but it also may be used to the remaindermen's advantage. Because there is no risk of Section 2036 inclusion, an RPM income trust can be structured so that the term lasts until the earlier of (1) a term of years, or (2) the grantor's death. With this type of RPM income trust, the remaindermen could receive the property early if the grantor does not survive the term of years, providing them with a possible windfall. Of course, the price of the remainder interest must be increased to reflect this potential windfall.
The lack of mortality risk and the windfall possibility allow the grantor to use longer trust terms to reduce the cost of the remainder interest, knowing that if he does not survive the trust term the remaindermen will not need to wait to receive the property.
One of the largest drawbacks of the QPRT is that it entails a large taxable gift, using the client's gift tax exemption or triggering a hefty tax bill. If the remaindermen already have the assets to pay for the remainder interest, an RPM trust could be funded without a taxable gift. Otherwise a taxable gift to the remaindermen in advance may be required. But, because of the lack of mortality risk and the potential for a windfall, the grantor can stretch the length of the trust term, decreasing the value of the remainder interest and the purchase price paid into his estate. Such a decrease can be large enough to make the purchase price of an RPM income trust structured with a windfall to be about the same as a QPRT with a shorter term.
Thus, the RPM income trust structured with a windfall transforms the greatest risk of a QPRT (a long trust term) into a strategic benefit.
No Administrative Restrictions
A second advantage of an RPM income trust over a QPRT is the greater flexibility and increased opportunity for customization it affords drafters and their clients. A QPRT is subject to restrictions3 that may limit its utility for certain clients. Such provisions and restrictions include:
The QPRT may hold no assets during the retained term other than one residence to be used as a personal residence by the term holder. Such residence must be either the principal residence of the term holder (within the meaning of IRC Section 1034), one other residence of the term holder (which meets the requirements of IRC Section 280A(d)(1) without regard to IRC Section 280A(d)(2)), or an undivided interest in either.
The governing instrument of a QPRT must include a prohibition on selling or transferring the residence to the grantor, the grantor's spouse, a trust treated as owned in whole or in any part by the grantor or grantor's spouse under IRC Sections 671 through 679, or any entity “controlled” (as defined in Treasury Regulations Sections 25.2701-2(b)(5)(ii) and (iii)) by the grantor or grantor's spouse.
Additions of cash to the QPRT are limited to only those amounts required to pay trust expenses or for improvements already made or to be paid within six months from the date of the addition.
The trust will cease to be a QPRT if the residence ceases to be used or held for use as a personal residence of the term holder.
The trust will cease to be a QPRT if the personal residence is sold and a new personal residence is not purchased within two years.
The trust will cease to be a QPRT if the personal residence is damaged or destroyed and the insurance proceeds received are not used to replace or repair the residence or to purchase a new residence within two years.
If the trust ceases to be a QPRT because of any of these reasons, the QPRT must terminate and, within 30 days, the trustee must either distribute all trust property outright to the term holder or convert it into a qualified annuity trust for the remainder of the term.
Because none of the interests in the RPM income trust are “qualified interests” under IRC Section 2702, it is not subject to these restrictions. The RPM trust is flexible. As a result:
An RPM income trust may be funded flexibly with different types of property.
Sales of the residence to the grantor, his spouse or grantor trusts are not prohibited.
The use of the residence does not need to be as a personal residence; for example, the residence could be rented to third parties.
Sale of a residence during the term of the RPM income trust will not cause termination or require a mandatory annuity.
The grantor may add more property to the RPM trust through a subsequent gift and sale.
The trustee may use insurance proceeds or sale proceeds as he or she deems best.
It's also important to note that, because a QPRT can be established only with the grantor's principal residence or one other residence, the grantor is essentially limited to two QPRTs. But the RPM income trust offers a valuable solution for clients who have multiple residences they would like to transfer.
