QPRTs vs IDGT sale-leasebacks
By Julius Giarmarco
Giarmarco, Mullins & Horton, P.C.
In our current low interest rate environment, the IDGT sale-leaseback may have an edge.
High-net-worth individuals looking to take advantage of the reduced market values of their residences and vacation homes often use a qualified personal residence trust (QPRT) to transfer the same to their children. A properly-structured QPRT freezes the value of the residence, resulting in significant estate tax savings. But in the current low interest rate environment, a sale and lease back with an intentionally-defective grantor trust (IDGT) may be more tax efficient. This article will compare the advantages and disadvantages of QPRTs to IDGT sale-leasebacks.
A QPRT is an irrevocable trust designed to hold a personal residence. The grantor retains the right to use and occupy the residence rent free for a fixed term of years. At the end of the term, the residence passes to the remainder beneficiaries (usually the grantor's children). A single taxpayer may create a QPRT for a primary residence and one for a vacation home, for a maximum of two QPRTs. A married couple may have three QPRTs: one spouse creates a QPRT for a primary residence and the first vacation home, and the other spouse creates a QPRT for the second vacation home.
The QPRT can give the grantor the option to lease the residence at the end of the rent-free term. If the grantor pays FMV rent, then there should be no adverse estate tax consequences. Moreover, if the QPRT is designed to be a grantor trust (more below), rent payments are not only gift tax free, but income tax free as well.
For gift tax purposes, the transfer of a residence to a QPRT is a gift of the future interest in the home to the remainder beneficiaries of the trust. The grantor must file a gift tax return (Form 709) for the year of transfer. The value of the gift is derived by first determining the fair market value of the residence (an independent appraisal is recommended), and then subtracting the value of the grantor's retained interest. The value of the retained interest is a function of the grantor's age, the length of the term, and the IRC Section 7520 discount rate (1.3 percent for May 2012). The longer the term and the higher the Section 7520 rate, the larger the value of the retained interest and, therefore, the smaller the value of the gift. The amount of the gift will usually be offset by the grantor's gift tax exemption ($5.12 million in 2012).
While a QPRT can be an excellent wealth transfer planning technique, it has its limitations. First, if the grantor dies before the rent-free term, the full value of the residence (valued at the date of the grantor's death) is included in the grantor's estate, but any gift tax exemption used is restored. Second, the grantor is prohibited from reacquiring the residence. Third, the grantor's generation-skipping transfer (GST) tax exemption cannot be allocated to the QPRT until after the rent-free term has expired. Finally, the remainder beneficiaries take a basis in the residence equal to the grantor's basis at the time of transfer.
An IDGT is a trust that is "defective" solely for income tax purposes. For estate and GST tax purposes, transfers to IDGTs are completed gifts and, therefore, outside the grantor's estate. But, for income tax purposes, the grantor is treated as the owner of the IDGT. A key feature of an IDGT is including one or more trust provisions that will cause the trust to be a grantor trust for income tax purposes, yet not be included in the grantor's estate for estate tax purposes. The most commonly used grantor trust "trigger" is the grantor's power to reacquire trust property by substituting other property of equivalent value.
An installment sale to a grantor trust can provide valuable income, gift and estate tax benefits. If the assets sold produce a total return (income and appreciation) in excess of the interest rate on the note, substantial wealth can be removed from the seller’s gross estate — gift and estate tax free. Following is a summary of the basic structure of an IDGT sale-leaseback:
The grantor creates an IDGT for the benefit of his or her descendants. The trust can also be designed as a generation-skipping (dynasty) trust so that any trust assets remaining at a child’s death pass — estate tax free — to grandchildren (and possibly more remote descendants, depending upon state law).
The grantor makes a gift to the IDGT. For estate tax reasons this “seed” gift should be equal to at least 10 percent of the value of the residence to be sold to the trust. This gift will use up a portion of the grantor’s $5.12 million gift tax exemption (for 2012).
