QPRT requirements: new proposed regs raise questions.

On Apr. 15, 1996, the IRS issued a notice of proposed rulemaking on the sale of a residence from a personal residence trust or a qualified personal residence trust (QPRT). The notice indicates that the sale of the residence to the grantor by the trustee of the personal residence trust or QPRT is not consistent with the intent of Congress in enacting Sec. 2702. As such, the proposed regulations would provide that the trust does not meet the requirements of Sec. 2702, unless the governing instrument prohibits the sale to the grantor or related parties.

Background

Valuation rules are provided by Sec. 2702(a) for determining the value of a gift on transfer in trust to or for the benefit of the donor's family when the donor retains an interest in the trust. Sec. 2702(a)(2)(A) values that retained interest at zero unless it is a"qualified interest." Hence, the value of a gift is equal to the property's full fair market value (FMV) at the time of transfer.

Sec. 2702(a)(3)(A)(ii) allows an exception to this rule for the transfer of an interest in trust of a residence to be used as a personal residence by persons with term interests in such trust. This enables a grantor to carve out the retained interest and the reversionary interest before valuing the gift based solely on the qualified remainder interest. The gift's FMV (less mortgage) is reduced by the present value of the right to reside tax free in the residence for the term of years (the retained interest). It may also be reduced by the present value of the right to retake the residence on death during the trust term (the reversionary interest). Regs. Sec. 25.2702-5(c) expands the viability of the personal residence trust through the creation of a QPRT. Should the grantor outlive the term of the QPRT, the personal residence passes to the remaindermen, who are the family members or designated members; the full FMV of the residence is no longer in the donor's estate at this time. The residence would otherwise be taxable at the incremental estate tax rate (which can reach 55% for the combined taxable estate and taxable gifts under Sec. 2001). Rather, only the remainder interest is subject to gift tax, and then only on the remainder's value as calculated when the residence originally was transferred into the trust. Any subsequent appreciation while in the trust avoids imposition of both gift and estate tax.

Assuming that the trust instrument meets the grantor trust rules such that the grantor is considered the owner of trust income and principal, he will enjoy the benefit of the deductible expenses incurred on behalf of the personal residence on his own income tax returns during the trust term. Any gain on sale and repurchase can be deferred under Sec. 1034, and the one-time $125,000 exclusion is available under Sec. 121 for taxpayers 55 years of age and older.

One major disadvantage to the remaindermen is that they will inherit the grantor's tax basis in the gift of the personal residence under Sec. 1015. If they had received the personal residence through the estate, they would have enjoyed a basis equal to FMV under Sec. 1014 (or a market value six months later if using the alternate valuation date election of Sec. 2032).

Taxpayers have been addressing this disadvantage by having the grantor repurchase the residence prior to the end of the trust term for the then full FMV. The residence then passes to the estate at death, valued at its then current FMV. Because this is a grantor trust, in Rev. Rul. 85-13, the transaction was not treated as a sale or exchange but rather as a nontaxable event with no gain realized. Thus, cash passed to the remaindermen on trust termination (in place of the residence), and was effectively removed from the estate, with only a fraction of its value remaining and subject to estate tax (represented by the remainder interest on which the residence was valued).

Prop. Regs. Sec. 25.2702-5(c)(9) would provide that the trust does not meet the requirements of Sec. 2702 unless the governing instrument prohibits the sale to the grantor or related parties:

(9) Sale of residence to grantor, grantor's spouse, or entity controlled by grantor or grantor's spouse. The governing instrument muse prohibit the trust from selling or transferring the residence, directly or indirectly to the grantor, the grantor's spouse, or an entity controlled by the grantor or the grantor's spouse during the original term interest of the trust, or at any time after the original term interest that the trust is a grantor trust. For purposes o the preceding sentence, a sale or transfer to another grantor trust of the grantor or the grantor's spouse is considered a sale or transfer to the grantor or the grantor's spouse. For purposes of this section, a grantor trust is a trust treated as owned by the grantor or the grantor's spouse within the meaning of sections 671-677. The term control is defined in 525.2701-2(b)(5)(ii) and (iii). . . .

The Service goes on to explain:

The amendments to [sections]925.2702-5(b) and (c) are proposed to be effective for trusts created after May 16, 1996. Thus, a trust created after this date will not satisfy the requirements of a personal residence trust of [sic] a qualified personal residence trust if the trust document does not comply with the regulations, as amended. Such a trust would be eligible for reformation under the proposed regulation.

Notwithstanding the proposed effective date, if the IRS examine [sic] a pre-effective date trust and finds it inconsistent with the purposes of section 2702 or the regulations thereunder, the IRS, by using established legal doctrines such as the substance over form doctrine, may treat the trust as not qualifying under section 2702. Thus, for example, if the grantor actually purchases the residence from the trust pursuant to a right or option to purchase that is stated in the trust instrument or a collateral document, the IRS may not treat the trust as a qualified personal residence trust.

Conclusion

The proposed regulations seem to take: the position that a transaction that could occur several years after the gift could affect the amount of the taxable gift Moreover, the proposed regulations would allow no reduction in the gift for the retained interest for that period prior to repurchase during which the residence was actually used as a principal residence while in trust. It is unclear how this could equitably affect those QPRTs created prior to the issuance of these proposed regulations. A number of these QPRTs have relied on letter rulings that have explicitly provided for the purchase by the grantor prior to trust expiration.

A hearing was held on duly 24, 1996 in Washington, D.C., to solicit comments prior to adoption of the regulations. IRS officials indicated they would welcome examples of legitimate deals involving grantors buying back residences placed in residence trusts. The intent expressed was a willingness to modify the proposed rules under Sec. 2702 for grantor buy-back transactions that should not be prohibited.

From Peter M. Brophy, CPA, Yonkers, N.Y. (Own Account; Not Affiliated With DFK)