The Potentional Disadvantage of a Qualified Personal Residence Trust

With a Qualified Personal Residence Trust (QPRT), you can remove the value of your residence from your taxable estate with little or no gift taxation. If you are still living at the end of the term, your children (or trusts for their benefit) are now the owners of the house.

Even better, however, you do not have to move out. To assure that you have a place to live, the terms of the QPRT can permit you to enter into a lease or rental agreement of the house with the remainder beneficiaries when the trust ends. The terms of the lease must be at fair market value. An additional benefit is that each payment of rent to the remainder beneficiaries will effectively transfer additional funds to them, free of gift or estate tax. The QPRT can also be written so that after the initial term of the trust, if you are survived by a spouse, your spouse can be permitted to occupy the residence rent-free for his or her life.

However, there can be disadvantages to the QPRT strategy. For example, if you don’t live until the end of the trust term, the house will still be included in your taxable estate. You are in no worse position however – the house is simply treated as though you never placed it in the QPRT.

The second disadvantage is that with a QPRT, you are passing the house to your children with your original income tax basis. By way of illustration, assume that you bought your house for $50,000 and lived in it for 30 years without putting any more money into it. After 30 years, you decide to sell it, and you are paid $350,000 at today’s market prices. For income tax purposes, the IRS would say that you had a “basis” in the house of $50,000 and a taxable gain on that house of $300,000. You might have to pay capital gains tax on that $300,000 of “profit.” At 15%, for example, the tax would be $45,000 – leaving $305,000 for the children. However, if the house is your primary residence, under current law you can avoid taxation on all gain up to $250,000, or $500,000 for a married couple.

Let’s say, however, that you never sell the house, but rather live in it until your death, and then leave it to your children as part of their inheritance. In that case, the house gets a “step-up” in basis to the date-of-death fair market value. If the fair market value on the day of your death is $350,000, the “basis” is adjusted to that level. Then, if your children sell the house a month later for $350,000 there is no capital gains tax due. They were able to get the full value of the $350,000 inheritance. When you gift your house to a QPRT, the remainder beneficiaries do not get a step-up in basis to your date of death value. The likely result is payment of capital gains tax when the children eventually sell the house.

As a “grantor trust,” you are treated as the owner of the property for federal income tax purposes. Therefore, all income, deductions, and credits associated with the property pass through the trust to you. For the same reason, if your primary residence is the property of a QPRT, then you will qualify for the $250,000 ($500,000 for married couples) capital gain exclusion.

You, as the grantor, pay for all repairs to the house, utilities, lawn care and other basic maintenance, homeowner's insurance premiums, and real estate taxes. Such payments are for the benefit of you, the grantor, as the tenant during the trust term, and do not constitute taxable gifts.