When a grantor establishes a QPRT, the QPRT will necessarily be a grantor trust to the grantor under IRC Section 677 (income retained for benefit of grantor) and possibly IRC Section 675 (reversionary interest that exceeds 5 percent of the value of the trust). Therefore, if there's any disposition of the QPRT trust property, the grantor will be taxed on any resulting gains and losses.
For example, if the QPRT were to sell the personal residence, any gain (or loss) on the sale would be taxed to the grantor.
Let's assume that the QPRT succeeds (that is to say, the grantor survives the term). Because the transfer of the personal residence to the QPRT is a gift, the QPRT's basis in the personal residence is a carry-over basis under IRC Section 1015, meaning that the QPRT has the same basis in the property as the grantor. Pursuant to Section 1015, the carry-over basis may be increased by the amount, if any, of gift tax the grantor paid when transferring the property to the QPRT.
If the grantor does not survive the QPRT term, the property reverts to the grantor, will be included in his taxable estate, and will receive a stepped-up basis to fair market value pursuant to IRC Section 1014.
The RPM trust, like a QPRT, initially will be a grantor trust to the grantor under Section 677 (income interest for benefit of the grantor's spouse). But, depending on how the term of the RPM trust is structured, the grantor trust status of the RPM trust could change if the grantor does not survive the term. For example, if the RPM trust were designed with a term that lasts for a specified number of years or until the grantor spouse's death, and the grantor were to die before the term expired, the RPM trust would become a non-grantor trust upon the grantor's death.
Assuming that the trust that purchases the remainder interest also is structured as a grantor trust to the grantor, the sale of the remainder interest will be disregarded for income tax purposes. Therefore, there will be no gain or loss to the grantor upon the sale of the remainder interest.
Regarding the basis of the residence, the RPM trust receives a carry-over basis, because it, like the QPRT, is funded with a gift of the income interest to the spouse and the sale of the remainder interest is disregarded so long as the purchaser is also a grantor trust. Therefore, when the RPM trust terminates, assuming the original sale of the remainder interest was disregarded for income tax purposes, the remaindermen will receive the trust assets with a carry-over basis. Unlike with the QPRT, however, the grantor has flexibility in income tax planning with an RPM trust because he can easily substitute assets in the RPM trust (which is not possible with a QPRT). For example, if the RPM trust was originally funded with a low basis residence and the grantor's health began to decline, the grantor could substitute high-basis assets for the RPM trust's assets, thus allowing the low-basis assets to be included in his taxable estate and to receive a stepped-up basis upon his death.
The advantage of the RPM trust is that the term can be extended. (See “QPRT v. RPM Trust,” p. 20.)
For example: an RPM income trust with a “shorter of” term that allows the remaindermen to receive the property at the grantor's death before the end of the term costs the remaindermen more; the possibility of receiving the property early comes with a higher price tag. In a 10-year term scenario, if the RPM income trust is structured with a windfall option, the cost of the remainder interest increases from $1,227,826 to $1,304,360. But, the term of the trust can be extended, decreasing the cost of the remainder interest while increasing the possibility of a windfall occurring,4 yet without the risk of an inclusion of the trust property in the grantor's taxable estate.
If the trust term were extended to 20 years, the cost of the remainder windfall interest would be $1,018,920 (reduced from $1,304,360), which is less than the cost of a remainder interest in the 10-year RPM income trust without the windfall and only $85,540 more then the QPRT.
It's Good to Have Options
Of course, because the QPRT is sanctioned by statute, its form and the attendant restrictions provide certainty. And, the RPM trust is not an option for clients who are unmarried, as it depends on a marital deduction for the gift of the income interest. But, while the QPRT and the RPM income trust may both be effective ways to remove the value of a personal residence from the estate, the RPM income trust still offers unique advantages compared to a QPRT. It's not constrained by any mortality risk. Its unique structure allows the practitioner to transform mortality risk into a potential mortality benefit by increasing the length of the term. Also because the RPM income trust is not required to conform with the IRC, it provides greater flexibility in the estate-planning process.
