QPRT

(QPRT)

August 13, 1997

Caution: This newsletter is not meant to replace a QUALIFIED accountant or attorney. You are warned not to use this for your planning without the advice of a professional. Laws change, and your circumstances may not be appropriate for this trust. Specific rules must be followed which are not identified thoroughly herein.

Combination Estate Tax Containment And Protection For Personal Residence

Qualified Personal Residence Trust (QPRT or Residential GRIT). The QPRT is an excellent technique to gift substantial assets to the next generation at substantially discounted values. However, unless the grantor outlives the trust term, the residence in the QPRT will be included in the grantor's gross estate.

What Is A "Qualified" Personal Residence Trust?

What can it do ?

In a very broad and general definition this is a type of transfer of ownership that can transfer one's personal residence to an heir, eliminate the home from the estate inventory, eliminate the home from the probate inventory, allow for a transfer at less than the fair market value, protect the personal residence from the grantor's creditors including those debts incurred in health care costs. The rules are very complex and the grantor is warned that the grantor may not be able to, or want to follow all the rules. It is not necessary to attempt to obtain all the benefits of this type of trust. It may very well be, your goals and needs are to meet only one — or a few, of the benefits.

This newsletter includes introductory material and actual {highly technical} legislation sections. Read those areas that you believe are important to your goals in looking over this document.

A special kind of irrevocable trust can be used to transfer your home to your children at a significantly reduced gift tax cost and with no estate tax, yet allow you to continue to live in the home for as long as you wish. This special type of trust is known as a qualified personal residence trust (QPRT). Here's how it works.

During the grantor's lifetime, the grantor will transfer the home (see the note on gifts of undivided interests and who the deed is titled) to the trustee, who can be the grantor (yourself). The trustee must allow you to continue to use the home rent-free for a fixed number of years specified in the trust instrument (the "fixed" term), which should be a term you are likely to survive. During the fixed term, you will continue to pay mortgage expenses, real estate taxes, insurance, and expenses for maintenance and repairs, and will continue to deduct mortgage interest and real estate taxes on your individual income tax return. If the home is sold before the date the trust is to end, or becomes irrevocable with a new trustee, other than yourself (the grantor), then the new laws will apply for the sale of a personal residence. In overly simplified terms, the gain is tax free up to $500,000 after two years of ownership. When the fixed term ends, the home is distributed to your children, or remains in the (irrevocable trust with a newly appointed trustee for the beneficiaries.

What to do about a place to live, when the home goes to the irrevocable trust or to the heirs? When the fixed term ends, you may use the home in one of several ways. The home can be retained in trust for the grantor's spouse's lifetime, plus the surviving spouse's lifetime, thus assuring that the home is available indirectly to a surviving spouse. Second, you can enter into a lease with the trust or the beneficiaries which will allow the grantor and his or her spouse to live in the house for as long as needed.

If the grantor survives the fixed term of the QPRT, the value of the home will not be included in the estate for estate tax purposes. Additionally, since the grantor has transferred title, it is not included in probate. Although transfer of the home to the trust is a taxable gift, one may exclude the rental value for the term the grantor is using the property. Any gift tax consequence must be computed on a basis for each grantor. The present value of the residence for the future transfer is the magic number to apply for the computation of the current year gift tax. It may be large, it may be small. You may have the entire unified credit available — the unified credit may be consumed. You may use annual exclusions for the gifting of the property — you may have other transfers which consume the annual exclusion entirely.

The Generation-Skipping Transfer Tax Consequences of Funding a QPRT

Although the QPRT allows excellent, planning opportunities for leveraging one's $600,000 unified credit, the same leveraging of one's $1 million generation-skipping transfer tax exemption is not permitted. Therefore, from a tax standpoint, it is generally advisable to name one's children, rather than one's grandchildren, as the primary beneficiaries of a QPRT.

Internal Revenue Code Requirements ("technical")

QPRTs must meet several requirements set forth in the Internal Revenue Code and underlying Treasury Regulations. For example, the trust may hold only one residence that must be used or held for use as a personal residence by the grantor. Although the residence does not have to be the grantor's primary residence, the grantor may establish only two QPRTs, each of which may hold no more than one residence. For example, a grantor may wish to set up a QPRT for his primary residence as well as a QPRT for his vacation home.

If the trust produces any income, the income must be distributed at least annually to the grantor. Further, no distributions can be made from the QPRT to anyone other than the grantor during the trust term.

