Gimme shelter.

EXECUTIVE SUMMARY

* ALTHOUGH QUALIFIED PERSONAL RESIDENCE TRUSTS are less flexible than when they first were created, they still can provide attractive tax benefits to certain homeowners. To set up a QPRT, a taxpayer transfers a remainder interest in his or her personal residence to someone else in trust while retaining possession of the residence for a term of years.

* UNDER 1997 TREASURY DEPARTMENT REGULATIONS, a taxpayer no longer can buy back the residence from the trust during its term. This was a common practice under prior law because it left trust beneficiaries with cash rather than a residence with a low-income tax basis.

* INDIVIDUALS OR COUPLES CANNOT USE THEIR ANNUAL gift tax exclusions to shelter QPRT transfers from tax. Rather, they must reduce their unified credit. While this reduces the amount they can leave tax-free at death, the hope is the tax savings on the property's subsequent appreciation will make the transaction worthwhile.

* THE PROPERTY A TAXPAYER CAN PUT IN A QPRT includes his or her primary residence or a vacation home if personal use exceeds 14 days per year or 10% of the days it is rented out. The trustee can sell the residence during the trust term and has two years to reinvest the proceeds in a replacement residence.

* ALTHOUGH THE GRANTORS CANNOT PURCHASE the residence during the trust term, the remainder beneficiaries can buy it just before the trust ends in exchange for a promissory note. When the trust terminates, the note is distributed to the children and disappears as a liability. The children's income tax basis in the residence now equals its purchase price and the parents can avoid capital gains on up to $500,000 under IRC section 121.

A look at the tax advantages of qualified personal residence trusts.

At a time when few things are as certain as death and taxes, techniques that freeze the value of appreciating assets for estate tax purposes can be an important way for CPAs to help clients save money. One such technique is the qualified personal residence trust (QPRT). Because the regulations governing these trusts have changed since they first were created, CPAs now find they are less flexible. However, a new strategy has emerged that means QPRTs remain an attractive tax planning tool for certain homeowners.

SOME ESSENTIAL BACKGROUND

In 1990, Congress added chapter 14 to the IRC, which created three statutory irrevocable trusts: the grantor-retained annuity trust (GRAT), the grantor-retained unitrust (GRUT) and the QPRT. IRC section 2702(a)(3)(A)(ii) details the requirements for a QPRT and sets forth the rules a taxpayer--as the settlor or grantor who transfers the home to the trust--must follow to enjoy the tax benefits of transferring a remainder interest in a personal residence to someone else while retaining possession of the residence for a term of years.

In December 1997, the Treasury Department finalized revised QPRT regulations. Treasury decision 8743, effective December 23, 1997, decreased the flexibility of QPRTs by eliminating the settlor's ability to buy back the residence from the trust during its term; previously, the settlor could reacquire the residence in a tax-free repurchase, leaving the trust's remainder beneficiary with cash rather than a residence with a low-income tax basis.

HOW IT WORKS

John and Nancy are married and own their home, which they acquired in 1966 for $50,000. Although they want the home to pass to their children and, perhaps one day, to their grandchildren, they are not interested in fully relinquishing control of the home just yet, as they anticipate living in it for at least another 10 to 15 years. However, they fear that if they wait to give it to their children at that time or at their deaths, the property will have appreciated in value so dramatically that gift or estate taxes will be too costly to permit keeping the home in the family.

Assuming family relationships are harmonious, these are ideal circumstances for the CPA to recommend a QPRT. For example, under the terms of the QPRT John and Nancy can retain possession of the home for, say, a 15-year term, at the end of which their children will own it outright. During that 15-year term, they can even act as trustee of the trust. Or, they can designate a trusted friend or other family member. The couple can retain the right to replace the trustee whenever they wish.

If the home has a current fair market value of $500,000, for tax purposes John and Nancy will be giving only the remainder interest. This will be worth about $200,000 based on IRS tables that are used to calculate a remainder interest. The couple cannot make use of their $10,000 annual gift exclusion to shelter the transfer from tax. They can, however, reduce their $625,000 unified credit, the amount an individual can pass free of estate or gift tax. A transfer such as this one is a worthwhile use of the credit, particularly if the couple anticipates the home will continue to appreciate in value. Thus, if John and Nancy make such a transfer in 1999, they each will reduce their unified credit by $100,000.

