VOL. CLXXXV– NO.
11 – INDEX 981
FINANCIAL PLANNING
Eliminating the Home
From the Equation
Sale of remainder interest can save on estate and gift taxes
By Michael P. Spiro
A ccording to a report published
by the U.S. Census Bureau, in
the year 2000, equity in a per-
sonal residence comprised 33.7 percent
of the average net worth of American
families. Since 2000, the real estate
boom has continued and the extent to
which individual net worth is impacted
by valuable real estate has increased
exponentially. As a result, many estate
planners have found that removing the
personal residence from an individual’s
estate is one of the most effective ways
to avoid and/or minimize the estate tax.
One of the most popular means of
removing an individual’s personal resi-
dence from his or her estate, while still
allowing him or her to remain living in
the home, is through a Qualified
Personal Residence Trust (QPRT).
While the QPRT is a valuable tech-
nique, another —and possibly even
Spiro is an attorney in the corporate
law and taxation practice groups at
Flaster/Greenberg of Cherry Hill. He
focuses his practice on providing advice
in the areas of taxation, estate planning
and corporate transactions.
This article is reprinted with permission from the SEPTEMBER 11, 2006 issue of the New Jersey Law Journal. ©2006 ALM Properties, Inc. Further duplication without permission is prohibited. All rights reserved.
SEPTEMBER 11, 2006
more beneficial— means of removing a
taxpayer’s residence from his or her
estate is via the sale of a remainder
interest in the property.
In a typical QPRT, the grantor of
the QPRT transfers ownership of the
residence to the QPRT, retaining the
right to live in the home, and dispose of
the home by will, for a term of years.
The grantor is treated as making a gift
of the remainder interest in the resi-
dence equal to the value of the resi-
dence less the value of the grantor’s
retained interest. The transfer to the
QPRT is generally a taxable gift, and
does not qualify for the $12,000
Annual Exclusion. During the term of
the QPRT, the grantor has an unre-
stricted right to live in the property. At
the termination of the QPRT, the prop-
erty is transferred to the remainder
beneficiaries of the QPRT (usually, the
grantor’s children). If the grantor of
the QPRT does not outlive the term of
the QPRT, the residence will be
included in the grantor’s estate and its
disposition will be governed by the
terms of the grantor’s will. So long as
the grantor survives the term of the
QPRT, a QPRT allows the grantor to
remove an appreciating asset from his
ESTABLISHED 1878
or her estate and only pay gift tax on
the value of the remainder interest, a
fraction of the asset’s then-current
value. As a result, any gift tax due on
the transfer will be lower than the
estate tax that would be due on the res-
idence at the grantor’s death.
The primary downside of a tradi-
tional QPRT is that in order for a
QPRT to be an effective technique,
the grantor must outlive the term of
the QPRT. If the grantor dies during
the term of the QPRT, the residence
will be included in the grantor’s estate,
and the grantor will have paid both
gift tax and estate tax on it (though a
credit will be allowed for gift tax
already paid). The sale of remainder
interest, if structured using a Personal
Residence Trust (PRT), allows a tax-
payer to avoid this issue.
A remainder sale transaction
works very similarly to a QPRT with
one important caveat: Rather than
making a gift of the remainder interest
in the residence to a trust, the grantor
sells her remainder interest to the ulti-
mate beneficiaries. The use of a sale
rather than a gift can eliminate gift tax
on the transaction. It also allows the
grantor to live in the residence rent-
free for the remainder of his or her life
without generating inclusion in his or
her estate at death. In a remainder sale,
the grantor and the purchaser of the
remainder interest enter into a contract
of sale whereby the remainder interest
is purchased for a fraction of the total
value of the property, determined
using IRS actuarial life expectancy
tables. This simple transaction has the
2 NEW JERSEY LAW JOURNAL, SEPTEMBER 11, 2006
following tax benefits:
For purposes of the estate tax,
property with a retained life interest,
which a grantor transfers during his
lifetime, is included in his estate for
purposes of the federal estate tax. It is
for this reason that a QPRT is only
effective where the grantor outlives the
initial term. However, there is an
exception to this general rule: a “bona
fide sale for adequate and full consid-
eration.” Traditionally, the IRS had
required that the fair market value of
the entire property be paid as the sale
price for a remainder interest in order
to qualify under this “bona fide sale”
exception. In 1996, however, the Third
Circuit Court of Appeals held, in
D’Ambrosio v. Commissioner, that the
proper way to determine whether there
had been a “bona fide sale for adequate
and full consideration” was to “com-
pare the value of the remainder trans-
ferred [rather than the value of the
entire fee-simple interest in the proper-
ty] to the value of the consideration
received.” If the values are equal, the
property will not be included in the
gross estate. Thus, under the
D’Ambrosio decision, a grantor can
(for adequate and full consideration)
sell a remainder interest in the proper-
ty, live in the property for the remain-
der of her life, and not have the proper-
ty included in her gross estate.