If the IDGT is designed as a generation-skipping trust, the grantor must allocate a portion of his/her GST exemption to the trust to cover the amount of the seed gift. The GST exemption is the same amount as the estate tax exemption, and the allocation is reported on a gift tax return (Form 709).
The grantor then sells the residence to the trust for its FMV (as determined by an independent appraiser). Typically, there is no down payment, interest is payable annually on the note and a balloon payment is due at the end of a set term, ranging generally from nine to 30 years. Because sales between a grantor and an IDGT are ignored for income tax purposes, the grantor will not recognize any gain on the sale and the IDGT's basis in the residence will be equal to the grantor's basis.
The interest rate on the note is fixed for the entire note term at the lowest rate allowed under the tax law. This rate is known as the applicable federal rate (AFR) and is published monthly by the Treasury Department. For May 2012, the interest rate for a nine-year note is 1.3 percent; and the interest rate for a note longer than nine years is 2.89 percent.
The grantor then leases back the residence from the IDGT for fair market value rent (as determined by an independent appraiser). The lease payments are then recycled to service the note. Because the grantor and the IDGT are considered the same person for income tax purposes, both the lease payments and interest payments are ignored for income tax purposes. The grantor's lease payments further reduce the grantor's estate and are essentially tax-free gifts to the IDGT beneficiaries. Which is better?
Both QPRTs and IDGT sale-leasebacks have advantages and disadvantages. Which technique works best for a particular taxpayer will depend on a number of factors, including the Section 7520 rate and AFR, the grantor's age and health, valuation issues, basis issues and GST planning.
Section 7520 rate and AFR
QPRTs are less tax efficient when the Section 7520 rate is low (like now) because the value of the grantor's retained interest is lower; therefore, the value of the gift is greater. Conversely, IDGT sale-leasebacks are more tax efficient in times of lower interest rates, since the interest payments back to the grantor are less.
Grantor's age and health
For a grantor advanced in age or in poor health, there is a mortality risk with a QPRT. If the grantor fails to survive the term, the entire value of the residence is added back to the grantor's estate. In contrast, with an IDGT sale-leaseback, only the unpaid balance of the note is included in the grantor's estate. However, some commentators believe that the IRS will argue that the grantor's death before the end of the note term will result in the grantor's estate being taxed — at that time — on any gain attributable to the unpaid balance of the note.
While residential real estate is generally easy to value, it is possible that the residence's value could be challenged by the IRS (upon a gift tax audit). With a QPRT, an upward adjustment on audit increases the value of the gift. However, with an IDGT sale-leaseback, it may be possible to avoid an increased gift by using a defined value clause in the sale agreement.
For example, the defined value clause might provide that, if the IRS adjusts upward, the "excess" gift will pass to the grantor's spouse (and, thus, qualify for the unlimited marital deduction). One way to possibly lower the value of the gift tax exposure is to transfer partial interests in the residence to multiple IDGTs (or to two QPRTs established by each spouse) so that each gift qualifies for a fractional interest discount. These discounts are typically in the range of 10 percent to 20 percent.
As mentioned above, the remainder beneficiaries of the QPRT and the IDGT beneficiaries take a basis in the transferred residence equal to the grantor's basis. And with a QPRT, the grantor cannot reacquire the residence. Thus, with a QPRT, it is not possible to obtain a stepped-up basis for the residence (by having the grantor die with it in his or her estate). In contrast, with an IDGT, the grantor can reacquire the residence in exchange for high basis assets of equivalent value. As discussed above, this power is one of the most commonly used grantor trust triggers. Thus, with an IDGT, a stepped-up basis for the residence can be obtained at the grantor's death. But be aware of the property tax and homestead exemption ramifications of this maneuver (see below).
Because of the so-called ETIP (estate tax inclusion period) rules, GST exemption cannot be allocated upon QPRT funding. Instead, it can only be allocated at the end of the rent-free term based on the residence's FMV at that time. In contract, IDGT sale-leasebacks allow the grantor to leverage his or her GST exemption by allocating exemption to the initial seed gift when made. Allocation of additional GST exemption is not required because the sale-leaseback is not a gift.
