Sale of residence before end of term may produce extraordinary benefits for QPRT beneficiaries.

One of the hottest planning techniques available for enhancing overall family wealth involves the use of a qualified personal residence trust (QPRT). Because the special valuation rules of Sec. 2702 do not apply to the transfer of an interest in a QPRT, the technique can be used to transfer the remainder interest in a residence to junior family members at a discounted gift tax value. The primary disadvantage of using a QPRT is that the trust's remainderpersons do not get a step-up in basis for the home when the term interest holders (e.g., parents) die. However, there may be a way for certain clients to get the best of both worlds - the full advantage of a QPRT's transfer tax savings potential and a step-up in the home's basis - by having the trust sell the home back to the transferor shortly before the transferor's term interest expires.

Exception from

Chapter 14

valuation rules

Generally, under Chapter 14 of the Code, when a transfer is made in trust, any retained interest is valued at zero for purposes of determining the value of the resulting gift (Sec. 2702(a)(2)(A)). This rule does not apply if the retained interest is a "qualified interest"; nor does it apply if the only property held in the trust is a personal residence that is to be used as a personal residence by a person holding a term interest in the trust (usually, the transferor) (Sec. 2702(a)(3)(A)(ii)). In the case of a QPRT, the amount of the gift is calculated under the more favorable valuation tables that applied to grantor retained income trusts before the enactment of the Chapter 14 rules. Moreover, if the transferor survives until his term interest expires, the value of the residence will not be included in his estate. Thus, a QPRT can generate significant transfer tax savings.

Buy home back from trust

From an income tax standpoint, the QPRT loses some of its attractiveness if the remainderpersons intend to sell the home once they take possession (assuming the transferor survives until his term interest expires). Reason: Since the remainderpersons will have received their remainder interest by gift, their basis in the home generally will not be stepped up to its fair market value (FMV) on the date of the transfer. In fact, their basis may be limited to a carryover basis. Although Sec. 1015 provides that for gain purposes, the donee's basis of property acquired by gift is the donor's adjusted basis plus the gift tax attributable to the appreciation of the property to the point of sale (for loss purposes, the donee's basis is the lesser of the basis for gain or the property's FMV on the date of the gift), certain individuals at the Treasury apparently believe that, for the transfer of a remainder interest in trust, the remainderpersons may not be entitled to step up their basis by that portion of the transferor's gift tax that is attributable to the property's unrealized appreciation before the gift. Until this issue is clarified, practitioners should assume (for purposes of making their analysis) that the donor's basis generally will carry over to the donee. As a result, if the home has appreciated significantly over the transferor's basis, selling the home will result in large capital gain. A transferor may be able to avoid this basis problem - without losing the benefits of the QPRT - by buying the home back from the QPRT at FMV shortly before the transferor's term interest expires, and converting the former QPRT into a grantor retained annuity trust. By doing so, the home can pass to the remainderpersons through the transferor's estate, thus securing a basis step-up to FMV on the date of death (or alternate valuation date) (Sec. 1014).

Prop. Regs. Sec. 25.2702-5(e)(6) provides that if the QPRT sells the residence and does not purchase another residence to be used by the term holder as a personal residence, the trust must terminate and all trust property must be distributed outright to the term holder. Prop. Regs. Sec. 25.2702-5(e)(6)(ii) provides an exception to this rule if the QPRT is converted to a qualified annuity. The annuity that must be paid to the transferor (in lieu of the transferor having the use of the residence) can be no less than the amount determined by dividing the value of all interests (i.e., the term interest and the reversionary interest) retained by the term holder as of the date of the original transfer (determined as of the date of the original transfer), using the Sec. 7520 rate as of that date for the original term of the term holder's interest.

Adding the home back into the transferor's estate should not increase the size of his estate for estate tax purposes, since he is paying FMV for the house. In other words, the transferor will either have the cash that would have been used to purchase the home, or the home itself, in his estate at death. If most of the home's unrealized appreciation is realized when it is sold by the QPRT back to the transferor, future appreciation in the transferor's estate may be minimized.

Aside from the basis step-up on the transferor's death, the buyback should have no income tax effect. Under Rev. Proc. 85-13, to the extent a grantor is treated as the owner of a trust, the grantor and the trust are treated as a single taxpayer - and a taxpayer cannot sell property to himself. Thus, if the transferor buys the house back from the QPRT, the trust should not recognize any gain, and the transferor should simply retain his old cost basis in the house. Even in the absence of Rev. Proc. 85-13, Sec. 1034 would apparently apply to exclude the gain when a grantor purchases his principal residence from his own grantor trust (see Rev. Rul. 66-159).

Caution

A taxpayer who establishes a QPRT with the intention of buying the home back before the end of his term interest runs the risk that the IRS will regard the transfer as a sham and collapse the entire transaction. Alternatively, the Service could argue that the trust never qualified as a QPRT, since the intent of the arrangement was to transfer cash or other property, and not a personal residence, to the remainderpersons. However, if there is no prearranged plan to dispose of the residence during the trust term and the trust term extends for more than one or two years, it is less likely that the IRS would be successful in challenging this arrangement. See the example on page 377.

Example: Benefit for QPRT Beneficiaries

of Repurchasing a Residence

Husband, H, age 60, owns the residence in which he and his wife, W, reside. The residence has a cost basis of $200,000. On Sept. 1, 1991, H transfers the personal residence to a QPRT having a 10-year term and a standard reversionary clause (i.e., if H dies before the end of the 10-year term, the residence reverts to his estate), remainder to H's two children. According to the report of a valuation expert, the home is worth $600,000 on the date of transfer. H has made no previous taxable gifts. According to Rev. Rul. 91-48, the Sec. 7520 rate for September 1991 is 9.6%. On establishing the QPRT, H has made a gift of $195,558 to the children, determined as follows.

Probability H survives trust term

(Table 80 CNSMT) age 70/age 60

($68,248/$83,726) 0.815135

Remainder interest for a 10-year term certain

    (Table B - 9.6%)                              x  0.399848
  Factor for valuation of gift to children          0.3259301
  FMV of residence on date of transfer            x  $600,000
  Value of gift to children                          $195,558

During the final year of the QPRT, H and W decide that they would like to continue to live in the residence. On Sept. 1, 2000, H purchases the residence from the QPRT for its then FMV of $1,350,000. As a result of the sale of the residence, the QPRT is converted to a grantor retained annuity trust (GRAT). During the remaining term of the trust (i.e., one year), H must be paid an annual annuity of $64,694, determined as follows.

Value of interest retained

    by H on 9/1/91             $404,442
                                          = $64,694
  Annuity factor for a          6.2516

10-year term certain

(Table B - 9.6%)

H dies in 2001 when the residence is valued at $1,350. Shortly thereafter, the residence is sold by his estate and the proceeds are distributed to his two children. Because the residence is repurchased before the end of the QPRT term, the value of property passing to the children is increased by $329,724, determined as follows.

                                      Residence      Residence not
                                     repurchased      repurchased

Property transferred to children

    Cash                             $1,393,306(a)
    Residence                                         $1,350,000
  Income tax on sale                          0         (322,000)(b)

Additional estate tax

    on annuity payment                  (35,582)(c)            0
  Net to children                    $1,357,724       $1,028,000
  Benefit                            $  329,724

(a) $1,350,000 + ($1,350,000 x 8% before tax rate of return) - $64,694. This amount, $1,393,306, is not reduced by taxes because H is required to pay under the grantor trust rules. (b) ($1,350,000 - $200,000) x 28%. (c) $64,694 (annuity paid to transferor that would not have been paid had the residence not been repurchased) x 55%.