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Dec 1992

Sec. 2702 - special valuation rules personal residence trust. (Estates & Trusts)

by Briloff, Lenore A.

    Abstract- IRC Section 2702 contains the mimimum valuation regulations that cover transfers of assets in trusts. This section is one of the four sections (Secs 2701-2704) comprising Chapter 14 of the IRC that require certain transfers of assets within families to comply with minimum valuation rules. These regulations require older family members who hand over valuable assets to their heirs to pay an appropriate gift tax. The provisions in Sec 2702, however, do not apply to certain trusts that contain a personal residence of the grantor of asset. Personal residence trusts are not subject to the same fixed payout rules as a qualified interest, thus permitting the residence of the grantor to be transferred to heirs at an amount lower than its full value at the time of the trust's creation. This strategy offers considerable potential tax savings if the strict requirements of the personal residence trust regulations are satisfied.

The 1990 legislation enacted Chapter 14, four sections of IRC (Secs. 2701-2704) that impose minimum valuation rules on many intra-family transfers. These rules seek to force older family members to pay adequate gift tax when they transfer valuable, potentially appreciating assets to their heirs. Specifically, Sec. 2702 sets minimum valuation rules applicable to transfers in trust.

Suppose an individual places property in trust, reserving for herself the income for a period of time and transferring the remainder to her children. This individual has made a gift of the remainder interest. For gift tax purposes, the gift is valued by determining the value of the transferred property, and subtracting the value of the term interest that the trust grantor reserved for herself. Sec. 2702 states that if the interest retained by the grantor is not a "qualified interest," it will be deemed to have a value of zero, meaning the remainder interest will be taxed at the entire value of the transferred assets. Generally, a qualified interest is one in which regular payments (of either a fixed dollar amount or a fixed percentage of trust assets) are required to be made, to the grantor, or it is a remainder interest when all other interests are of such fixed payments.

Personal Residences Are Different

The 1990 statute carved out an important exception for certain trusts containing a personal residence of the grantor. These trusts need not meet the fixed payout rules of a qualified interest, so they allow the residence to be passed to heirs at a discount from its full value at the time the trust is created. Assuming the grantor survives until the property passes to the heirs, substantial tax savings can result.

The statutory definition of a personal residence trust is very strict, particularly in the requirement that it hold only a personal residence and proceeds of the residence, but only for a limited period of time and only if the proceeds are "qualified." In the regulations, the Treasury created a safe harbor through "qualified personal residence trusts," which will be permitted to operate in a slightly more liberal manner.

Briefly, the regulations require that the governing instrument prohibit the trust from holding any asset other than one residence, to be used as the personal residence of the term holder, and qualified proceeds. The residence is deemed to be held for use as a personal residence of the term holder so long as it is not occupied by any other person (other than the spouse or a dependent of the term holder) and is available at all times for use by the term holder as a personal residence |Reg. Sec. 25.2702-5(b)(1). The fact that the residence is subject to a mortgage does not prevent its being used to fund a personal residence trust |Reg. Sec. 25.2702-5(b)(2)(ii).

Qualified proceeds mean the proceeds payable as a result of damage to, or destruction or involuntary conversion of the residence held by the trust. Such proceeds can be held in a personal residence trust provided that the governing instrument requires that the proceeds be reinvested in a personal residence within two years from receipt of the proceeds |Reg. Sec. 25.2702-5(b)(3).

A "qualified personal residence trust" generally has the same requirements as a personal residence trust. But a qualified residence trust also must:

* Require that all income be distributed to the term holder at least annually |Reg. Sec. 25.2702-5(c)(3).

* Prohibit distributions of corpus to any beneficiary other than the transferor prior to the expiration of the retained term interest |Reg. Sec. 25.2702-5(c)(4).

* Prohibit commutation (prepayment) of the term holder's interest |Reg. Sec. 25.2702-5(c)(6).

* Require that the trust cease to be a qualified personal residence trust if the residence ceases to be used or held for use as a personal residence |Reg. Sec. 25.2702-5(c)(7).

* Provide that assets will be distributed outright to the term holder, or held in a separate trust for the term holder, within 30 days after the trust ceases to be a personal residence trust |Reg. Sec. 25.2702- 5(c)(8).

A qualified personal residence can hold cash in situations when a personal residence trust cannot. The governing instrument of a qualified personal residence trust may permit additions of cash to the trust, and may permit the trust to hold additions of cash in a separate account so long as the balance of such account does not exceed the amount required for the payment of trust expenses, improvements, or replacement of the residence. Furthermore, if the trust instrument permits additions of cash to the trust, it can authorize excess cash to be distributed to the term holder |Reg. Sec. 25.2702-5(c)(5)(ii)(2).

A trust of which the term holder is the grantor that otherwise meets the above requirements is not a personal residence trust (or a qualified personal residence trust) if, at the time of the transfer, the term holder of the trust already holds term interests in two trusts that are personal residence trusts (or qualified personal residence trusts) of which the term holder was the grantor |Reg. Sec. 25.2702-5(a). Trusts holding fractional interests in the same residence will be treated as one trust.

The strict requirements regarding the assets of personal residence trusts raised some questions about other forms of real estate ownership. For example, the statute and regulations are silent about cooperative apartments, in which the resident owns shares of a corporation which in turn owns the apartment building. But in a ruling last year (PLR 9151046, September 26, 1991), the Treasury determined that shares in a co-op could constitute appropriate corpus for a personal residence trust.

Some planners report strong interest on the part of clients in using personal residence trusts as an estate planning device. Clearly, the technique offers good tax-saving potential in certain circumstances, but failure to meet the requirements of the personal residence and qualified personal residence trust rules could result in substantial unplanned tax liability.

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