Qualified personal residence trust

Personal residences that are mortgaged may be transferred to a residence trust. To the extent the residence is encumbered, the value of the property transferred will be reduced for gift tax purposes. As mortgage payments continue to be made by the grantor, additional gifts are made to the remaindermen.

Some commentators suggest that the additional gifts can be avoided by having the grantor indemnify the trust for the mortgage debt. Under this analysis, the amount of the gift to the trust is the fair market value of the residence undiminished by the mortgage, and the grantor's mortgage payments do not constitute additional gifts.[1]

To escape valuation under Code section 2702 (i.e., retained interest valued at zero), a PRT must comply with the following two primary requirements: (i) the trust may hold only one residence which must be used as the grantor's personal residence during the term of the trust; and (ii) the trust may not allow the sale of the residence during the term of the trust. Additionally, following the expiration of the residence term, sale to grantor or grantor's spouse is also prohibited.

The inability to sell the residence is a major restriction on the flexibility of a PRT and usually makes QPRTs more desirable. PRTs do not, however, have many other technical restrictions that QPRTs are subject to.

Similar to PRTs, QPRTs must comply with certain requirements to avoid valuation under Code Section 2702. The QPRT requirements are as follows: (i) income must be distributed to the grantor at least annually; (ii) no distributions of principal may be made to any person other than the grantor; (iii) only one personal residence may be held in the trust, but as discussed below, certain other assets may be held in the trust, as well; (iv) to the extent the trust hold cash in excess of the amount allowed, such cash must be distributed at least quarterly; (v) the QPRT status will cease if the residence is no longer used in such capacity.

QPRTs are permitted the following: (i) the residence may be sold, but not to the grantor or the grantor's spouse (the residence may pass to the grantor's spouse without any consideration at the end of the term); (ii) if the residence is sold, the trust may continue holding the sale proceeds, so long as the cash is held in a separate bank account; (iii) cash may be added to the trust, and then held in a segregated bank account, for the payment of certain expenses connected with the residence; (iv) the trust may permit improvements to be added onto the residence; and (v) the grantor's interest may be converted into an annuity, if the trust contains provisions required by Treasury Regulations Section 25.2702-3 for a qualified annuity interest.

If the residence is sold and the trust retains the cash, then the trust must provide that it will terminate as a QPRT with respect to the cash, no later than the earlier of: (i) the date that is two years after the date of sale; (ii) the termination of grantor's interest in the trust; or (iii) the date on which a new residence is acquired by the trust. If the QPRT status of the trust terminates as to the cash, then the cash comes back into the grantor's estate.

A residence trust (PRT or QPRT) will remain a grantor trust during the grantor's retained term. Grantor status is important, because it will allow the grantor to take mortgage interest and property tax deductions, and will also avail the grantor of the Code Section 121 gain exclusion.

Following the expiration of the residence term, the grantor status of the trust usually ceases, unless the trust is drafted in a manner to make the trust intentionally grantor following the expiration of the term. This may be advantageous if the trust holds a vacation home and the grantor wishes to deduct mortgage interest and expenses associated with that home.

If a grantor dies during the retained term of a residence trust, the full value of the trust property is included in the grantor's estate under Code Section 2036(a)(1) (because the grantor retains the right to possess or enjoy the property). If the grantor retains a reversionary interest during the retained term of the trust, the value of the residence is included in the grantor's estate under Code Section 2033.

However, it is usually prudent to include in a QPRT a contingent reversionary interest during the retained term of the trust. If the grantor dies during the retained term, the residence is included in the grantor's estate whether or not there is a reversionary interest. But, if there is a reversionary interest, the age of the grantor now comes into the valuation of the retained interest. Because now there is a possibility that the grantor will die within the retained term and the remainder beneficiaries will then receive nothing, the value of the retained term increases and the value of the remainder interest decreases (only the transfer of the remainder interest is subject to the gift tax, so it is beneficial to decrease its value).

Following the expiration of the retained term, the residence is no longer included in the grantor's estate; provided that the grantor is not a beneficiary of the trust and does not have the right to rent the residence for less than fair market value.