While this reduces the amount each can leave tax-free at death, the hope is the tax savings on the property's subsequent appreciation will make the transfer worthwhile. For example, if John and Nancy's home is worth $750,000 at the time of their deaths, by freezing the home's value for estate tax purposes at $200,000 they will have helped their heirs avoid paying estate tax on $550,000--a tax that could be $300,000 or more since estate tax rates run as high as 55%.

If a grantor dies during the term of the retained interest and did not pay any gift tax on the transfer but, instead, used some or all of his or her unified credit--and the trust is includable in the grantor's estate under section 2036(a)(1)--any unified credit the grantor used is restored at his or her death. Thus, if John and Nancy die seven years after placing their home in a QPRT, they each would have their $100,000 unified credit restored.

A home is fixed in value (for gift tax purposes) at the time it is placed in a QPRT. The taxable gift is determined by subtracting the value of the grantor's right to remain in the home (valued as an income interest) and the value of the possible reversion to the grantor's estate. No gift tax will ever be paid on any future appreciation on the home.

In the above example, if John and Nancy change their minds at the end of the 15-year term and decide they are not ready to relinquish their home to their children, they can (if the children are willing) retain possession of the home by paying fair market rent to the children or by purchasing the home from the children for its current fair market value. Some clients may balk at the idea of paying rent for a home that once was theirs, but this step is crucial for the IRS to recognize the QPRT'S validity.

The property a taxpayer can put in a QPRT includes his or her primary residence or a vacation home if personal use exceeds 14 days per year or 10% of the days it is rented.

A QPRT also can be funded with an undivided interest in either type of property. In some cases, adjacent lots as well as other structures, such as barns, can be included in the definition of a residence. (See private letter rulings 9328040, 9442019 and 9503025; see also Treasury regulations section 25.2702-5(b)(2)(ii) and 25.2702-5(c)(2)(ii)).

A QPRT trustee can sell the residence during the trust term and has two years from the sale date to reinvest the proceeds in a replacement residence to maintain the qualified status of the trust. If the trustee does not reinvest the sale proceeds within two years, the trust becomes a GRAT and the grantor will receive an annuity for the remainder of the trust term. At the end of the term, the cash in the GRAT will be distributed in accordance with the provisions previously included in the QPRT instrument.

THE FINAL REGULATIONS

The December 1997 regulations provide that the governing instrument for a QPRT prohibit the sale of any residence held in the trust to the grantor, his or her spouse or an entity controlled by the grantor or the grantor's spouse. Previously, a QPRT could permit the grantor to repurchase the residence from the trust--tax-free--during the trust term.

This change presumably is aimed at the common occurrence of QPRT grantors buying back the residence during the trust term, which allowed trust beneficiaries to receive cash instead of a residence with a low carryover income tax basis. The result--in the IRS'S view--violated the spirit behind the creation of section 2702-5. The regulations do not affect the trustee's ability to sell the residence to a third party if the grantor no longer can live in it.

Because the regulations fail to address specifically whether a residence can be leased to the grantor at the end of the trust term, CPAs should consider recommending to clients that they incorporate lease terms into QPRTs to bind the parties to leases after trust terminations, since the IRS previously approved such arrangements. Two private letter rulings (PLR 9448035 and 9433016) permitted lease language to be incorporated into QPRT documents.

AVOIDING CAPITAL GAINS

A major drawback of a QPRT is that the beneficiaries acquire the residence with the same income tax basis as the grantor(s). This means that in the earlier example, John and Nancy's children would have a $50,000 basis in the residence. Upon a subsequent sale by the beneficiaries, a significant capital gain may result. Before such a sale was prohibited, beneficiaries avoided this problem when the parents bought back the residence from the QPRT before the term ended.

