A residence trust is used to transfer a grantor’s residence into a trust in order to exclude any future appreciation of the residence from the grantor’s estate. These personal residence trusts (“PRTs”) are irrevocable and split-interest in character. In essence, the transfer of the residence is a complete gift, while at the same time the grantor retains the right to live in the house; rent-free for a number of years, and then it becomes fully vested in the beneficiaries.
If the grantor retains an interest in the trust then his retained interest is valued at zero, for estate and gift tax valuation purposes. However, if it is qualified (Code Section 2702(b)), its value is determined under Code Section 7520. It is desirable to minimize the value of the gift.
The gift is valued as the fair market value of the residence less the value of the retained interest. If the retained interest is valued at zero then the taxable gift equals the fair market value of the residence. If the retained interest is valued under Code Section 7520 its value will be greater than zero and the gift value is minimized.
Code Section 7520 values the retained interest using the term of the trust, the life expectancy of the grantor, and the 7520 rate in effect for the month of the transfer. But what is a personal residence? The actual principal residence of the grantor, one other residence of the grantor, or an undivided fractional interest in either. However, only up to 2 residences may be transferred into residence trusts and one must be the primary residence. Personal residences that are mortgaged may be transferred to a residence trust.
In order to escape valuation under Code Section 2702 the trust must comply with two requirements: the trust may hold only one residence which must be used as the grantor’s personal residence during the term of the trust, and the trust may not allow the sale of the residence during the term of the trust. Further, following the expiration of the residence term, sale to the grantor or grantor’s spouse is also prohibited. The inability to sell the residence is a major restriction on a personal residence trust compared to a qualified personal residence trust (“QPRTs”).
In QPRTs the following are allowed: the residence may be sold, but not to the grantor or the grantor’s spouse (the residence may pass to the grantor’s spouse without any consideration at the end of the term); if the residence is sold, the trust may continue holding the sale proceeds, so long as the cash is held in a separate bank account; cash may be added to the trust, and then held in a segregated bank account, for the payment of certain expenses connected with the residence; the trust may allow improvements to be added on to the residence; and the grantor’s interest may be converted into an annuity, if the trust contains provisions required by Treasury Reg Section 25.2702-3for a qualified annuity interest.
Things to consider are: naming the grantor’s spouse as the beneficiary to the trust. This would allow the spouse to live rent-free and the grantor as well. Another is to name a grantor trust as beneficiary, yes you read that right, a trust can be a beneficiary. And the beneficiary to the grantor trust? The spouse. This would allow the grantor to continue to qualify for Code Section 121 exclusion and allw the spouses to live in the house rent-free. Also, name children as beneficiary to PRT/QRTs, not the trustee. A trustee has the power to kick out the grantor once the residence trust expires.
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