This article was originally posted in the BBA Trusts & Estates Section's Blog. Click here to read the original post.
BY: Christine Carlstrom, Esq.
When a client has misgivings about paying rent after his QPRT term expires, or is unable to afford it, there are limited options. One of them is a relatively new, IRS-sanctioned technique known as a "Reverse QPRT," which can avoid the potential income, gift, and estate tax consequences of alternatives such as using a promissory note or simply foregoing rent payments.
In a Reverse QPRT, the Settlor creates an irrevocable trust and transfers to it his interest in a residence, just as in a standard QPRT. Rather than retaining a right to live in the residence for X years and making a gift of the remainder, however, in a Reverse QPRT the Settlor makes a gift of the term interest and keeps the remainder interest.
Imagine a client, Don, who at age 65 created a QPRT. Don is a widower with one child, Ben. Through his QPRT, Don retained the right to live in his home rent free for 10 years, after which it would be distributed outright to Ben. At the end of the 10 years, the Trustee conveyed the residence to Ben, and Don began paying fair market rent. It is now some months later, and Don, having reassessed his financial situation, determines it would be best to postpone making rent payments for some time.
One way to accomplish this would be for Ben to create a Reverse QPRT. Specifically, Ben, now the owner of the residence, can create an irrevocable trust, transfer the home to it, and direct the trustee to allow Don to live in the home rent free for 5 years. At the end of that time, the trust could be liquidated and the property conveyed back to Ben.
Normally, such a transfer in trust to a family member with a retained interest would be subject to the Code's special valuation rules, I.R.C. §§ 2702(a)(1) and (2). Under these rules, Ben's remainder interest, which he would like to deduct for gift tax purposes from the value of his gift of the residence to the trust, would be deemed to have a value of zero.
These special valuation rules do not apply to QPRTs, of course, which are exempt under I.R.C. § 2702(a)(3)(A)(ii) and regulations at 25.2702-5(c). Since 2008, the IRS has recognized in over a dozen Private Letter Rulings that Reverse QPRTs are likewise exempt from the special valuation rules.
Accordingly, the value of Ben's remainder interest can be determined using the I.R.C. § 7520 rate, which for June 2012 is 1.2%. This historically low rate depresses valuations for income interests and increases valuations for remainder interests, compared with higher rates. So from a gift tax standpoint, it discourages the use of QPRTs, but produces quite favorable results for Reverse QPRTs. Unless Ben has made substantial lifetime gifts, he can create a Reverse QPRT and give his father a term interest in the residence, while paying no gift tax and using a relatively small fraction of his $5.12 million gift tax exemption.