Sometimes, however, when Congress and the IRS take something away with one hand, they give something back with the other. Legislation amending IRC section 121, effective for sales of personal residences after May 6, 1997, now allows a husband and wife to exclude from tax up to $500,000 of gain on the sale of a personal residence, creating a tax planning opportunity. If the residence in the QPRT is the grantors' primary residence, the remainder beneficiaries--usually the children--can purchase the residence from the QPRT for its fair market value in exchange for a promissory note. The best time for this transaction is just before the end of the QPRT term. Upon termination of the trust, the promissory note will be distributed to the children and thus disappear as a liability. The children's income tax basis in the residence will equal its purchase price and the parents avoid capital gains on up to $500,000 (married couples filing jointly) under section 121.

If a family uses this technique, the beneficiaries will own the residence with an income tax basis equal to its current market value. The grantors can use the QPRT to save on gift taxes in transferring the residence to beneficiaries, and as long as the "sale" of the residence to the beneficiaries (via the QPRT) does not exceed $500,000 in total gain, no capital gain tax results.

For example, John and Nancy's children will have a basis of only $50,000 in a residence worth 10 or more times that amount. As long as the trust residence is the couple's primary residence (this strategy would not work for a vacation cabin), their children can buy the house at its fair market value from the QPRT during its 15-year term, perhaps in the thirteenth or fourteenth year. At the end of the term, the promissory note will be distributed to the children and canceled. Because John and Nancy are deemed to have sold their personal residence (via the QPRT), they can shelter up to $500,000 in gain under the exclusion available to married couples filing jointly. In their case, the gain is $450,000 (the $500,000 value at transfer to the trust less the $50,000 basis).

TIPS FOR MAXIMIZING QPRT BENEFITS

CPAs can make several other suggestions to their clients to help them gain maximum advantage from a QPRT. Rather than a husband and wife jointly creating one QPRT, each can transfer an undivided one-half interest in the home. The value of the home at transfer will be reduced by virtue of their respective fractional interests in the property. Therefore, the remainder gift will be less.

Another method to maximize the benefits is to change the trust's duration. Since there is no limit on the length of the term interest of a QPRT, a grantor can place a first home into a QPRT with the remainder to pass to his or her children in 40 years. The taxable portion of such a gift will be minimal and the grantor will be able to replace or upgrade the residence at any time during the trust term or convert the interest into a qualified annuity. This strategy is best employed by a young grantor with a long life expectancy.

NO BED OF ROSES

QPRTs are not without problems. The grantor must outlive its term to enjoy the tax advantages. Because of the grantor's retained interest in the trust, the entire value of the residence is included in the grantor's estate under IRC section 2036 if he or she dies during the trust term. Although the consequences of this may wipe out any benefits, the risk can be decreased significantly by transferring the residence to the spouse with the longest life expectancy and having him or her act alone as grantor.

According to regulations section 25.2702-5(b) (2), mortgaged property can be placed in a QPRT. However, additional "housekeeping" efforts apply. Although the grantor can continue to deduct mortgage interest whether he or she pays it directly or through the trust,, future payments of mortgage principal will be treated as gifts by the grantor to the remainder beneficiaries. Some CPAs suggest clients avoid transfers of mortgaged property to QPRTs; however, as long as appropriate annual gift tax returns are filed and taxes paid, there is no reason to avoid them under these circumstances. As an alternative, the grantor can personally assume the outstanding mortgage on the QPRT property. He or she can then continue to make payments and claim interest deductions while avoiding gift consequences to the remainder beneficiaries.

Psychologically, QPRTs are a tough sell for some clients. At the end of the trust term, the grantors must leave the residence or lease it from their children and pay rent. Even the friendliest of families can feel the strain of requiring aging parents to pay rent, particularly at a time when the parents may be adjusting to a decrease in income or beginning to feel they are losing control over their possessions. As advantageous and flexible as modern QPRTs can be, CPAs should make sure willing, informed clients contemplate the technique only under the right circumstances.

BE CREATIVE

QPRTs remain a very viable estate and tax planning technique. CPAs should heed the evolution of this technique and be mindful of the benefits of creative structuring of such trusts in light of recent and not-so-recent developments. In so doing, CPAs can be sure that only clients likely to gain maximum benefits from QPRTs use them.

JAMES R. McDANIEL, JD, is a partner in the law firm of Reish & Luftman in Los Angeles. His e-mail address is [e-mail]. JENNIFER M. HONEY, JD, LLM, is self-employed as an estate planning attorney in Manhattan Beach, California.