Okay—so, you’ve sold your clients on the potential estate-tax benefit to be achieved with a qualified personal residence trust (QPRT). And you’ve explained that, with a married couple, the benefits can be even greater if each deeds only a 50 percent interest in the residence to a separate QPRT. Then, in addition to the valuation discount available for the QPRT, an additional fractional interest discount will be applied, thereby further reducing the taxable gift.
So, now the client wants to know: “What happens when the QPRT term is over and I still want to use the property?”
And you reassure him: “You’ll just enter into a lease providing for fair market rent—no problem.” But is it really as simple as that?
For example, it’s clear that, after expiration of the QPRT term, the grantor must pay rent if he’s going to continue to use the property. If he doesn’t, whatever the fair market value (FMV) of the property is when the grantor dies will be included in his estate for federal (and, in all likelihood, state) estate tax purposes. But, a lease arrangement raises some serious administrative questions:
(1) Who is the lessor?
(2) How is rent to be determined?
(3) How are rental payments to be administered?
(4) How are rental payments treated for income tax purposes?
Let’s examine those questions and potential answers one at a time.
(1) Who is the lessor?
In most cases, it will probably be desirable, after the QPRT term expires, to have the QPRT provide for retention of the property in a continuing trust (for example, for the benefit of the grantor’s children). If the property were distributed outright to the children, it would lose the asset protection benefit of a trust and might become subject to a partition action by a creditor of any one child.
Moreover, absent a buy-sell agreement among the children, upon the death of a child, his or her ownership interest could become fractionalized among the child’s heirs. Accordingly, outright distribution of the property could result in a multiplicity of lessors. This result should probably be avoided.
But even if the property remains in trust, there may be multiple lessors. For example, if when the QPRT term expires, the trust was divided among the children in separate trust shares, then arguably each separate trust would be a lessor with respect to its proportionate interest in the property. The problems posed by a multiplicity of lessors can be mitigated if the continuing trust can be treated as a grantor trust for income tax purposes.
(2) How are rental payments to be funded?
Because during the QPRT term the grantor will have been paying all expenses related to the property, simply converting these payments to rent under a lease normally would not increase his financial burden. To avoid application of Internal Revenue Code Section 2036(a), the rent must be set at fair rental value. To minimize the estate tax inclusion risk, rent should be determined by an experienced appraiser—or at least by a realtor. That rent also should be adjusted periodically to reflect the current market. Arguably, if the grantor were to perform maintenance and other services to the property, the rent could be reduced by the value of his efforts. But valuing such services may be difficult and, if overvalued, IRC Section 2036(a) may be an issue. One option would be for the grantor, in lieu of paying rent, to issue a promissory note (at the applicable federal rate for interest), with principal and accrued interest payable at the grantor’s death. Care should be taken in drafting the lease to make sure that the QPRT will be taxed only when the note is paid.
(3) How are rental payments to be administered?
Administration of rental payments when there is a single lessor is relatively simple: a checking account can be opened in the name of the lessor QPRT and rent checks deposited in that account. But administration becomes more complicated when there is more than one lessor. If at the end of the QPRT term the trust instrument requires division into separate trust shares among children, there is now a multiplicity of lessors.
The problem is compounded with a married couple with identical QPRTs. If the couple has three children, then arguably there are six lessors. Must six separate accounts be established and six rent checks be issued each month? QPRT administration can be simplified if the QPRTs can continue as grantor trusts.
(4) How are rental payments treated for income tax purposes?
Depending upon whether the QPRT is treated as a grantor trust for income tax purposes, QPRT administration can be relatively simple and inexpensive or annoyingly complex and quite expensive. Clients tend to have a short memory when you try to explain to them that the cost and complexity of QPRT administration are far outweighed by the estate tax savings realized by establishing the QPRT in the first place.
Let’s examine the two options: non-grantor trust treatment versus grantor trust treatment. First, with the non-grantor trust, expect these consequences:
• The QPRT will be a tax-paying entity and require its own tax ID number. If there are separate trusts created under the “umbrella” QPRT, each trust will be a separate taxpayer and require its own tax ID number. A separate Form 1041 fiduciary income tax return will be required for each trust.
• Rental payments will be taxable income to the trust(s), which may be offset, in whole or in part, by expenses related to the property. To minimize taxable income, the trust(s) would take a depreciation deduction, which means that in all likelihood there will be recapture when the property is ultimately sold.
• Each lessor trust may need to have a separate account into which the rental payments are deposited.
• If the property is the grantor’s principal residence, no capital gains tax exclusion would be available when the property was sold and the capital gains tax was payable by the trust(s).
The benefits of grantor trust treatment for income tax purposes are palpable:
• The QPRT, and the multiple trusts created under it, won’t be taxable entities and will not require separate tax ID numbers. No fiduciary income tax returns will be required.
• Rental payments will not constitute taxable income (the grantor is not taxed on income which for tax purposes is treated as being paid to himself), and the property won’t be depreciated.
• While, technically, the property may be owned by several subtrusts, because they’re not taxable entities, the QPRT may open a single account (owned by all the subtrusts but using the grantor’s social security number) into which rent checks may be deposited.
• If the property is the grantor’s principal residence, the capital gains exclusion will be available, and because the grantor will pay any capital gains tax, this payment further reduces the grantor’s estate and is the functional equivalent of a tax free gift to the children.
Advisors know that the effectiveness of a QPRT in reducing estate taxes outweighs the many administration issues that arise when the QPRT term expires. With careful advance planning and drafting by the practitioner, the client is likely to share that conclusion.
A longer version of this story, including drafting suggestions to achieve grantor trust status, originally ran in the May issue of Trusts & Estates
