Federal Gift and Estate Tax Planning- Part 6 of 7: Advanced Planning with QPRTs

Andrew M. Brower

A Qualified Personal Residence Trust aka “QPRT” can be an effective gift and estate tax planning tool, especially in cases where an individual has a large amount of wealth of which a primary residence and secondary home make up a significant percentage. IRC Section 25.2702-5 governs the use of QPRTs.

What property can be transferred to a QPRT?

The IRS allows an individual to transfer no more than two residences (i.e. noncommercial property), including appurtenant structures and adjacent land for residential purposes (primary residence or secondary home) or interest therein to a QPRT.

How is a QPRT structured?

A QPRT is structured where the grantor of the trust retains a right to live in the home for a term of years, with the property vesting in non-charitable beneficiaries, typically children, at the end of the term. If the grantor fails to outlive the term, the property interest reverts to the grantor and, therefore, no benefits are realized. During the term, the grantor retains the exclusive right to occupy the residence, rent free, and is responsible for expenses, taxes, insurance and ordinary repairs much like a life tenant; however, the interest is not for life but strictly for the term of years. 

A taxable gift is assessed at the time of the transfer to the QPRT.  The value of the gift is based on the total property value at the time of the transfer less the present value of the grantor’s retained right to use the property for the term of years. More specifically, the value of the gift is a complex calculation based on the grantor’s age at the beginning and end of the term, the term of the trust, and the Section 7520 rate for the month of the transfer. As the Section 7520 rates increase, when no annuity or income interest is involved, remainder interest values (i.e. the gift amount) decrease and, therefore, the grantor’s retained interest increases. Therefore, with a higher Section 7520 rate, a QPRT is more effective. This is the opposite as is the case for GRATs and IDGTs which rely on lower AFR and Section 7520 rates to be effective. There are more nuances to the calculating the taxable gift but, as an illustrative example and not a precise calculation, the calculated gift for a grantor at 66 to a 10-year QPRT may be 48% of the home’s value, or $4,800,000 for a 10 million dollar home when the Section 7520 rate is 4.8%.  But at a Section 7520 rate of 5.8%, the calculated gift value would be more like 43% of the home’s value, or $4,300,000 for a 10 million dollar home.  Therefore, the discount of the gift can be much greater with a higher Section 7520 rate. With non-income producing property during the term, a future interest has less value in a high interest rate environment.  

Additionally, the appreciation of the home over the term will pass to the residuary beneficiaries tax free at the end of the term. For example, if the 10 million dollar home in the example above appreciated to 15 million dollars during the term and the grantor survived the term, the grantor would have passed the entire 15 million dollar home to their beneficiaries while making less than a 5 million dollar gift for tax purposes. Finally, the longer the term of the QPRT the lower the calculated gift value, but the risk of mortality during the term is higher, and the younger the grantor at the beginning of the term, the higher the calculated gift value, but the risk of mortality is much lower during the term.   

Disadvantages and risks of a QPRT

The most prominent disadvantage of a QPRT is that if the individual does not survive the term the QPRT provides no benefit as the residence will be included in their taxable estate (however, the calculated gift is erased as well). Additionally, assuming the grantor survives the term, they no longer own their residence as it is owned by their beneficiaries, typically children. Therefore, the grantor must begin paying rent to their beneficiaries/children at fair market value at the end of the term. Of course, this is somewhat advantageous in that the grantor can further reduce the size of their taxable estate by passing those rent payments to their children or beneficiaries without making a taxable gift. 

Another disadvantage is the reduced freedom and red tape in dealing with one’s home during the term of the QPRT. For example, the grantor may decide to sell their home during the term. This may be done without terminating the QPRT status if the proceeds are reinvested in another qualifying residence within two (2) years or by the date the trust term ends, whichever occurs first.  However, the QPRT cannot hold cash so if the value of the replacement residence is less than the cash from the sale, the excess cash may need to be converted to a GRAT. Further, if the grantor decides not to purchase a new residence in lieu of all the cash reverting back to the grantor the trust terms can provide that the cash be converted to a GRAT where the grantor receives annuity payments during the remaining term and appreciation exceeding the Section 7520 rate can be passed to the beneficiaries.   

Finally, a QPRT is an irrevocable grantor trust and per Revenue Ruling 2023-2 does not receive a step up in basis. Therefore, if the grantor survives the term, although the property will be removed from their taxable estate with discounted gift tax consequences, the beneficiaries of the QPRT will not receive a step up in basis as they would if they had inherited the property from the grantor.  This should be considered if the grantor has a very low basis in the residence/s. That said, the max capital gains tax rate of 20% is significantly less than the max 40% gift and estate tax rate so despite the capital gains tax consequences for low basis property, a QPRT may still make sense. It should also be noted that, because a QPRT is a grantor trust, the grantor will still qualify for the $250,000 primary residence capital gains tax exclusion if the residence is sold before the term expires.   

Lastly, for States which have homestead exemptions for property tax, the grantor may be ineligible for those programs during the term and thereafter.  

To learn more about estate tax planning, contact our office.