Recent developments in QPRTs and QTIPs.

• Author: Easton, Reed W.
• Position: Qualified personal residence and qualified terminable interest property trusts

Two methods by which property can be transferred within a family to minimize estate taxes are use of a qualified personal residence trust or a qualified terminable interest property trust. This article discusses recent court decisions and rulings in each area and suggests why future planning strategies using either of these methods may have to be modified.

Recent developments in gift and estate taxation have clarified some of the rules governing qualified personal residence trusts (QPRTs) and qualified terminable interest property (QTIP) trusts. These developments dictate that new strategies be applied to intrafamily transfers of interests in property.

QPRTs

Individuals with assets exceeding $675,000 or married couples with assets exceeding $1.35 million need planning beyond annual exclusion gifts and life insurance trusts. A QPRT can be a valuable estate planning tool for clients who own a residence. It allows one to part with ownership of the residence, but not lose control over it, for an extended period of time. As is discussed later, the definition of "residence" has been liberally interpreted recently to include large recreational areas and certain rental properties.

However, the advantages of QPRTs are conditioned on relinquishing ownership (if not use) of the residence. Many clients will not part with ownership of a residence (or for that matter, any other asset) during life. In such case, can the taxes ultimately due on the second death of a married couple be minimized? One answer might be to separate assets otherwise passing to a surviving spouse on death into assets conveyed outright to that spouse and assets conveyed to a QTIP trust for that spouse's benefit. As will be discussed, recent authority would allow a fractional interest discount for the assets owned outright by the surviving spouse at death.

Example: H owns 100% of the stock of XYZ Corp. At his death, he leaves 49% of that stock outright to his wife, W, and 51% of it to a QTIP trust for her benefit. The executor of H's estate claims a marital deduction for the full value of the XYZ stock; thus, H's estate pays no estate tax. On W's subsequent death, her executor includes in her estate both the stock she received outright, as well as the entire value of the QTIP trust, but claims a 40% fractional interest discount for the stock she owned outright at death.

Is this a permissible method for creating a valuation discount on the surviving spouse's death? As confirmed by recent court decisions (discussed below), the answer appears to be "yes," but that is not the IRS's position.

In determining the value of a gift of an interest in property, the property's fair market value (FMV) is generally reduced by the FMV of any interest retained by the transferor.(1) The burden of establishing the value of the retained interest is on the transferor.(2) Generally, the transferor would use actuarial principles and Federally determined interest rates (under Sec. 7520) to meet that burden. However, normal valuation rules typically do not apply to intrafamily transfers; Sec. 2702(a)(2)(A) generally values any retained interests at zero, effectively increasing the value of the conveyed interest. However, if the transfer is of an interest in trust, all the property in which is a residence used as a principal residence by the term interest holders, Sec. 2702(a)(3)(A)(ii) provides that Sec. 2702(a) does not apply; the normal Sec. 7520 valuation rules apply.

Regs. Sec. 25.2702-5(b) and (c) provide for two types of personal residence trusts; the QPRT is the more flexible and commonly used. In a QPRT, a person generally transfers a remainder interest in a personal residence in trust to a family member and retains use of the property for a term of years.

Use of a QPRT is a way of leveraging the unified credit and removing all future appreciation from the estate. By delaying when the residence will pass to the ultimate beneficiaries, the value of the gift can be discounted for gift tax purposes. However, if the grantor does not survive the trust term, the entire trust value is included in the estate and the unified credit is restored. During the trust term, the trust is normally structured as a grantor trust; the grantor is entitled to the income tax deductions for real estate taxes and mortgage interest he had before the transfer of the property to the trust.

Defining "Personal Residence"

The term "personal residence" is defined by Regs. Sec. 25.27025(c) (2)(i)(A) and (B) to include the term holder's principal residence or one other residence as defined in Sec. 280A(d)(1) (or an undivided fractional interest in either). A personal residence includes a houseboat, house trailer, stock in a cooperative housing corporation,(3) appurtenant structures used for residential purposes (e.g., a garage) and adjacent land not in excess of that reasonably appropriate for residential purposes (taking into account the residence's size and location).(4)

Cooperative apartment: In Letter Ruling 9925027,(5) a taxpayer intended to transfer legal title to her shares and proprietary leases in a cooperative housing corporation to a QPRT, but the cooperative association...