If there are no concerns about eminent death of the grantor, it would appear that there is a significant gift tax savings inherent in a GRIT. The discount for the grantor's retained life estate can significantly reduce the value of the transfer for gift tax purposes. The GRIT, however, is a creation of tax law. With that comes a plethora of complex rules and possibility of future law changes. Before the planner recommends the GRIT, he or she should be fully aware of its chief advantages and disadvantages.

The Outright Gift

An outright gift of a personal residence has simplicity as its most persuasive selling point. There are no complex rules that come into play. However, if the donor retains a life estate in the residence, the transfer will be ineffective for estate tax purposes. The IRS over the years has found implied agreements when the donor is allowed to continue to live in the residence for the rest of his or her life, and the IRS has been able to include the transfer in the donor% gross estate. Property has even been included when the IRS has found an "understanding" that the parent would rent the residence from his or her children. To overcome this problem, donors have been advised to enter into an arm'slength lease agreement for the fair market value for rental of the property. The rent paid could have the effect of being an additional gift tax-free transfer by the donor, but it may also be taxable income to the donees, presumably the children.

It is a best-case scenario when the rental payments cover the out-of- pocket expenses for real estate taxes, and maintenance. The tax deduction for depreciation then becomes a "bonus" to the donee. When this transaction is motivated for estate planning purposes, a high rental payment is desirable as long as it is within the justifiable confines of fair market value.

An outright gift of a personal residence, despite the fact that GRITs funded with personal residences have entered the picture, still remain a viable, perhaps even attractive, estate planning device. This is particularly true today when real estate values are depressed.

There are also non-tax issues to consider. It may not be easy for a parent to give up ownership of what may be his or her largest asset and be placed in the position of a lessee.

The GRIT Using a Personal Residence

Prop. Reg. Sec. 25.2702-5 allow two types of GRITs that will be funded with personal residences: the Personal Residence Trust (PRT) and the Qualified Personal Residence Trust (QPRT).

To qualify as a PRT, the governing instrument must prohibit the trust from holding, for the entire term of the trust, any asset other than the residence to be used as a personal residence by the grantor beneficiary (the term-holder). It seems possible that this requirement may present difficulties. The property could be sold even without the consent of the trustee (e.g., an involuntary conversion under the right of eminent domain). Or the grantor may cease using the personal residence (e.g., disability renders the home unsuitable for use or grantor no longer wants to use it).

It seems that the second type of permissible GRIT, a QPRT is more practical and therefore preferable.

For gift tax purposes, a transfer to a GRIT in the form of a QPRT is entitled to a full reduction for the actuarial value of the retained income interest plus the actuarial value of any contingent reversion. A QPRT is also practical because the proposed regulations give guidance with respect to permitted, required, and prohibited trust terms, including ways to provide for the disposition of the trust should the residence be sold.

The Qualified Personal Residence Trust

For a QPRT the governing instrument must prohibit distributions of income, corpus, or any term interests to any beneficiary, other than the term-holder. With three exceptions, the governing instrument must prohibit the trust from holding, for the entire term of the trust, any asset other than one residence to be used as a personal residence by a termholder. The governing instrument may permit additions of cash or the holding of cash not in excess of the amount required for three purposes:

1. Trust expenses already incurred or reasonably expected to be incurred within the next three months;

2. Improvements to the residence to be paid within three months; or

3. Purchase of a personal residence either at inception or within three months.

Furthermore, the governing instrument may permit the trust to hold proceeds from the sale of the personal residence or proceeds of insurance paid to the trust as a result of damage to the personal residences for a period not to exceed two years. The trustee must intend to purchase another personal residence for use by the term-holder or must repair the personal residence with the insurance proceeds. The trust instrument must also require that any excess cash be distributed to the term-holder. Any cash on hand at the termination of the trust must be distributed to the term-holder under the trust's terms. The trust instrument must also contain a provision prohibiting commutation of the income interest.

The governing instrument must require that if the residence held by the trust ceases to be a personal residence of the term-holder, the trust must either terminate with all property being distributed to the term-holder or the trust must be converted to Qualified Annuity Trust (GRAT). This requirement may be subject to a provision allowing the trustee to sell the residence and purchase another within a two-year period. However, it does not appear that the trustee can convert the trust to a GRAT using the two-year time period. The conversion to such a trust must occur upon the receipt of the proceeds of sale, if at all.