In deciding between a QPRT and an IDGT sale-leaseback, several other factors should be considered. First, QPRTs are statutory techniques with clear regulatory guidance about how they work. In contrast, IDGTs are based on case law and IRS rulings. But, recent rulings from the IRS (particularly Rev. Ruls. 85-13, 2004-64, 2008-22 and 2011-28) have provided planners with great comfort that IDGTs should work as planned. As mentioned above, a single taxpayer may have two QPRTs and a married couple may have three. In contrast, there is no limit on the number of IDGT sale-leasebacks that can be done — subject, of course, to the seed gift requirement. Finally, state law issues must be considered when using either a QPRT or an IDGT sale-leaseback, particularly the impact of the transfers on property taxes and homestead exemptions. For example, in Michigan, with a QPRT, there is no uncapping of the property taxes (or loss of homestead) until the end of the rent-free term. In contrast, with an IDGT sale-leaseback, the uncapping (and loss of homestead) occurs at the time of sale.
Another example: Assume a 70-year-old transfers a $2.7 million residence to a 15-year qualified personal residence trust when the IRC Section 7520 rate is 1.4 percent. The value of the gift will be $1,010,151. If the residence appreciates at 4 percent per year, upon expiration of the 15-year trust term, the residence's value will be $4,862,547. Assuming the grantor dies after the QPRT term with a taxable estate, and assuming the estate tax rate is 45 percent, the estate tax savings would be $1,733,578 (45 percent x [$4,862,547 - $1,010,151]).
Alternatively, assume that same person: (1) gifts a 37.413 percent interest (valued at $1,010,151, assuming no discount) in the same residence to an IDGT; (2) sells the remaining 62.587 percent interest (valued at $1,689,849, assuming no discount) to the same IDGT for zero down, annual interest payments at the long-term AFR (assume 2.72 percent, or $45,964 per year), with a balloon payment at the end of 15 years; and (3) leases the residence from the IDGT for $135,000 per year. As before, assume the residence appreciates at 4 percent per year. In addition, assume the same 4 percent rate of appreciation for the net rental payments ($135,000 - $45,964 = $89,036) retained by the trust.
At the end of 15 years when the note is paid off, the IDGT will be worth $4,955,518, for an estate tax savings of $1,775,415 (i.e., 45 percent x [$4,955,518 - $1,010,151]). Added estate tax savings will continue to occur to the extent the grantor pays income and capital gains taxes on trust investments. Even without this, the estate tax savings is $41,837 more with the IDGT ($1,775,415 - $1,733,578).
However, if the grantor dies just days before the 15-year QPRT term expires, the entire value of the residence ($4,862,547) would be taxable in the grantor's estate. But the IDGT estate tax savings would still be $1,775,415. Thus, the mortality risk associated with QPRTs is a big IDGT advantage, particularly for older grantors and grantors with health issues.
After the 15-year term as to the residence, both the QPRT (if designed as a grantor trust) and the IDGT will perform identically if the grantor continues to lease the residence. But, as mentioned above, with the IDGT, these ongoing reductions in the grantor's estate (by paying the income and capital gains on trust investments) would be greater with the IDGT, as the building up of the investment fund would start 15 years sooner.
When transferring a primary residence or vacation home for estate tax purposes, no one technique fits all. With recent declines in property values, both QPRTs and IDGT sale-leasebacks make more sense now than ever. However, in our current low interest rate environment, the IDGT sale-leaseback may have an edge.
THIS ARTICLE MAY NOT BE USED FOR PENALTY PROTECTION. THE MATERIAL IS BASED UPON GENERAL TAX RULES AND FOR INFORMATION PURPOSES ONLY. IT IS NOT INTENDED AS LEGAL OR TAX ADVICE AND TAXPAYERS SHOULD CONSULT THEIR OWN LEGAL AND TAX ADVISORS AS TO THEIR SPECIFIC SITUATION.