Article:
Residence Trust
by Paul H. Roskoph
July 1, 2006
A "Qualified Personal Residence Trust" is a "Code qualified" technique to reduce the value of the donor's estate by transferring the ownership of a residence and/or a second (vacation) home to the children (or other desired donee) through a trust, where the donor-owner retains the ownership and use of the property for a selected number of years.
The following information is provided to assist in the understanding of the purpose and planning use of a "Qualified Personal Residence Trust" (QPRT). Typically, separate trusts are established by husband and wife for their respective interests in the residence or vacation property used for the trust (the only properties permitted under the tax law for a QPRT). Each property could be transferred to separate QPRT trusts.
Using two trusts results in separate transfers, each of less than the full ownership. Thus, for transfer valuation purposes, the value of each transfer of ___ interest is discounted to an amount less than ___ of the value of the entire property. Although this procedure may seem counterintuitive, it has been expressly approved by the Internal Revenue Service and the U.S. Tax Court.
An important consideration in a QPRT is the term for the trust. The longer the trust term, the lower the gift value. BUT, THE GRANTOR MUST SURVIVE THE TERM OF THE TRUST TO ACHIEVE THE TAX PLANNING BENEFITS. If the grantor dies during the trust term, there is no penalty – it just doesn't provide any benefit, as the asset is included in the grantor's estate at its full fair market value at the date of death.
The Trust Format:
The tax law requires this trust be a "Grantor Retained Interest Trust." It also requires that the trust convert to an annuity payment during the Grantor's retained term if the house is sold and the proceeds not reinvested within 2 years of the sale in another qualified residence or vacation property. It is generally not the grantor's intention to sell the house, but the law does not deal with current intentions; rather, the law mandates the implementation of the annuity in the event the property is sold and the proceeds not invested in another qualified residence.
The general purpose of a QPRT is to transfer currently a remainder interest in the residence to the Grantor's children through a trust which will provide ownership after a given number of years. The value of the gift is discounted from its current value by the mathematical factor of deferral (the present interest of the right to receive the value in the future). This provides an easily established mathematical result.
If the trust includes only a fractional interest in the property, the gift tax transfer valuation reflects discounts associated with the lack of a full interest being transferred. Thus, it is not unusual to claim a 25% to 35% discount for the transfer of a fractional interest.
Example: Assume the property has a value of $1,000,000. Each spouse transfers a 50% interest. Therefore, our starting point is $500,000. Applying approximately a 30% discount to this for lack of control over the entire property and a discount for the reduced marketability of the fractional interest, each spouse would make a current transfer of approximately $350,000. Applying the current discount factors, the value of the gift might be approximately $180,000 for each spouse based upon their current ages and the life expectancy determined by today's tables for a 10-year trust, or even less for a 15-year trust. Specific calculations will be made when the values are discussed further. The current interest rates are also a factor for the actuarial calculations. Lower current interest rates create larger remainder values (larger gifts). Higher interest rates reduce the amount of the gift. These rates are revised monthly. For example, the rates have fluctuated between 3.8% and 8% in three years.
To further benefit from the discounts, the trust will provide that if the grantor fails to survive the trust term, the property will revert to the grantor (for disposition under the grantor's personal trust). The personal trust will then gift the property to the surviving spouse of the original creator of the trust (to preserve the marital deduction and estate tax deferral). Without this right of reversion, the discounting is less.
If the property is sold and the proceeds not reinvested in a new qualified residence, the trust is required to pay an annuity in an amount set forth by formula based upon the interest rate factor established at the creation of the trust. This rarely occurs, but the plan must provide for it.
If you would like further information, please contact our office by email or at (650) 470-5300.
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