It seems counterintuitive, but qualified personal residence trusts (QPRTs) can make a lot of sense now.
QPRTs are generally not considered effective in a low interest rate environment. And these days, the Internal Revenue Code Section 7520 rate — the interest rate employed to value wealth transfers — is at historic lows. In February 2009, it was just 2 percent. March 2009 saw it bump up, but only to 2.4 percent.1 (See “The Section 7520 Rate,” p. 16.)
Yet, QPRTs present an estate-planning opportunity to be seriously considered these days because of the decline in the value of real estate during the last 18 months. This technique becomes even more attractive when the trust agreement refers to the grantor's retaining a reversionary interest.
In a QPRT, a grantor transfers a personal residence or vacation home into an irrevocable trust for a term of years and reserves the right to live there during that term.2
At the end of that term, ownership of the residence passes to the designated beneficiaries, typically the grantor's children or other family members, either outright or in further trust for their benefit. If the grantor wishes to remain in the residence at the end of the trust term, the grantor should rent the residence at fair market rental value to avoid unintended gifts from the remainder beneficiaries to the grantor, and more importantly, to avoid the potential adverse estate tax consequences of having the value of the house included in the grantor's estate for estate tax purposes.
Significant estate and gift tax benefits may be realized by moving property into a QPRT. The transfer of the home into the trust is a taxable gift, but the value of the gift is not the fair market value (FMV) of the property on the date of transfer. Rather, the value of the gift is reduced to reflect: (1) the grantor's right to live in the residence during the term of the trust; and (2) the grantor's reversionary interest, which is the probability of death during the term, which would cause the property to revert back to the grantor.
In addition, any appreciation in the value of the residence during the QPRT term passes gift and estate tax free to the remainder beneficiaries. The grantor must survive the QPRT term to realize the tax benefits. But the grantor is in no worse position than if he did not establish the trust.
The reason a low interest rate is considered unfavorable to QPRTs is that the value of the retained interest (which is based, in part, on the term of the trust and the applicable 7520 rate) is lower, thereby increasing the value of the gift to the remainder beneficiaries. Correspondingly, when 7520 rates are high, the value of the grantor's retained interest increases, thereby reducing the value of the gift to the remainder beneficiaries.
Reversionary Interest Is Key
If the grantor dies before the end of the term, regardless of whether there is a specific reference to the retention of a reversionary interest, the FMV of the residence is included in his estate for estate tax purposes.3 Therefore, advisors should consider including a provision in the trust agreement under which the grantor retains a contingent reversionary interest in the property during the trust term. This will increase the value of the grantor's retained interest, thereby decreasing the value of the gift of the remainder interest to the designated beneficiaries.
Let's look at how this plays out in high and low interest environments.
First, the high interest environment: Let's say a 65-year-old man named Lou has a personal residence or a vacation home located somewhere nice and sunny. Let's assume that his property had a FMV of $1 million in March 2004, when the 7520 rate was 4 percent.4 Let's also assume that Lou then created a QPRT with a 10-year term and retained a reversionary interest in that property during the term of the trust. Under this scenario, the value of his gift to his QPRT's beneficiaries was $513,550.
If Lou didn't retain a contingent reversionary interest in the property, the value of the taxable gift would have been $675,564, which is $162,014 more.
Let's look at the same scenario in a post real estate crash environment. Lou's $1 million home is now worth just $800,000 — 20 percent less. In March 2009 when the 7520 rate was 2.4 percent, he created the QPRT. The value of the gift with a revisionary interest is lower than it was when real estate prices were riding high. It's just $479,744.
If Lou doesn't retain a contingent reversionary interest in the property, the value of the taxable gift is higher — $631,089. But it's still less than it would have been without a revisionary interest when his home was valued at $1 million.
Let's take a look at another example that reflects the benefit of this technique due to the precipitous drop in real estate values in the past 24 months. We selected a shorter term in this example because the grantor is older.
Let's give Lou an older brother: Sam is 75 and has a personal residence or vacation residence in the same sunny community that Lou has his vacation home. That property had an FMV of $1 million in March 2007, when the 7520 rate was 5.8 percent.5 If Sam created a QPRT with a five-year term and retained a reversionary interest in the property during the trust's term, the value of the taxable gift would be $587,560. If Sam did not retain a reversionary interest in the property during the trust's term, the value of the taxable gift would be higher: $754,348 (that's $166,788 more.)
Now, let's look at Sam's options in March 2009 after the real estate crash when his property value dropped to $850,000, or down 15 percent in just 24 months. Given the March 2009 7520 rate of 2.4 percent, the value of the taxable gift to his QPRT's beneficiaries is $588,038 if he retains a revisionary interest. If Sam doesn't retain a reversionary interest in the property during the trust's term, the value of the taxable gift will be higher, $754,951, which is greater than it was pre-real estate bust.
Note that, because the terms and age are different, unlike Lou's gift, Sam's gift in both instances is slightly greater than it was before the real estate bust.
What these examples show is that QPRTs can be quite a viable estate-planning technique even though interest rates are low. Now is a good time to revisit QPRTs to see if they'll help clients take advantage of the depressed housing market. After all, when the housing market does rebound, the QPRT will keep all appreciation free of transfer taxes.
Revenue Ruling 2009-5, 2009-6 I.R.B. 432; Rev Rul. 2009-8, 2009-10 I.R.B. 645
See generally Treasury Regulations Section 25.2702-5(c)
Internal Revenue Code Section 2036(a)(1)
Rev. Rul. 2004-25, 2004-11 I.R.B. 587
Rev. Rul. 2007-15, 2007-11 I.R.B. 687
Michael M. Mariani is a senior vice president, deputy general trust counsel and director of Trust and Estate Services in the New York office of Fiduciary Trust Company International