Home sale exclusion limited.

More and more individuals are using living trusts to avoid probate court and transfer their property to named beneficiaries upon their death. A new letter ruling exposes a potential problem if a married couple's revocable trust becomes irrevocable after the first spouse dies and the trust then sells the surviving spouse's home.

In letter ruling 200104005, a husband and wife established a revocable living trust and transferred most of their assets to it, including their principal residence. Upon the wife's death, the revocable trust was split into two: (1) a revocable trust funded with the marital deduction amount and (2) an irrevocable trust that received the balance, including the residence. The surviving husband was the beneficiary of each trust.

The husband had the right to occupy the home and to direct its sale and replacement. The irrevocable trust gave the husband a noncumulative power to withdraw each calendar year, from the principal of the trust, an amount not to exceed the greater of $5,000 or 5% (the "five-or-five" power) of the then aggregate market value of all property included in the trust.

After living in the home for more than 30 years, the husband was forced to move into an assisted living facility. The trustee wanted to sell the residence and asked the IRS if the beneficiary (the husband) could exclude the first $250,000 of gain under IRC section 121.

The husband argued that, since he had the right to occupy the home and the power to force the trustee to rent, lease, sell or replace it, he should be deemed the home's owner.

The IRS disagreed. Under IRC section 121, the $250,000 exclusion of gain on the sale of a principal residence is available only if the taxpayer owns and uses the home as a principal residence for two of the five years preceding the sale. According to the IRS, there is no question that the husband fulfilled the use requirement. The problem was "Who owns the residence?"

The service ruled the husband could use the home sale exclusion only to the extent he was deemed to own a portion of the residence through his five-or-five power. The rest of the gain was taxable. The IRS said that the power vested a portion of the corpus of the irrevocable trust in the husband. Each year in which he failed to exercise this power resulted in his owning an increased portion of the trust corpus and being, therefore, eligible to exclude a larger portion of the gain.

Observation. This ruling has little effect on taxpayers whose spouses recently died and where a trust obtained the property with a partial or full stepped-up basis. However, for taxpayers who have outlived their spouses for several years or those who have had substantial gains, the gains may not be fully excludable under the home sale rule.

As an alternative, homeowners should consider the advantages of establishing a qualified personal residence trust (QPRT). The home is transferred to the QPRT, but the owner reserves the right to live in it rent-free during the trust's term. The owner may have to pay a small gift tax, but if he or she survives the term, the home "passes" to his or her children estate tax-free.

If the owner dies during the term of the QPRT, the residence reverts to his or her estate where it would have been taxed anyway. But the probate process is avoided and the home transfers directly to the named beneficiaries.

If the home is sold during the trust's term, the exclusion amount is still available to the owner. And, for income tax purposes, he or she can still deduct the interest on the mortgage and the real estate taxes.

--Michael Lynch, Esq., professor of tax accounting at Bryant College, Smithfield, Rhode Island.