Generally, the QPRT can hold no assets other than a residence, with a few limited exceptions. For example, the QPRT may hold cash for payment of up to six months of trust expenses. The trust may also hold cash for improvements to be made to the residence within six months. If the QPRT holds excess cash, it must be distributed to the grantor at least quarterly.

The QPRT must provide that it will no longer be a QPRT if the grantor ceases to use the residence as his personal residence or, if the residence is sold, the proceeds are not held in a separate account and used to purchase a new replacement residence within a certain time period.

If the trust ceases to be a QPRT during the trust term, the trust property must be returned to the grantor or the trust must be converted into a grantor retained annuity trust ("GRAT") for the remaining trust term.

The End of the QPRT Term

If the grantor outlives the trust term, s/he will no longer have the right to live in the residence. However, if s/he wishes to continue living in the residence, s/he could rent the home from the trust beneficiaries (usually his or her children), at fair rental value.

The IRS has issued proposed regulations (PS-4-96) permitting the reformation of a personal residence trust or a qualified personal residence trust to comply with the applicable requirements under the code.

The proposed regs provide that a trust that doesn't comply with one or more of the regulatory requirements for qualification as a personal residence trust or a qualified personal residence trust will be treated as satisfying those requirements if it is reformed by judicial reformation to comply with the requirements. Nonjudicial reformation, if effective under state law, is also permitted. The reformation must be started within 90 days of the due date (including extensions) for filing the gift tax return reporting the transfer of the residence and must be completed within a reasonable time. If reformation is not completed by the due date of the gift tax return, a statement must be attached to the gift tax return stating that the reformation has been started, or will start, within the 90-day period

The proposed regs also clarify that the governing instruments of these trusts must prohibit the sale of a residence held in the trust to the grantor of the trust, the grantor's spouse, or an entity controlled by the grantor or grantor's spouse. Thus, the proposed regs prohibit a grantor from placing a personal residence in trust, obtaining all the tax benefits of a qualified personal residence trust, and then purchasing the residence from the trust just prior to the expiration of the grantor's retained term so that cash or other assets pass to the remaindermen in place of the residence.

A QPRT is an extremely effective way to remove a home's value from the estate inventory and the probate inventory at a greatly reduced gift tax cost.

Proposal Regs Make Personal Residence Trusts More Adaptable

Split interest transfers in trust--where the grantor retains a present term interest in a property while giving away the remainder interest to a family member--are still widely used despite the enactment of the special valuation rules. These rules in effect value the retained interest at zero, making the grantor liable for gift tax on the entire value of the property even though he is not giving away his whole interest. Taxpayers can escape this harsh valuation rule, however, when the property transferred in trust is the grantor's personal residence

How the trusts save tax. With a personal residence trust or a qualified personal residence trust, a grantor may deduct the value of his retained term interest from the value of the property in computing the gift tax on the transfer, thereby reducing the unified tax.

Example. Suppose a 55-year old parent has a residence valued at $500,000 that he wants to pass on to his daughter. If he gives the house outright to his daughter, the entire $500,000 value of the residence will be subject to gift tax. If he creates a qualified personal residence trust for a term of 15 years with the daughter receiving the remainder interest and, with a provision that the residence reverts to his estate if he dies before the expiration of the term of the trust, the value of his retained interest (assuming a §7520 rate of 8.2 percent) will be $381,570. This means that only $118,430, the present value of the remainder interest, of the value of the house will be subject to gift tax, even though the value of the house will have increased to $724,149 after 15 years assuming a low growth rate of 2.5 percent. In the highest estate tax bracket, this represents a potential estate tax saving of $333,145.

è Personal residence trust vs. qualified personal residence trust. The distinction between personal residence trusts and qualified personal residence trusts is important. The regulations provide that both types of residence trusts are exempt from the special valuation rules but personal residence trusts are rarely used because they cannot hold any other asset besides the residence and the trust does not have the power to sell the residence. A qualified personal residence trust, on the other hand, can hold cash to pay trust expenses such as the mortgage, property taxes, insurance and similar expenses and retain cash from the sale of the residence. Although a trust can only hold one residence, taxpayers are permitted to establish a total of two residence trusts: for a principal residence, a vacation home (if personal use exceeds the greater of 14 days or 10 percent of the days it is rented in a tax year) and/or land adjacent to either that is reasonably necessary for residential use.

