Estate planning with a personal residence.

In many situations, to minimize estate taxes, practitioners often recommend the use of annual exclusion gifts and/or taxable gifts in an amount below or equal to the client's unified credit equivalent amount (currently $600,000). At times this suggestion is met with some reluctance; the client may not wish to give away income-producing assets (especially liquid assets) due to the adverse impact the gifts would have on the client's future cash flow and the availability of assets for the client's use. It is under this type of scenario that the tax adviser should consider recommending to the client that the gifts be made with nonincome-producing (and illiquid) assets such as real estate (e.g., the client's residence). Recently, however, many creative estate planning techniques for intrafamily transfers of real estate have been legislatively or judicially eliminated, or severely restricted-mainly by the enactment of Chapter 14 of the Code and the Gradow decision, 897 F2d 516 (Fed. Cir. 1990). However, estate planning techniques still exist for intrafamily transfers of real estate, especially with regard to a client's residence.

Outright gift

When considering the transfer of a personal residence, an individual may be concerned with the retention of its control. Oftentimes the desire to retain control of the residence outweighs the estate tax savings available, thereby making the outright transfer of a residence not a desirable alternative. In this type of situation, the practitioner needs to advise the client of a way to transfer the residence to achieve estate tax savings, while at the same time allowing the client to retain sufficient control of the residence.

If a client decides to make an outright gift of a partial (minority) interest in a residence, in most states it is advisable for the client to execute a waiver of partition before the transfer. A waiver of partition prevents the transferees from selling their interest in the property unless all parties with interests in the property agree to do so. The waiver of partition also supports the application of the minority interest discount. Without the execution of a waiver of partition, the IRS may be able to disallow any discount taken, by making the argument that each interest transferred was a severable interest that could be independently sold for a price equal to the interest's pro rata share of the property's fair market value (FMV).

Residence trusts

The Revenue Reconciliation Act of 1990 added new special valuation rules under Sec. 2702 applicable to estate freeze techniques involving trusts i.e., grant r retained income trusts grantor retained annuity trusts (GRATs) and grantor retained unitrusts (GRUTs)). The enactment of this section significantly diminished the use of these vehicles for estate planning purposes. However, contained within Sec. 2702 and Regs. Sec. 25.2702-5 are special provisions that allow a GRIT to be used to transfer a personal residence" between family members. The exception applies only if the trust qualifies either as a personal residence trust PRiT) or a qualified personal residence trust (QPeRT). By using a PRIT or QPeRT an individual would transfer his personal residence into trust for a specified term. The individual would be able to retain control of the residence during the trust term and also achieve estate tax savings by transferring the residence at a value less than the total current FMV using valuation techniques prescribed in Sec. 7520.

Personal residence trust (PRiT): A PRiT is a trust whose governing instrument prohibits it from holding any assets other than one residence (the term holder's personal residence) and qualified proceeds" (Regs.Sec. 25.2702-5(b)). The latter phrase is needed to provide for insurance proceeds in the event the residence is damaged, destroyed or involuntarily converted during the trust term. During the PRiT term, the residence may not be sold or used by anyone other than the term holder, a spouse or a dependent. Uses other than a personal residence are prohibited unless such use is secondary (e.g., a home office). The use of a residence as a hotel or bed and breakfast is not considered secondary.

Qualified personal residence trust (QPeRT): A QPeRT is allowed to hold assets other than a personal residence (Regs. Sec. 25.2702-5(c)). Additions of cash are permitted, but not in excess of that required to pay for trust expenses within the next six months, improvements to the residence within the next six months, or the purchase of the initial or replacement residence pursuant to a contract within the next three months. Also, improvements to the personal residence, sales proceeds, insurance policies and insurance proceeds relating to the residence are allowed to be held in a QPeRT.

In allowing additional assets to be held in a QPeRT, Regs. Sec. 25.2702-5(c)(51 provides a number of detailed requirements to assure that these assets are necessary to the operation )f the trust and are not for the purpose of generating income. (A discussion of these requirements is beyond the scope of this article.)

Tax planning implications of PRiTs and QPeRTs: A practitioner must use extreme care in establishing the term of a PRiT or QPeRT. The term must be reasonably established to ensure that the individual making the transfer to the PRiT or QPeRT (the "grantor") outlives the trust term. If the grantor dies during the trust term, the trust assets are brought back into the grantor's estate at their then current FMV, thereby eliminating any estate tax benefit of the original transfer.

In setting up a PRiT or QPeRT, the practitioner must also make sure that household furnishings are not transferred in trust. Under the regulations, these items would disqualify the trust.

In the case of the sale of a personal residence in a QPeRT, the nonrecognition provisions generally available to an individual taxpayer apply.

When choosing between a PRiT and QPeRT, the grantor must consider the trade-off between flexibility and the extra requirements of the QPeRT. The inability to have extra cash to pay expenses, make improvements to the residence and pay insurance policies on the trust assets makes the PRiT less attractive than the QPeRT for most taxpayers.

Another advantage of the QPeRT is that if it becomes disqualified, the regulations allow the trust to be converted to a qualified annuity trust.