Personal residences that are encumbered by a mortgage require additional consideration. The general rule is that when property is transferred subject to debt the gift tax basis is the value of the property reduced by the debt. If the grantor then amortizes or repays some or all of the debt, the payment would be an additional taxable transfer to the trust. Of course, the value of the transfer is subject to a gift tax discount for the grantor's retained interest. In most cases it will be desirable to transfer unencumbered residences.

By contrast, there does not seem to be an issue with respect to mortgage interest. A QPRT, by definition, is a grantor trust for income tax purposes, (with respect to accounting income only). If the trustee is obligated to make mortgage interest payments from income, then the grantor should be able to receive the benefits of the deduction. If the grantor remains personally liable on the mortgage and pays the interest directly, he or she should be entitled to deduct the interest.

Similarly, if the trustee is obligated to pay real estate taxes from income, the grantor should receive the benefit of the deduction. If the trust instrument imposes upon the grantor of a QPRT the obligation to pay real estate taxes which accrue during his or her term interest, there is authority which says that the grantor will be intitled to deduct the taxes for income tax purposes. (see Rev. Rul, 67-21, C.B 1967-1.45)

As noted earlier, the grantor of a QPRT is emitled to a full reduction for gift tax purposes for the actuarial value of the retained income interest plus the actuarial value of any contingent reversion. The most popular form of reversion is the return of the personal residence to the estate of the grantor if he does not survive the trust term. In addition to the reduced valuation, the reversion provision avoids the possibility of having the residence includible in the grantor's gross estate and the loss of a potential marital deduction, by having the property pass to the remaindermen. If the grantor retains such a reversion, the trust also becomes a grantor trust with respect to principal for income tax purpose (assuming the value of the reversion is greater than 5%). This scenario has distinct advantages.

Where a QPRT is a wholly-grantor trust, eligible grantors should be entitled to exclude $125,000 of capital gains on the sale of the residence by the trustee. Furthermore, the capital gain on the sale of the residence can be deferred under the rollover provisions of Sec. 1034. The availability of these special QPRT income tax provisions provide planning flexibility upon sale of the residence in the trust.

Extra Effort Has Extra Benefits

Clients may not have the patience to endure the trust creation process, or the added complexities of living in a home which is owned by a QPRT, even though many advantages of direct ownership can be retained. This choice may not seem as attractive as an outright gift and then renting the home from the children even with the estate tax saving possibility.

However, there is one advantage to a QPRT which in some cases can make it more desirable than an outright gift. A grantor can purchase the home from a QPRT before the end of the trust term with no adverse gift, estate, or income tax consequences! If the QPRT sells the residence, the trust, under its terms, must convert to a GRAT when the sales proceeds are received. The grantor would receive an annuity for the balance of the trust term, presumably a short period of time if the sale is properly arranged.

A properly structured grantor trust very likely will not have any recognizable capital gain upon the sale. The trust is not recognized as a separate taxpayer capable of entering into a sales transaction with the grantor. For this reason, it is important that the purchase be made from the trust and not from its remaindermen.

The grantor, of course, must pay fair market value. He or she receives the trust's income tax basis as no gain is recognized. When the trust later terminates, the remaindermen will receive cash. This result is much more desirable, from both a psychological and tax point of view than an outright gift to children with the grantor's low basis carrying over to them. And, of course, the cash the children receive is usually much more attractive to them than an undivided outright interest in what was their parent's home.

The end results of the buy-back by the grantor are favorable to everyone. Upon termination of the trust, the grantor will own the home again. Its basis will be later stepped up in his or her estate. His children will receive cash equivalent to the fair market value of the personal residence (less whatever must be paid out during the short period that the QPRT is a GRAT). This also neatly avoids the problems of what to do with the home when the trust terminates, and the personal residence passes to the children.

The assumption was made throughout this discussion that an outright gift and a QPRT were equally attractive from the point of view of the taxpayer's mortality. However, the grantor must survive the trust term of the QPRT in order for its sion is greater than 5%). This scenario has distinct advantages.

