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This memorandum describes an opportunity to save gift and estate taxes for a family by use of a special type of trust. The trust is sometimes termed as "grantor retained income trust" or "GRIT," and sometimes is called a "qualified personal residence trust," or "QPRT".

The Mechanics

To create a QPRT, you transfer your house or a vacation home to an irrevocable trust. The trust terms provide that you are the beneficiary for a period (e.g., five or ten years). During that period you are entitled to use the house held in the trust. At the end of the trust term, the house becomes the property of the beneficiaries you name in the instrument, such as your children or other beneficiaries.

During the trust term, you are responsible for the property taxes and normal expenses of repair to the property. You may act as trustee during this period, so you have full control over the property.

If a husband and wife jointly own a property, each of you may transfer your one-half of the property to a separate QPRT for your benefit. At the end of the trust term, both trusts end and the children become entitled to the trust property.

For Proposition 13 purposes, there is no reassessment of the property upon creation of the QPRT. At the end of the trust term (or at your earlier death), the property does undergo a "change in ownership." The property may be subject to reassessment at that time unless it qualifies for the parent-child exemption from property tax reassessment under Proposition 58.

The Tax Advantage

The tax advantage arises because you are deemed to make a gift of the remainder interest in the house to your children (or other beneficiaries) at the time that you create the trust, and the value of this gift is discounted from its fair market value. The exact amount of the discount depends on your age, the trust's term of years, and the IRS published interest rate for the month of the gift. Attached to this memorandum are sample calculations based on various ages, assumed trust terms and an assumed $1 million residence.

For example, suppose that you are 60 years old and transfer a house to a QPRT for ten years. You are deemed to make a gift equal to roughly 37% of the property that you transfer. If you have a house worth $1 million, then you are making a gift of $370,000.

The advantage of this device may be illustrated by comparing it with doing nothing. In the above example, if you do nothing, at your death you will own a house worth $1 million and subject to tax at that value. In contrast, if you give away the property using a QPRT, you may transfer the property to the next generation at a "value" of only $370,000. The transfer also eliminates any appreciation from being included in your estate over the $1 million value.

Possible Disadvantages

If you do not live to the end of the trust term, this technique does not save any taxes because your estate is treated as if you continue to own the property. This consequence produces neither any advantage or disadvantage from a tax perspective. The only real costs to you are the legal and accounting expenses of creating and maintaining the trust.

If you survive the original period of the trust, the residence then is owned by your children (or other trust beneficiaries). Thereafter you may not use the property except by arrangement with the new owners. If you transferred your primary residence to this trust, you would have to rent the property from your children. For a vacation property used by the entire family, you may avoid renting the property if you are invited to use property as a guest of the new owners.

Assuming you live to the end of the trust term, your beneficiaries acquire the trust property at a tax cost basis equal to your cost basis in the property (rather than at the new "stepped-up" basis they would have received had you died owning the property). This consequence makes this type of trust especially attractive when the tax basis is likely not to matter, such as for a property that is likely to stay in the family (e.g., a family vacation home).

If the residence transferred to the trust is subject to a mortgage, there may be some complexity in making the monthly mortgage payments to minimize the tax consequences.

Summary

In summary, a personal residence QPRT is an excellent mechanism for minimizing family estate taxes by transferring a residence at a fraction of its true value. In each case, the decision whether to create the QPRT requires balancing the potential tax savings against the consequences of dealing with ownership by the next generation.

Sample Calculations