QPRT Variations

t may be a sign of one's age to still think of Qualified Personal Residence Trusts (QPRTs) as the "new kid on the block." Yet the novelty of having a new acronym in the lexicon of estate planning has long since worn off. We no longer have to wonder how courts will react to the many real estate circumstances that arise, since there is now a body of case law that has developed.

As another clear sign of how well established QPRTs have become over the past decade, estate planners have now begun proposing a number of intriguing variations on their use. It goes without saying that if one originates an estate-planning arrangement, someone will find some way of combining it with life insurance. The installment sale of a residence to a defective grantor trust provides a collection of several advantages. And the use of split-purchase trusts as an alternative approach may be useful in certain circumstances. Let us set the stage for three of these new ideas with some background on the basic QPRT.

Background of QPRTs

To make a long story short, this approach just flat out didn't work. So Congress made a 180-degree turnabout and in 1990 repealed §2036(c) retroactively and replaced it with Chapter 14, i.e., sections 2701 through 2704.¹ The new approach established a zero value for certain retained interests, therefore assuming that all or most of the value of an asset has been transferred and imposing gift tax accordingly. But a major exception was carved out for qualified personal residence trusts under §2702.²

QPRT Guidelines

It must not contain assets other than a personal residence. However, it can contain a limited amount of cash for operating expenses. The personal residence must be the term holder's principal residence or one other residence of the term holder.

Income from the trust must be distributed to the term holder at least annually. The trust instrument must prohibit distributions of corpus prior to the end of the trust term to any beneficiary other than the transferor.

The term holder's interest may not be commuted or prepaid.

The trust must cease if the residence ceases to be used as a personal residence of the term holder.

Within 30 days after ceasing to be a QPRT, the assets must be distributed to the term holder or the trust must be converted to a grantor-retained annuity trust (GRAT).

Over the past decade, the IRS and the Tax Court have ruled upon a variety of situations. Thus, we have seen that the following properties (and appurtenant structures used for residential purposes under Reg. §25.2702-5(c)(2)(ii)) all qualified for QPRT status:

A home, two buildings, and a swimming pool on a large tract of land that was restricted by a conservation easement. Let. Rul. 200039031.

A residence on a 65-acre tract. Bennett, DC-Ga, 61-2 USTC.

A vacation home qualified for QPRT status despite having a Jacuzzi, a separate one-bedroom cabin, a tennis court, and sufficient acreage to qualify for a conservation easement. Let. Rul. 200109017.

A 2.5-acre parcel with a home and a barn that was co-owned by a husband and wife and severed from a 14.3-acre parcel which was leased to a farmer. Let. Rul. 200004037.

A gift of the grantor's house that was transferred to a QPRT by the beneficiary pursuant to a power of attorney. TAM 199944005.

A grantor's stock shares in a cooperative apartment. Let. Ruls. 199925027, 9447036, 9433016, and 9151046.

A home owned by a couple as community property. Let. Rul. 199908032.

A vacation home with a section that is leased to unrelated individuals. Let. Rul. 199906014.

Land with multiple buildings, all of which were used residentially. TAM 9722009.

Three adjoining parcels with land appropriate for residential purposes. Let. Rul. 9705017.

A 16.6-acre coastal property was qualified for use in a QPRT. Let. Rul. 9645010.

Modern QPRT Strategies

And just like the original estate-freezing devices that existed prior to legislative forays into this area, today's QPRT provides a means of having one's cake and eating it too. The personal residence continues to be possessed and used, yet its value has been frozen at current levels for transfer tax purposes.

Several variables affect the size of the taxable gift that arises from the QPRT: (1) The length of the term of years being retained. A longer term of years generally means more value is being retained by the grantor and less value is assigned to the remainder and taxed as a gift. (2) The age of the grantor. As the age of the grantor rises, the life expectancy declines and the likely term may be less than the term of years indicated by the optimistic QPRT documentation. (3) Applicable Federal interest rates also affect the gift tax consequences.

Finally, the potential for capital gains comes into play as well. Retaining assets for a stepped-up basis must be considered, at least to the extent such a step up will apply to a given estate under the changing rules that exist. Contending with capital gains may also lead to the use of an intentionally defective grantor trust so that tax liabilities would apply to the grantor and thereby constitute an additional tax-free gift.

Just Add Life Insurance

Who can say whether, 10 or 20 years in the future, the remainderman could have creditor problems or be involved in a pending divorce. The remainderman may have died or become incompetent. Another important consideration is the potential desire of the grantors to continue to remain in the home. A bankrupt remainderman may be forced to sell the home. Nor is there any guarantee that the remainderman would permit the grantor to continue to remain living in the home. Payment of a fair rent at that time may have become burdensome for the grantor and/or represent unnecessary taxable income to the remainderman. So the loss of control and tax consequences may not be ideal.