Where a QPRT is a wholly-grantor trust, eligible grantors should be entitled to exclude $125,000 of capital gains on the sale of the residence by the trustee. Furthermore, the capital gain on the sale of the residence can be deferred under the rollover provisions of Sec. 1034. The availability of these special QPRT income tax provisions provide planning flexibility upon sale of the residence in the trust.

Extra Effort Has Extra Benefits

Clients may not have the patience to endure the trust creation process, or the added complexities of living in a home which is owned by a QPRT, even though many advantages of direct ownership can be retained. This choice may not seem as attractive as an outright gift and then renting the home from the children even with the estate tax saving possibility.

However, there is one advantage to a QPRT which in some cases can make it more desirable than an outright gift. A grantor can purchase the home from a QPRT before the end of the trust term with no adverse gift, estate, or income tax consequences! If the QPRT sells the residence, the trust, under its terms, must convert to a GRAT when the sales proceeds are received. The grantor would receive an annuity for the balance of the trust term, presumably a short period of time if the sale is properly arranged.

A properly structured grantor trust very likely will not have any recognizable capital gain upon the sale. The trust is not recognized as a separate taxpayer capable of entering into a sales transaction with the grantor. For this reason, it is important that the purchase be made from the trust and not from its remaindermen.

The grantor, of course, must pay fair market value. He or she receives the trust's income tax basis as no gain is recognized. When the trust later terminates, the remaindermen will receive cash. This result is much more desirable, from both a psychological and tax point of view than an outright gift to children with the grantor's low basis carrying over to them. And, of course, the cash the children receive is usually much more attractive to them than an undivided outright interest in what was their parent's home.

The end results of the buy-back by the grantor are favorable to everyone. Upon termination of the trust, the grantor will own the home again. Its basis will be later stepped up in his or her estate. His children will receive cash equivalent to the fair market value of the personal residence (less whatever must be paid out during the short period that the QPRT is a GRAT). This also neatly avoids the problems of what to do with the home when the trust terminates, and the personal residence passes to the children.

The assumption was made throughout this discussion that an outright gift and a QPRT were equally attractive from the point of view of the taxpayer's mortality. However, the grantor must survive the trust term of the QPRT in order for its estate tax advantages to be realized. (It was pointed out earlier, in the case of an early death of the term holder, it is possible by a reversion to put the client's estate back in the same position as if no QPRT had been created.) If the age or health of the grantor suggests that a trust term of years that has gift tax savings significance will exceed the life of the client, then an outright gift may be preferable.

For example, for a grantor who is age 65, the nontaxable gift portion of any transfer is about 70% for a trust term of 10 years and about 4496 for a term of five years. Therefore, to achieve a large reduction in gift tax value, the grantor must survive 10 years.

Trust or Children?

The QPRT has several attractive features despite its complexities and should be carefully considered by the planner. From the taxpayer's point of view, ownership of the personal residence by a trustee may be preferable to ownership by his children. From an income tax point of view, the advantages of personal ownership, such as the deductibility of mortgage interest and real estate taxes, the $125,000 exclusion, and the 1034 rollover provisions, can be retained. And perhaps most importantly, the client can purchase the residence back, should this be desirable, with no adverse tax consequences, and in fact with some tax and other planning benefits.

There remain a few caveats for the planner. The transfer of property held jointly in tenancy by the entirety presents issues which are best avoided by creating a tenancy in common and establishing two QPRT's. (It is unclear what the effect of the transfer of the right of survivorship to the QPRT would be.) Gift splitting should be avoided because the downward adjustment to the grantor's adjusted taxable gifts will only be onehalf the value of the includible trust should he die before the expiration of the trust term, as compared with the full gift that reverts on the Form 706 estate tax return. Also, generation-skipping transfers should be avoided. The $1 million generation-skipping tax exemption cannot be allocated upon the creation of a QPRT. The exemption can only be allocated at the end of the estate tax inclusion period under Sec. 2642(f). As a result, post-transfer-appreciation is taken into account in allocating the generation-skipping tax exemption. It should be remembered also that a beneficiary who is a non-family member does not fall within the provisions of the code section. For example, a nephew or niece would not be considered a family member. A common law GRIT for their benefit would be tax effective.

By William H. Mears, Jr., Brown Brothers Harriman Trust Company