Qualified personal residence trusts.

Many of the traditional estate planning techniques are no longer viable today, either because they have been legislated out of existence or because, while technically available, they do not make economic sense. One of the remaining techniques that has been increasingly popular involves personal residences that are expected to appreciate in value and grantor retained income trusts; this technique can generate significant estate tax savings.

CREATING A TRUST WITH A PERSONAL RESIDENCE

In general, when a property interest transfer is made in trust, any retained interest is valued at zero in determining the resulting gift's value; this increases the value of the gift and the resulting tax that must be paid on the gift. However, this rule does not apply if the only property to be held by the trust is a personal residence that will continue to be used as a personal residence by a person holding a term interest in the trust. (This is usually the person transferring the residence to the trust.) Thus, setting up a trust that includes a qualified personal residence (a QPRT) may provide tax-saving opportunities.

Mechanics. The transferor transfers his or her home to a QPRT for a fixed period, with the trustee holding the title to the house. At the same time, the transferor retains the right to live in the house for the trust term's duration. When the QPRT ends, the trust beneficiaries (often the transferor's children or other family members) become the owners of the house.

Requirements. Several requirements must be observed. The home must be the transferor's personal residence during the entire term of the QPRT. (A vacation home may qualify.) If the transferor wishes to move during the duration of the trust (and assuming the trust's terms permit such actions), the trustee may sell the house and reinvest the proceeds in a new residence within two years with no adverse tax consequences.

If the transferor wishes to live in the house after the trust ends, a fair market rental will have to be paid to the new owners.

Note: If the transferor dies before the trust term ends, the full property value is included in his or her estate. Basically, any tax advantages that might have been gained are nullified.

TAX CONSEQUENCES

Estate taxes. When the residence is transferred to the QPRT, a taxable gift occurs, in the value of the beneficiaries' remainder interest in the house. The transferor must pay gift tax (or use part of his or her $600,000 estate and gift exemption) to offset this tax. Because the beneficiaries cannot take immediate possession of the house and must wait until the trust term expires, this gift amount is less than the house's fair market value (FMV) at the time of the transfer. (This analysis does not consider any state gift or estate tax effects.)

The estate tax value of the residence is set when it is transferred to the QPRT. Any appreciation in the house's value from the time of the transfer until the transferor's death will not be subject to estate tax, since the residence's value no longer will be included in his estate (because he or she already has given it away).

Income taxes. If the beneficiaries intend to sell the residence when they take possession, QPRTs lose some of their attractiveness. Because the beneficiaries received their interests in the house by gift, their basis in the property will not be "stepped up" (increased) to its FMV on the transfer date; instead, they generally will take the donor's basis. As such, if the residence's value has appreciated significantly, selling it will result in a large capital gain.

One possible way to get around this problem is to have the transferor buy back the home at FMV from the QPRT shortly before the trust's term is to expire and convert the QPRT into a grantor retained annuity trust. Because the transferor is paying market value for the house (and therefore has the cash or other assets to afford the purchase), the total value of the transferor's estate should not be changed significantly. However, the beneficiaries of the transferor's estate will receive the stepped-up value of the residence; any sale will result in much lower capital gains.

Caution: A taxpayer who establishes a QPRT with the intention of buying back the house before the end of the trust term runs the risk of having the Internal Revenue Service disallow the entire arrangement. However, if there is no prearranged plan and the trust term extends for more than one or two years, the IRS probably would be much less successful with any such challenge.

For a discussion of QPRTs and other developments, see the Tax Clinic, edited by Philip J. Wiesner, in the June 1992 issue of The Tax Adviser.