PS4-96 allows reformation of a personal residence trust. Because the technical requirements for a valid residence trust are so complex, errors can be made in the formation of the trust, which cause it to fail to qualify as a valid personal trust, even where the taxpayer has relied on professional advice. According to the Service, these errors are usually not discovered until the time the gift tax return is being prepared. Since disqualification results in a total collapse of the anticipated tax benefits because the grantor's retained interest is then valued at zero, the Service has issued proposed regs allowing a defective trust to be treated as qualified if reformation is commenced up to 90 days (including extensions) after the due date of the gift tax return. The reform must be completed in a reasonable time and if it is not completed by the due date, the taxpayer must attach a statement to the return that reformation was started before, or will start within the 90-day period.

Comment. The rules that must be followed in residence trusts are found in Reg §25.2702-5. They include limits on holding cash and other property, disqualification if the property is no longer used as a residence, consequences of the sale of the residence and the purchase of a replacement residence.

Closing a loophole. In a transaction described by some experts as the "bait and switch," the grantor places a personal residence in a residence trust, obtaining the benefit of avoiding the special valuation rules, with the intention of repurchasing the residence just prior to the expiration of the grantor's retained term. This allows the grantor to effectively pass on to the remaindermen cash, and possibly other property, which does not qualify for the special valuation rules. Although Congress enacted the personal residence exception to enable family homes to pass to younger generations of the family, in this case, the residence is only acting as a "stand-in" for other property that the grantor wants to pass on without being subject to the special valuation rules. Therefore, the just-issued proposed regs provide that the governing instruments of a valid residence trust must prohibit the sale of the residence back to the grantor or the grantor's spouse or a grantor trust of either the grantor or the grantor's spouse.

Caution. The regs are proposed to be effective for trusts established 30 days after the final regs are adopted and published in the Federal Register. However, the Service indicated that if it examines a pre-effective date trust and finds it is using the bait and switch technique, it will use the substance over form doctrine or another appropriate legal theory to disqualify the trust.

The rules do not apply to a transfer of an interest in a personal residence trust or a qualified personal residence trust (QPRT). A personal residence trust is a trust the governing instrument of which prohibits, for the original duration of the term interest, the holding of any asset other than one residence used or held for use as a personal residence of the term holder, and qualified proceeds.

The rules also do not apply to a transfer to the extent that regulations are issued that provide that the transfer is not inconsistent with the purposes of the special valuation rules.

A personal residence is the term holder's principal residence, one other residence, or an undivided fractional interest in either. The Service has privately ruled that the fact that the form of ownership of a residence is shares of stock of a cooperative housing corporation does not preclude qualification of the property as a personal residence. Thus, the Service has privately ruled that a transfer of a beneficial interest in a cooperative apartment was sufficient to qualify for the personal residence exception when the rules of the cooperative prevented the transfer of legal title and the transfer was a completed gift. The residence must not be occupied by anyone other than the term holder, his spouse and dependents, and must be available at all times for use as a personal residence by the term holder.

Example: Harding transfers a personal residence to a trust that meets the requirements of a personal residence trust, retaining a term interest for ten years. During the period of Harding's term interest, Harding is forced for health reasons to move to a nursing home. Harding's spouse continues to occupy the residence. If the residence is available at all times for Harding's use as a residence during the term, without regard to Harding's ability to actually use the residence, the residence continues to be held for Harding's use and the trust does not cease to be a personal residence trust. However, if the trustee rented the residence to an unrelated party, the residence would cease to be held for use as a personal residence because it would no longer be available for Harding's use at all times.

A personal residence can include appurtenant structures used for residential purposes and adjacent land that is reasonably appropriate for residential purposes. The Service has privately ruled that a large vacation home and a small guest house, which accounts for 3.7 percent of the appraised value of the property and is used occasionally by family and friends without remuneration, meets the definition of personal residence. The Service privately ruled that a residence located on four adjacent parcels of land qualified as a single personal residence, when the residence and parcels of land were shown on the local tax assessor's map as a single tax lot. However, the Service has also privately ruled that spouses owning connected vacation homes on adjoining realty can divide the property and create a separate qualifying trust for each residence, even though the structures are physically connected. Further, a personal residence can be subject to a mortgage. The term holder can use a portion of the residence for business purposes, but cannot provide transient lodging, such as a hotel or bed and breakfast, or substantial services in connection with lodging.

Example: Greene owns a vacation condominium that he rents out for six months of the year, but that is treated as his personal residence because he occupies it for at least 18 days per year. Greene provides no substantial services in connection with the rental of the condominium. Greene transfers the condominium to an irrevocable trust, and retains the right to use the condominium for 15 years. Assuming the other requirements for a personal residence trust are met, the trust is a QPRT.