Making an irrevocable life insurance trust the beneficiary of a QPRT could address these issues without detracting from the advantages of the QPRT. While the heir intended to be the remainderman of the QPRT could become the beneficiary of the ILIT instead, the assets would remain under the control of a trustee, perhaps a corporate trustee or an impartial professional.

If the ILIT is constructed as a grantor trust, the grantor's payment of rent to the trust would not be taxed as income. Nor would such payments be treated as taxable gifts. In fact, this represents a remarkable nontaxable wealth transfer system. Moreover, these payments can then be used to pay life insurance premiums or can be part of a split-dollar arrangement and used to repay the grantor's company for the purchase of life insurance. In fact, while the QPRT is limited to the grantor's personal residence and operational expenses, the ILIT is flexible and can utilize the rental payments to invest in a variety of assets.

The Installment Alternative

Grantor trust status can be useful for the same reasons outlined in the context of ILITs above, i.e., rental payments by the grantor would not be taxed as income to the beneficiary, nor as a gift. But the creation of the grantor status must be done with great caution.

Grantor trust status can be achieved by including trust language that gives the grantor power to borrow the income or principal of the trust without adequate security or reacquire the property by substituting other property of equal value. Grantor trust status can also be secured by providing the power to non-adverse parties to add beneficiaries to the trust.

However, the grantor should not be given any rights to possession or enjoyment of the trust's income or principal or the right to designate beneficial enjoyment of the property. The grantor should not be able to amend or revoke the trust. Nor should beneficiaries be required to survive the grantor to benefit from the trust. The harm of empowering the grantor too fully would be the inclusion of the trust assets in the grantor's estate for estate tax purposes under §§2036, 2037, and 2038.

Example: A parent could sell a residence to the grantor trust in exchange for a note which can be structured to pay interest only with a balloon payment in the future. The parent can then enter a lease arrangement with the trust. Lease payments to the trust can be used to make the interest payments owed to the parent on the note. Neither the lease payments nor the note payments would constitute taxable income because both the parent and the grantor trust are treated as the same person for income tax purposes.

If the parent dies before the term of the trust, only the unpaid portion of the note is included in the parent's estate. So unlike the QPRT, appreciation on the value of the home would escape estate taxation despite the premature death of the grantor.

Split-Interest QPRT

A split-interest QPRT entails a trust's purchase of a personal residence on behalf of two parties, typically the parents and a child. The parent is granted a lifetime interest. The child is granted the remainder interest. The funding contribution by each party is actuarially determined.

In Letter Ruling 9841017, the IRS found such an arrangement to meet QPRT requirements. There was no taxable gift to the child. The trust property will not be includible in the parents' estate.

But unlike the traditional QPRT, the split-interest QPRT apparently does not result in the entire property being included in the parent's estate if the parent dies before the termination of the life interest. Since there is an exchange for adequate consideration, the property should not be included in the parent's estate under §2036.

Note that split-interest trusts typically involve the purchase of a new home. It is not merely a matter of convenience in setting up the acquisition as a split purchase from the start; there is uncertainty about the estate tax consequences of a parent selling a child the remainder interest in an existing home.

A better alternative is to sell a remainder interest to a split-interest trust of which a spouse is the grantor and the children are the beneficiaries.⁶

Consider how valuable this advantage actually is. With a traditional QPRT, the parent's life interest must be restricted to a term that is much shorter than the parent's life expectancy so as to prevent the unwanted inclusion of the entire property in the parent's estate. With a split-purchase QPRT, the parent's life term can be far longer without concern for this risk.

The split-interest approach is also beneficial for generation-skipping transfer tax purposes. Traditional QPRTs would be subject to an estate tax inclusion period (ETIP) that would prevent the grantor's GST tax exemption from being allocated to a grandchild's remainder interest until after it had appreciated in value. With a split-purchase, the GST tax exemption could be allocated to the trust based on the actuarial value of the remainder interest.

One potential drawback to this approach may be the remainderman's ultimate tax basis in the property. Having paid only for the remainder interest, yet ending up with the entire property and all additional appreciation, a large potential capital gain is likely.

Other Variations

While President Clinton's 1999 and 2000 budget proposals would have eliminated QPRTs, the Bush Administration has embraced the elimination of estate taxation. It appears that the QPRT as a wealth-transferring mechanism would therefore be regarded favorably for the foreseeable future.

TECHNICAL REFERENCES