Nikolaos I. Tsouros, LL.M., Esquire

In evaluating a client's estate planning needs, the use of a Qualified Personal Residence Trust ("QPRT") should be considered and, if appropriate, utilized to reduce a Client's taxable estate for federal estate tax purposes. For the tax year 2006, the federal estate tax is imposed on estates greater than $2,000,000. A QPRT is a very helpful estate planning tool when interest rates are higher and when a Client (the "Transferor") places his or her primary residence or vacation home into an irrevocable trust that is managed by a Trustee (i.e., someone other than the Transferor) for a term of years and upon the expiration of the term the ownership of the residence is transferred to the beneficiaries of the trust. The key estate planning benefit to a QPRT is that as long as the Transferor outlives the term of the trust, the value of the residence is removed from a Tranferor's federal estate at a discounted value based upon the term of years of the trust. The longer the term of the trust, the greater the discount.

Background
A QPRT is a type of trust called a Grantor Retained Income Trust which is permitted under the Internal Revenue Code ("IRC") Regulation Section 25.2702-5. It is called a Grantor Trust because all income, deductions and credits are treated as if there was no trust and all such items flow through to the Transferor and he or she may include or deduct such items on his or her federal income tax return. The QPRT is also allowed to hold other assets in addition to a personal residence. As such, the trust may hold additions of cash in a separate account, which must be used, within 6 months of their contribution, to pay for expenses of the trust, such as mortgage payments, insurance premiums, improvements, or taxes. Additionally, the Trustee of the Trust must determine quarterly what the trust's expenses will be and can either request that the amounts of expenses be contributed from the Transferor to the Trust itself or be paid directly by the Transferor. Also, any income earned by the trust must be distributed to the Transferor annually.

Early Disposition of Trust Property
If the residence held in the trust is ever sold before the expiration of the term, the proceeds from the sale can be held in a separate account by the trust and can be used to either purchase a replacement residence or be paid out to the Transferor as an Annuity for the balance of the Term of the Trust. Additionally, any insurance proceeds from damage or destruction to the residence can be retained in the Trust and utilized following the rules as set forth above in the event of the sale of the residence.

Termination of Trust upon Expiration of Term/Prior to Term
After the expiration of the term of the trust, the Transferor may wish to continue to occupy the residence. In that case, the Transferor can enter into a lease arrangement with the beneficiaries. However, the Transferor will be required to pay fair market lease value for continued use of the residence in order to preserve the exclusion of the residence from his or her federal estate.

If the Transferor dies before the expiration of the Trust Term the residence is included as part of his or her taxable federal estate, which is discussed below.

Gift Tax Consequences
The annual gift tax exclusion of $12,000 per donee, for the tax year 2006, is not available for contributions to a QPRT because these gifts are considered transfers of a future interest rather than a present interest. Thus, what ever the value of the gift via a QPRT is that value will reduce the amount of the Transferor's lifetime federal gift tax exemption of $1,000,000. A Transferor would like the value of the QPRT gift to be lower so that the gift will not use up a large portion of his or her lifetime federal gift tax exemption. In gifting a residence to a QPRT there is a built in discount because the Transferor retains a present interest (a retained interest) in the residence for the Trust Term, and after the Term the Beneficiaries are entitled to receive the future gift (a remainder interest) in the residence. The value of the gift, the remainder interest, is determined by subtracting the actuarial value of the retained interest from the entire value of the residence. This calculation factors in the current interest rates, the age of the Transferor and the term of the trust. Thus, the longer the term of the Trust, the larger the value of the retained interest and, therefore, the lower the value of the gift. This is the ideal situation because the Transferor removes from his or her estate a very valuable asset for a discounted amount through the gift.

Also, if the Transferor makes subsequent contributions of cash into the trust to be used to reduce the principal of the mortgage or to make home improvements, these contributions are considered as additional gifts of future interests. However, the payment of current expenses such as real estate taxes, insurance and the interest component of any mortgage payment does not constitute an additional gift.

Estate Tax Consequences
As stated above, if Transferor dies during the Term the entire value of the trust assets will be included in the Transferor's federal gross estate, because the Transferor retained the use of the residence for a period that did not end before his or her death. If the Transferor does outlive the trust term the assets held by the QPRT are not included in his or her federal estate, provided that there is no continued use of the residence without paying fair market value rent to the beneficiaries.

Exclusion of Residence Sale Gain
If the trust sells the residence to a third party, and the residence is the Transferor's primary residence according to the rules of the IRC Section 121, the Transferor should have the benefit of electing to exclude $250,000 of gain (or $500,000 for married individuals filing jointly) because from an income tax perspective the sale of the residence was made directly by the Transferor.

Tax Basis
When the trust's term expires and the beneficiaries obtain the residence, the beneficiaries' income tax basis for the residence will be what is referred to as carry over basis, plus the amount of the federal gift tax on the appreciation of the residence that was the result of transferring the residence into the QPRT. Thus, whatever it cost the Transferor to purchase and make improvements to the residence, that is what the income tax basis will be for the beneficiaries plus any gift tax that was attributable to the appreciation of value of the residence placed in the QPRT.

Some Concerns regarding QPRT
Significant non-tax problems may be associated with refinancing the mortgage indebtedness on a residence owned by a QPRT. It seems that Fannie Mae (FNMA) guidelines do not permit FNMA to purchase any secured loan where the collateral, the residence, is held by a irrevocable trust. This restriction limits the availability of credit to a QPRT. So before transferring a mortgaged residence into a QPRT, Settlor should refinance their current mortgage, or, ideally, transfer a residence that is not encumbered by a mortgage into a QPRT.

Summary
As illustrated above, a QPRT is a very useful estate planning tool for Clients who are comfortable transferring ownership of their residence into a trust for a term of years. Upon the expiration of the trust term, the residence is then transferred to the Beneficiaries and the Transferor can still use the residence provided he or she pays fair rental value to the Beneficiaries.

MacElree Harvey
17 West Miner Street
Post Office Box 660
West Chester, PA 19381–0660
p | 610.436.0100
f | 610.430.7885
f | 610.429.4486
e | info@macelree.com