Passing the family residence to one's spouse or children after death: Should transfer be directly or in trust?

In devising a will, a testator must consider an appropriate vehicle for passing various assets to loved ones. Assets may be given outright, in trust or under some other custodial arrangement. Although the testator may wish that his beneficiary could gain possession of the property shortly after the testator's death, having the inheritance pass to a trust or under some other custodial arrangement often may be more prudent. For example, when beneficiaries include the testator's minor children (or legally or financially incompetent relatives), it would be especially appropriate to have the will create a trust by which a competent and experienced trustee could manage the assets for many years on behalf of the named beneficiaries. Additionally, having the assets pass in trust may provide protection from creditors that would not otherwise be available if those same assets passed directly to the intended beneficiaries.

An asset common to most estates is a personal residence. Often, the residence is held in joint tenancy or in a tenancy by the entirety, in which case the residence would not pass under the will but rather would pass to the remaining joint tenant under operation of law. If, however, the testator were the sole owner of the entire residence or if he held ownership as a tenant in common, he could provide in the will for its ultimate disposition. Typically, the testator would provide in the will that the residence pass outright to his surviving spouse or other relative. However, there are times when he would prefer it to pass in trust to his named beneficiaries.

In deciding whether to pass the residence outright to or in trust for an intended beneficiary, a testator may also wish to consider whether the beneficiary qualifies for exclusion under Sec. 121, should the beneficiary later decide to sell the residence. Under Sec. 121, a taxpayer may exclude from taxable income up to $250,000 of gain ($500,000 for qualifying married taxpayers filing jointly) incurred on a sale of his principal residence, if certain requirements are met. To qualify for this exclusion, the taxpayer must have owned and used the property as his principal residence for periods aggregating at least two years during the five-year period ending on the sale date.

If a testator bequeaths a residence outright to a beneficiary and the beneficiary uses the residence as a principal residence for the requisite period, the beneficiary will be entitled to the gain exclusion under Sec. 121. If, however, the testator bequeaths the residence in trust for the beneficiary and the beneficiary uses it as a principal residence for the requisite period, the beneficiary's ability to exclude gain under Sec. 121 on sale depends on whether he is deemed to "own" the residence.

The IRS dealt with this issue in Letter Ruling 200018021, in which a taxpayer was a beneficiary of a trust established several years earlier by her mother. Under the trust's provisions, the taxpayer was the income beneficiary, but had no power to reach the trust principal or appoint the principal to herself or any other person. At the taxpayer's death, the trust principal was to vest in the taxpayer's children who were over the age of 21. The only trust asset was the taxpayer's mother's former residence, which had not generated any income for the taxpayer. Until moving to an assisted living facility, the taxpayer had used this residence as her principal residence for the past 18 years. The trustees were now planning to sell the residence and thus requested a ruling from the Service on whether gain from the sale would be excludible under Sec. 121.

In denying the exclusion, the IRS maintained that Sec. 121 requires a taxpayer to both own and use the residence as his principal residence for the requisite period. Thus, the Service argued that, while the taxpayer's mother did use the residence as her principal residence for the past 18 years, the taxpayer did not own the residence, as title to the home was vested in the trust.

In the ruling, the IRS cited Rev. Rul. 85-45, which held that when the tax law considers a beneficiary to be the owner of a trust, a sale by the trust is treated as if made by the beneficiary. A trust beneficiary would be considered the trust's owner if Sec. 678 applies. Sec. 678, among other things, deems a beneficiary an owner of a trust if he is able to vest the trust's principal in himself.

The Service concluded in the letter ruling that, because the taxpayer was never given the power to invade the principal or appoint the principal to herself or any other person, she was not deemed the "owner" of the trust and thus was not the "owner" of the residence. Therefore, the taxpayer could not exclude any of the gain as provided in Sec. 121.

Both Letter Ruling 200018021 and Rev. Rul. 85-45 underscore the point that, if a testator wishes to provide an intended beneficiary with potential gain exclusion under Sec. 121 on a future sale of a residence, the testator should either bequeath the residence outright to the beneficiary or bequeath it to a trust that provides the beneficiary with any of the powers provided in Sec. 678. Of course, the testator needs to weigh the value of this benefit against the reasons for creating a trust in the first place (e.g., prevention of wasting of trust corpus by minor children, protection from creditors, etc.).

FROM IRA OLSHIN, CPA, J.D., LL.M., NEW YORK, NY