Section 2702 of the Internal
Revenue Code provides that unless a
retained life estate is a “qualified” life
estate, the transferor of a remainder
interest is treated as having made a gift
of the entire property to the transferee
(if the transferee is a member of the
transferor’s family). Gift tax would
therefore be due on the transfer.
However, the regulations provide an
exception from this general rule for
transfers in a “Personal Residence
Trust” (PRT). Thus, gift tax can be
avoided by structuring the contract for
the sale of the remainder interest as a
PRT.
A PRT is defined as “a trust, the
governing instrument of which pro-
hibits the trust from holding, for the
duration of the term interest, any asset
other than one residence to be used or
held for use as a personal residence of
the term holder and qualified proceeds
thereof.” The PRT must enumerate the
following provisions in the “governing
instrument”: (i) the personal residence
of the term holder may not be sold dur-
ing the term estate; (ii) any insurance
proceeds received due to damage to, or
involuntary conversion of, the personal
residence must be held by the trustee in
a separate account and reinvested in a
personal residence; (iii) the personal
residence may not be sold back to the
term-holder, the term-holder’s spouse
or the term-holder’s estate when the
term estate expires; and (iv) the trust
must contain as its only asset the per-
sonal residence and the qualified pro-
ceeds thereof.
Generally, under Section 121 of
the Internal Revenue Code, a taxpayer
may (subject to certain restrictions)
exclude up to $250,000 in gain from
the sale of a remainder interest in his or
her personal residence from gross
income ($500,000 for married couples
filing jointly). This general exclusion
is, however, subject to two substantial
hurdles: (i) the exclusion does not
apply to sales to family members; and
(ii) the exclusion does not apply to
sales between a “fiduciary of a trust
and a beneficiary of such trust.” Each
of these hurdles, can, however, poten-
tially be overcome:
Family members. A remainder
interest sale between a parent and child
will be subject to tax. However, sales
between parents and the spouses of
children (i.e. sons or daughters in law)
185 N.J.L.J. 981
are not barred by Section 121. Thus a
sale could potentially be structured
between a grantor and his or her son or
daughter in law that would qualify for
exclusion under Section 121.
Fiduciary/Beneficiary. The use
of a PRT raises the question as to
whether the sale is between a fiducia-
ry and beneficiary. However, the
Regulations provide that “a transfer
of an interest in property with respect
to which there are one or more term
interests is treated as a transfer in
trust.” Thus, a remainder interest sale
is, by definition, a “transfer in trust,”
even if an actual trust is not used.
Some commentators have advanced
the notion that because the transfer of
a remainder interest meets the defini-
tion of a “transfer in trust,” the “gov-
erning instrument” of a PRT need not
actually be a trust instrument, but
rather could be a basic contract of
sale, which incorporates the “govern-
ing instrument” provisions of a PRT.
This leaves open the question of
whether using a nontrust PRT would
actually allow exclusion under
Section 121 for the sale of a remain-
der interest. The IRS has not ruled on
this question. To the extent that the
sale of a remainder interest is subject
to income tax, tax will be assessed at
long-term capital gains rates, which
are substantially lower than the estate
tax rate.
Use of a QPRT has tremendous
benefits for those homeowners who
wish to make gifts of their personal
residences with minimal gift and
estate tax consequences. However,
where the ultimate devisees of the
residence have the resources to pur-
chase a remainder interest, the
grantor can enjoy similar estate tax
benefits without the gift tax conse-
quences and estate tax risk of a
QPRT. ■