Deborah V. Dunn and Alison E. Lothes, “RPM Trusts: Reduction of Valuation Risk,” Tax Management Estates, Gifts and Trusts Journal (Sept. 2008) at p. 191; David A. Handler and Deborah V. Dunn, “GRATs and RPM Annuity Trusts: A Comparison,” Tax Management Estates, Gifts and Trusts Journal (July 2004) at p. 175; David A. Handler and Deborah V. Dunn, “RPM Trusts: Turning the Tables on Chapter 14,” Trusts & Estates (July 2000); Deborah V. Dunn and Katherine M. Cunningham, “Advantages to Back-Loading: An Analysis of Back-Loaded Annuity Payments from a CLAT or RPM Annuity Trust,” Tax Management Estates, Gifts and Trusts Journal (Nov. 2007) at p. 263.
Internal Revenue Code Section 2523(b)(1) (“Where, on the lapse of time, on the occurrence of an event or contingency, or on the failure of an event or contingency to occur, such interest transferred to the spouse will terminate or fail, no deduction shall be allowed with respect to such interest (1) if the donor retains in himself, or transfers or has transferred (for less than an adequate and full consideration in money or money's worth) to any person other than such donee spouse (or the estate of such spouse, an interest in such property.)”); Treasury Regulations Section 25.2523(b)-1(b) (“Section 2523(b) provides that no marital deduction shall be allowed with respect to the transfer to the donee spouse of a “terminable interest” in property, in case the donor transferred (for less than adequate and full consideration in money or money's worth) an interest in the same property to any person other than the donee spouse (or the estate of such spouse) and by reason of such transfer such person (or his heirs or assigns) may possess or enjoy any part of such property after the termination or failure of the interest therein transferred to the donee spouse.”)
See Treas. Regs. Section 25.2702-5(c)
Under a remainder purchase marital income trust structured for a potential windfall, the term should not be longer than the grantor's actual life expectancy. Otherwise, the only other limitation on the length of the term is the remaindermen's interest in receiving the property sooner rather than later.
Deborah V. Dunn, far left, is a partner; Alison E. Lothes and James J. Thibodeau are associates; all work out of the Chicago office of Kirkland & Ellis LLP
QPRT v. RPM Trust
A 20-year RPM trust can make a lot of sense; a 20-year QPRT probably does not
The taxable gift made by funding a qualified personal residence trust (QPRT) will be less than the price paid by the remaindermen for their interest in the remainder purchase marital (RPM) income trust with the same fixed term, because receiving the remainder interest in the QPRT is contingent upon the grantor surviving the term.
But in the fixed term RPM income trust, the remaindermen receive the gift at the end of the term regardless of whether the grantor survives.
By extending the term of the QPRT or the RPM income trust from 10 years to 20 years, the value of the gift (in a QPRT) or the price paid by the remaindermen (in an RPM trust) decreases significantly. While a 20-year QPRT is probably not feasible due to the mortality risk, a 20-year RPM income trust is not unreasonable.
Indeed, a grantor could establish a 20-year RPM income trust, without any mortality risk and none of the statutory restrictions, for less than the gift used to fund a 10-year QPRT.
Term holder's age: 65
Home value: $2 million
Section 7520 rate: 5%
Estate/gift tax rate: 45%
EXAMPLE 1: 10-YEAR TRUST TERM
Taxable gift using a QPRT: $933,380
Cost of remainder interest under a fixed term RPM Income Trust: $1,227,826
Cost of remainder interest under a “shorter of” RPM Income Trust with windfall: $1,304,360
EXAMPLE 2: 20-YEAR TRUST TERM
Taxable gift using a QPRT: $301,160
Cost of remainder interest under a fixed term RPM Income Trust: $753,778
Cost of remainder interest under a “shorter of” RPM Income Trust with windfall: $1,018,920
— Deborah V. Dunn, Alison E. Lothes & James J. Thibodeau