For those who have estates large enough to be subject to estate taxes, either currently or when the estate tax exemption falls as scheduled in 2026, various planning options are available to reduce or eliminate the estate tax liability. One strategy is the qualified personal residence trust (QPRT).
The Benefits of Qualified Personal Residence Trusts
A QPRT is a specific type of irrevocable trust that is designed to own a taxpayer’s personal residence. If a QPRT is designed and implemented correctly, it offers several benefits:
- Tax liability can be reduced by transferring the home to the trust beneficiaries during the taxpayer’s lifetime rather than at death.
- Subsequent appreciation in the home’s value is removed from the taxpayer’s taxable estate.
- The taxpayer can continue to live in the home rent-free for a period of time.
- The taxpayer can further reduce their taxable property’s value by paying rent to the trust after a specified term.
- The QPRT can hold the residence in continuing trust for the beneficiaries, providing robust asset protection from the beneficiaries’ creditors, divorcing spouses, bankruptcies, etc.
Requirements of a QPRT
Once a QPRT is prepared and signed, the taxpayer transfers their personal residence by deed to the QPRT. Within the terms of the trust, the grantor (the taxpayer) retains the right to reside in the home for a specific term of years. Because the taxpayer reserves the right to live in the property, the taxable value of the gift to the QPRT can be discounted under federal tax law. The value of the gift discount is increased by the length of the term of the trust. When the term ends, the grantor’s right to live in the home terminates, and the trust beneficiaries (usually, the grantor’s children) receive the residence either outright (if the trust is designed to terminate at the end of the term) or in further trust for asset protection purposes. If the grantor wishes to continue to live in the home, they can rent it at fair market value, which allows the grantor to make additional transfers of cash to the trust, transfer tax-free, for the benefit of the beneficiaries.
For the taxpayer to realize the above benefits, a QPRT must be carefully designed and implemented. For the trust to qualify as a QPRT under federal tax regulations, the following terms must be included:
- All income generated by the trust must be distributed to the trust’s grantor at least annually.
- The QPRT cannot allow the distribution of trust principal to any beneficiary other than the grantor before the term expires.
- The trust can hold only one residence with a reserved right of occupancy during the specified term and cannot hold any other type of property (with some limited exceptions to help maintain and insure the home).
- The QPRT must prohibit termination of the trust and distribution of trust property among the beneficiaries prior to the expiration of the trust term.
- The trust must require that if the residence is no longer being used as the grantor’s personal residence, the trust will cease to qualify as a QPRT.
- The trust must provide that if the home is damaged or destroyed to the degree that it becomes uninhabitable, the trust will cease to be a QPRT unless the home is repaired or replaced before the earlier of two years after the damage occurs or the expiration of the grantor’s residency term.
- The QPRT must not allow the trust to sell or transfer the residence to the donor, their spouse, or an entity controlled by either of them at any time during the grantor’s residency term or at any time after the grantor’s residency term that the trust remains a grantor trust.
In addition to the property, the QPRT can hold cash for a short period of time to allow for the payment of trust expenses such as mortgage payments or home improvements or to allow the trust to purchase a replacement residence should the residence be sold with the intent of replacing it.
Possible Downsides of QPRTs
As with most things tax related, whenever you get a tax benefit, there are going to be trade-offs that must be considered. Before you decide to use a QPRT in your estate planning, consider the following:
- There are typically significant legal and professional fees associated with the formation, funding, and tax reporting of a QPRT.
- In some states, holding a personal residence in a QPRT can result in reassessment of property tax liability and higher property taxes or a loss of certain property tax exemptions or abatements.
- After the QPRT’s term ends, the grantor must give up the right to occupy the residence and, if they desire to continue living there, they can do so only by renting the property from the QPRT beneficiaries, which can create an awkward situation in some families.
- Transferring the residence to the QPRT causes it to have a carryover basis in the hands of the beneficiaries, resulting in potentially high income taxes if they choose to sell the property after the term ends.
- Transferring a residence that has a mortgage on it can significantly complicate proper accounting for the tax aspects associated with mortgage payments and deductions. It is generally recommended to transfer only homes that are not encumbered by a mortgage.
Who Should Consider Using a QPRT?
A QPRT is a sophisticated estate tax planning tool that can allow a homeowner to transfer their property to the next generation with significant gift and estate tax savings. Those with a high net worth who may be facing estate taxes upon their death, who anticipate high appreciation in their personal residence, and who expect to outlive a certain term of years may want to consider using a QPRT in their estate planning. There are many tax and non-tax considerations associated with the QPRT, so it is important to use a qualified attorney and tax professional who can help you weigh the benefits against the downsides to determine if it is an appropriate tool for your own situation. If you would like to learn more about this strategy for yourself and your loved ones, please arrange a meeting with us. We are ready to help.