Both the PRiT and QPeRT pose a potential control problem to the grantor at the end of the trust's term, because the terms of a PRiT or QPeRT must require that the grantor part with all dominion and control of trust assets at the end of the trust term. The transfer of the trust assets to the remaindermen at the end of the PRiT or QPeRT term may require the grantor to pay rent to the trust remaindermen, or worse yet, may require that the grantor move from the residence. The loss of dominion and control of the residence at the end of the trust term is unavoidable in the case of a PRiT. However, an excellent planning opportunity exists in a QPeRT, allowing the grantor to retain dominion and control over the residence after the trust term in a tax-free transaction. The trust must continue as a qualified annuity trust under Sec. 2702, allowing the grantor's heirs to receive a tax-free step-up in basis in the residence at the time of the grantor's death. To achieve these objectives the grantor has to purchase the residence from the QPeRT before the trust term ends. By purchasing the residence from the trust, the grantor retains dominion and control of the residence after the QPeRT's term; has completed an estate freeze because the residence is required to be purchased from the QPeRT at its then FMV, thereby using other assets in the grantor's estate or requiring the grantor to obtain a loan for the purchase; and returns the residence back into the grantor's estate where it can receive a tax-free step-up in basis at death. The grantor also can purchase the residence from the QPeRT without recognizing any capital gain because under Rev. Rul. 85-13, transactions between the grantor and a grantor trust will be treated as between the same person and will not be taxable. The grantor's ability to purchase the residence from the QPeRT before the end of the trust term adds to the attractiveness of using a QPeRT instead of a PRiT.

Regs. Sec. 25.2702-5(c)(2)(i)(c) also allows QPeRTs to hold undivided fractional interests in a residence. However, separate trusts holding fractional interests in the same residence are treated as one trust. Allowing the residence to be split into undivided fractional interests may create another estate planning opportunity regarding the valuation of the residence based on Rev. Rul. 93-12.

The revenue ruling may allow an individual to fractionalize the ownership of a single residence, place the interests into two or more QPeRTS with different remaindermen, and use a minority interest discount in valuing the interests before applying the Sec. 7520 valuation methodology. However, as previously mentioned, the transferor may need to execute a waiver of partition to obtain the discount in some jurisdictions.

Sale and leaseback 

Generally, under a sale-leaseback arrangement, the owner of a residence sells the property to a junior family member or to a partnership comprised of junior family members. The junior family member then leases the residence back to the senior family member at a fair market rental rate.

Regs. Sec. 25.2702-4(b) indicates that a leasehold interest in property is not a term interest for purposes of Sec. 2702, to the extent the lease is for full and adequate consideration. Therefore, by using a fair rental value, a sale and subsequent leaseback to the original owner avoids the adverse gift tax consequences of Sec. 2702.

The gain realized from the sale generally will be recognized by the senior family member unless the over 55 exclusion is used, or another principal residence is acquired and the old residence is used as a second residence.

The sale-leaseback arrangement removes any posttransaction appreciation from the seller/lessee's estate. However, the removal of the subsequent appreciation in the residence, as well as the assets used to make the rental payments, from the seller/lessee's estate needs to be compared with the potential accretion in the seller/lessee's estate from the reinvestment of the after-tax sales proceeds, to determine whether the sale-leaseback is desirable.

Gift and leaseback

A gift-leaseback should be recommended if the residence to be transferred has a high basis; the transaction would fall within the transferor's unified credit equivalent amount; the transferor has significant other assets with which to make the lease payments (desiring to further reduce his estate); there is anticipated significant future appreciation in the residence but junior family members do not have significant cash flow or assets to either purchase the residence or obtain third-party financing; and/or the transferor has used his one-time over 55 exclusion. An important income tax difference exists between a sale-leaseback and a gift-leaseback: In a sale-leaseback the purchaser could depreciate the residence based on the price paid; however, in a gift-leaseback the lessor would have to depreciate the residence based on the transferor's original basis.

In transferring the residence in a gift-leaseback transaction, the posttransfer appreciation is removed from the donor's estate. Again, the lease must be for a fair rental value. Also, in executing a gift-leaseback transaction, the donor needs to be advised that he is forgoing the tax-free step-up in basis that could be obtained by holding the residence until death and may also be forgoing the onetime over 55 exclusion. Because of these potentiel adverse consequences, as well as the potential adverse economic consequences (i.e., the further reduction in the donor's cash flow or assets to make the lease payments), careful scrutiny must be given to this type of transaction before it is recommended.

In the case of a wealthy client who has not used up his lifetime unified credit equivalent amount and who has been making annual exclusion gifts to his heirs, has an appreciating home and has a high basis in his home, the gift-leaseback may provide more benefit than a sale-leaseback. The client not only receives the benefit of having an appreciating nonincome-producing asset transferred from his estate, but he must also pay rent, thereby removing additional assets from his estate. However, to achieve the estate tax savings from the rental payments, the transferees would be required to report the rent as income (which should be reduced by deductible expenses attributable to the residence). Therefore, the tax savings to the family attributable to the rent payments is the amount of the payments multiplied by the difference between the transferor's estate tax rate and the transferee's income tax rate.

If the facts are modified slightly, for example, the client desires to limit his annual net cash outflow in rent (or desires to increase his cash inflow) and can possibly take advantage of the over 55 exclusion of $125,000 of gain, the sale-leaseback may be more attractive.

Joint purchase

A joint purchase of a personal residence may be accomplished by using either a PRiT or QPeRT. This conclusion is based on an interpretation of the final Sec. 2702 regulations, which provide no specific guidance on joint purchases.

A joint purchase could be accomplished by having the older generation family member provide the consideration for the term interest in the trust, and the younger generation family member provide the consideration for the remainder interest in the trust and then having the trust purchase and hold the residence.

One potential advantage of a joint purchase over an acquisition of a home by the term holder followed by the creation of a PRiT or a QPeRT relates to the amount potentially included in the term holder's estate. If the term holder creates a PRiT or a QPeRT and dies before the trust term ends, the entire value of the home would be included in his estate. However, if the transaction is in the form of a joint purchase, only the remaining term interest is includible in the term holder's gross estate under Sec. 2033 (Regs. Sec. 25.2702-6(c), Example 8).

Additionally, in a joint purchase of a residence using a PRiT or QPeRT, the term holder could potentially acquire a life interest in the trust rather than an interest in the trust for a term of years, which would eliminate any control problem.