To QPRT or not to QPRT?

The area of estate and gift planning is an inexact science: Should a taxpayer give an "appreciating asset" now or later? How much advantage is there in letting heirs have a stepped-up basis?

These issues are often discussed in regard to various investments. Often forgotten is what (for many people) is their largest investment and one that usually has enormous appreciation--the personal residence.

This has changed. The qualified personal residence trust (QPRT) provides an easy method for transferring a residence to a person's heirs while still allowing the donor to live in the residence as if nothing had happened.

Even better, the transfer can be made at very substantial discounts from market value. The IRS created the QPRT through very specific regulations (Regs. Sec. 25.2702-5). While these regulations are not numerous, there are very specific requirements.

It is important to remember that the following requirements must be satisfied within the provisions of the trust document:

[] QPRTs apply only to an individual's principal residence and one other residence. The personal residence includes appurtenant structures used by the term holder and adjacent land not in excess of what is appropriate for residential purposes.

[] All the income, if any, must be paid to the term holder annually.

[] No transfers may be made to anyone other than the grantor during the trust's term.

The trust may receive only specific assets from the donor in addition to the residence. Cash contributions to the trust are limited to:

[] Sufficient cash to pay for trust expenses in the next six months.

[] Improvements to be made to the residence in the next six months.

[] Sufficient cash to purchase an initial residence. (There are significant restrictions on when and how cash can be contributed.

[] Cash to purchase a replacement residence within three months.

To be allowed, the trust document must specifically allow for these contributions. Additionally, if the trust document allows for these contributions, it must also provide that the trustee, not less frequently than quarterly, determine if there is excess cash. Any excess amounts must be immediately distributed to the term holder.

The trust must contain other restricting provisions, such as:

[] A prohibition on distributions, during the trust term, of trust corpus to anyone other than the term holder.

[] The trust must prohibit any prepayment (commutation) of the term holder's interest.

[] The property must be used exclusively as a residence of the term holder or his spouse.

Obviously, there are a great many restrictions on the use of a QPRT, and great care must be taken in its documentation. However, the estate/gift tax rewards can be worth the exercise. By qualifying as a QPRT, the valuation limitations of Sec. 2702 are avoided, and Sec. 7520 will apply.

Thus, the QPRT is entitled to full reduction for actuarial value of the retained interest plus the actuarial value of any reversion contingency.

Example 1: X, who is 65 years old, established a QPRT for the benefit of his daughter, Y The property has a current value of $1,000,000 and the current applicable Sec. 7520 rate is 10%. The trust is established to last until the earlier of 10 years or X's death. The actuarial value of X's retained interest is $552,690 and the value of his reversionary interest is $163,310. Therefore, the value of the gift X makes to Y is only $284,000 $1,000,000 -- $552,690 -- $163,310). If X does not survive the term of the trust-10 years--the property will revert back and be included in his estate at current value, less the value of the gift already made, $284,000 (i.e., as if the trust had not been established).

The possible advantages of the QPRT do not stop with the discounted gift. The trust instrument must provide that the trust ceases to be a QPRT on the sale of the residence unless the trust document allows the trust to hold the receipts from the sale for the earlier of

--two years from the sale date,

--the termination of the term holder's interest, or

--the date a new reside chased.

Example 2: Using the facts from Example 1, assume that the 10 years have passed and X is still alive and desires to continue living in the residence. The residence is now worth $1,500,000. One solution is to allow the trust to terminate, have the residence pass to Y and have X pay fair value rent to his daughter.

However, there is a more aggressive method. X can purchase the house from the QPRT for its $1,500,000 market value within two years of the trust's termination. Because X has a reversionary interest of more than 5%, the trust is considered a grantor trust under Sec. 673. Therefore, the purchase of the house is not taxable to the trust (since X is just purchasing the residence from himself). The cash or other consideration from the purchase will pass to X's daughter when the trust terminates. When X dies, Y can use the proceeds to purchase the residence from the estate and receive a step-up in basis.

It must be noted that this is an aggressive method. While there does not appear to be any statutory or regulatory violation, it is possible the Service could contest the transaction, contending that Congress never intended such use of Sec. 2702. What is important to remember is that the decision on using the purchase method is years away. By that time, the law in this area will become more settled. However, the structure of the trust to allow it must be done when the trust is established.

From Michael D. Koppel, CPA, Gray, Gray & Gray, Boston, Mass.