The Covid-19 Pandemic caused many Americans who reside in large cities to purchase vacation homes in places that are less congested or otherwise considered vacation areas. For example, many New York City residents have purchased homes in the Hamptons, the Jersey Shore, the Adirondacks and even more distant places such as Florida and Arizona to escape the city during the pandemic. In fact, many have not yet returned to their homes in New York City even though more than two years have passed since the commencement of the pandemic. An unintended, but hopefully beneficial consequence of the second/vacation home purchase is that the owners and their families will have a place to gather as a family for many years.
A qualified personal residence trust (QPRT) is a specialized irrevocable trust, authorized under Treasury Regulation Section 25.2702-5(c). It is also a grantor trust under Internal Revenue Code Sections 673 and 677. The primary objective of the QPRT is to eliminate from estate tax inclusion the value of one’s primary residence or second/vacation home. It is a planning tool utilized by those concerned about paying an estate tax and wanting to take proactive steps to reduce the size of their taxable estate. Under Treasury Regulation Section 25.2702-5(b)(1), a QPRT effectively can hold no assets other than an interest in one (1) personal residence.
Although a QPRT can only hold one residence, you are still able to sell the residence owned by the QPRT, provided that you purchase a new residence with the proceeds of sale within a reasonable time. Additionally, you can add additional funds to the QPRT to purchase another home, but under Treasury Regulation Section 25.2702-5(c)(5)(ii)(A)(1)(iv), the new funds cannot remain in the QPRT for more than three months and a contract of sale must already be signed.
To illustrate this point, if an individual transferred their primary home to a QPRT, but later decided that they would like to make an upgrade, such individual would be able to sell the home owned by the QPRT (provided that the QPRT contained language to allow it to hold the proceeds of sale), deposit the proceeds of sale into a separate account, then when a new house has been selected, use those funds to purchase the new home. A purchase of a new home should be completed as early as possible, but Treasury Regulation Section 25.2702-5(c)(7)(ii) does allow the proceeds to be held in the QPRT for up to two (2) years. If the purchase price of the new home is greater than the proceeds of sale of the home held in the QPRT, then additional funds may be added within three months of the closing, but only if the trustee has already entered into a contract to purchase the new residence.
In the event the opposite was to happen, and the purchase price of the new home was less than the proceeds of sale, the excess proceeds would not be permitted to remain in the QPRT. If this was to occur, there would be two options available to the trustee under Treasury Regulation Section 25.2702-5(c)(8), those being (1) to distribute the excess outright to the creator / grantor or (2) convert the excess proceeds into a qualified annuity interest and hold such excess in a separate account. Under option (2) this would effectively become a Grantor Retained Annuity Trust.
The transfer/gift of one’s principal residence or second/vacation home to the QPRT is a gift of the residence to the trust beneficiaries subject to the Grantor of the QPRT reserving the right to reside in the home for a period of time a/k/a “term of years” or “QPRT term.”
The selection of the term of years is an important decision that must strongly take into consideration the trust Grantor’s age and health. In order for the principal residence or second/vacation home to be excludible from the taxable estate of the Grantor, they must survive the term of years reserved. If they don’t, the creation of the trust will not achieve the goal of eliminating said residence from estate tax inclusion, as the residence will revert back into the estate of the trust Grantor.
For example, if the Grantor is 85 years old and decides to transfer their primary residence to a QPRT with a seven (7) year term, they would likely be entitled to a significant discount of the value of the gift. However, in the event the Grantor dies prior to surviving the full seven (7) year term, the entire value of the primary residence would revert to the Grantor and be included in his or her estate, thus, there was no added value in creating the QPRT.
Upon the expiration of the term of years, the ownership of the residence passes to the named beneficiaries of the trust at the Grantor’s cost basis of the property. If the Grantor(s) of the trust wishes to continue to reside in the premises they need to pay fair market value rent to do so. Which in effect is also beneficial to the affluent Grantor, as the payment of rent will also help reduce their taxable estate.
When the Grantor deeds the residence to the QPRT, they are making a completed gift of the remainder interest in the residence to the trust (at their purchase price plus capital improvements). The value of the gift made is reduced/discounted by the actuarial value of the term of years reserved by the Grantor. Thus, depending on their age and the number of years they reserved one could be gifting away an appreciating asset worth hundreds of thousands of dollars or millions from their taxable estate and only utilize a small fraction of their current federal estate and gift tax exemption which in 2022 is $12,060,000 per person. It is a clear hedge against having an appreciating asset being included in one’s taxable estate, and it provides the added feature of allowing a beloved family home or vacation home to remain in the family for generations.
As discussed above, if the Grantor survives the term of years, the trust beneficiaries will receive the residence at the Grantor(s) original cost basis (which is purchase price plus any capital improvement less any depreciation). Thus, if the property significantly appreciates after the term of years expires, the beneficiaries will be paying a capital gain tax, upon the sale which is still at a lower rate than the estate tax rate if the property is includable in the Grantor’s taxable estate. If the Grantor fails to survive the term of years, the property will revert back into the estate of the Grantor and receive the step up in basis.
It is also important to note that while not considered “real property,” a Housing Cooperative (“Co-op”), which is a combination of the owner being a shareholder in the corporation and having a long term lease for a specific apartment, can also be transferred to a QPRT. However, doing so requires obtaining consent and authorization from the Co-op Board and/or management company and attorney for the Co-op. Unfortunately, Co-op Boards and/or management companies are sometimes hesitant to allow a transfer of the Co-op shares into a QPRT (or any Trust) as often times the Trustees of the trust is different than the individuals who will actually be occupying the dwelling, or responsible for payment of expenses. If the intention is to transfer a Co-op to a QPRT, it is recommended that prior to execution of the Trust the trust is provided to the Co-op Counsel for their review and approval.
While the potential for capital gains taxes upon the sale are a drawback, QPRT’s are an ideal planning tool for second/vacation homes that one expects will remain in the family for generations. With the present real estate market suffering losses in value, it may be an opportune time to utilize a QPRT.
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Anthony J. Enea is a member of Enea, Scanlan and Sirignano, LLP of White Plains and Somers, NY. He focuses his practice on Elder Law, Wills, Trusts and Estates. Mr. Enea is the Past Chair of the Elder Law and Special Needs Section of the New York State Bar Association (NYSBA). He is the Past Chair of the 50+ Section of the NYSBA. Mr. Enea is the Past President and Founding Member of the New York Chapter of the National Academy of Elder Law Attorneys (NAELA). Mr. Enea is the Immediate Past President of the Westchester County Bar Foundation and a Past President of the Westchester County Bar Association. He is also a Certified Elder Law Attorney as accredited by the National Elder Law Foundation. He is fluent in Italian.
Michael P. Enea is an associate at Enea, Scanlan & Sirignano, LLP. He is currently a candidate for his Masters in Taxation from New York University School of Law. Prior to joining Enea, Scanlan & Sirignano, LLP, he was a corporate associate at Willkie Farr & Gallagher, LLP and a private equity associate at Weil, Gotshal & Manges, LLP, advising public and private companies and financial sponsors in connection with mergers and acquisitions.
Anthony J. Enea and Michael Enea can be reached at 914-200-1256 or at www.esslawfirm.com