The trust cannot hold personal property, even household furnishings,¹⁸⁹ but it can hold qualified proceeds, which are amounts held by the trust for no longer than two years that were received as a result of damage, destruction or involuntary conversion of the personal residence.

Spouses who hold interests in the same residence can transfer their interests to the same personal residence trust, but only if the governing instrument prohibits anyone other than one spouse from holding a term interest concurrently with the other spouse.

A QPRT is similar to a personal residence trust, except that a QPRT can also hold limited amounts of cash for payment of trust expenses, sale proceeds, insurance on the residence and insurance proceeds. Further, the governing instrument of a QPRT must prohibit distribution of trust corpus to anyone other than the term holder, and must provide that any income of the trust must be distributed to the term holder not less frequently than annually. In addition, the governing instrument must provide that on cessation of use of the residence as a personal residence, either the trust terminates and all trust assets are distributed to the term holder, or the term interest is converted to a qualified annuity interest. The trustee can be given sole discretion to choose either option. The distribution or conversion must occur within 30 days of the date on which the trust ceases to be a QPRT. Excess sale proceeds that are not reinvested in a new personal residence can be converted into a qualified annuity interest.

Under proposed regulations a transferor can reform a personal residence trust or a QPRT that does not comply with one or more of the requirements in the regulations. The trust is treated as if it satisfies all of the requirements in the regulations if the trust is reformed either by a judicial proceeding or a nonjudicial reformation, if a nonjudicial reformation is allowable under state law. The reformation proceeding must be started within 90 days after the due date, including extensions, of the gift tax return that reports the transfer of the residence to the trust, and the reformation must be completed within a reasonable time. If the reformation is not completed by the due date of the gift tax return, the transferor or the transferor's spouse must attach a statement to the return stating that the reformation proceeding has been started or will be started within the 90-day period.

The proposed regulations also provide that a trust is not a personal residence trust or a QPRT unless the governing instrument prohibits the trust from selling or transferring the residence to the transferor, the transferor's spouse or an entity controlled by the transferor or the transferor's spouse. The governing instrument for a QPRT may permit the sale of the residence and the retention of the sale proceeds only to the extent that the sale is not to the transferor, the transferor's spouse or an entity controlled by the transferor or the transferor's spouse.

Note: This provision is intended to prevent the use of the bait and switch transaction, by which a transferor places a personal residence in a trust, obtaining the benefit of the special valuation rules, with the intention of repurchasing the residence just before expiration of the transferor's retained term. This allows the transferor to effectively pass on to the remaindermen cash, and possibly other property, which would otherwise not qualify for the QPRT exception to the special valuation rules.

The proposed regulations apply to trusts created more than 30 days after the regulations are published as final.

Warning: Despite the effective date of the proposed regulations, the Service has stated that if it examines a pre-effective date personal residence trust or QPRT and finds that it is using the bait and switch technique, the Service will disqualify the trust by using the substance over form doctrine or other appropriate legal theory.

The Service had privately ruled that a provision requiring the trustee to offer to sell the property to the grantor at fair market value, if the trustee decides to sell at the end of the fixed term, did not prevent a personal residence trust from being a QPRT.

Warning: In light of the position subsequently taken by the Service in the proposed regulations, it is unlikely that a trust with any provision permitting the sale of the residence to the grantor could qualify as a personal residence trust or a QPRT.

STATE OF TEXAS

COUNTY OF __________

è Sample Only - Do NOT Use This Form !

RESIDENTIAL PROPERTY TRUST AGREEMENT

(It does not appear to be an updated "Qualified" PRT)

This AGREEMENT AND DECLARATION OF TRUST is made on this the __________ day of __________, 19_____, by and between __________ [name of trustee] ("Trustee"), and the undersigned Beneficiaries.

WHEREAS the Beneficiaries have conveyed cash to the Trustee and may from time to time convey additional cash to the Trustee; and

WHEREAS the Trustee shall use the cash to purchase real property as directed by the Beneficiaries; and

WHEREAS the Trustee acknowledges that legal title to the Real Property so purchased by the Trustee under this trust and all income and profits from the property, less expenses, shall be held by the Trustee in trust and shall be managed, administered, leased, mortgaged and disposed of by Trustee for the benefit of the Beneficiaries under the terms of this agreement;

IT IS, THEREFORE, AGREED:

1. The trust shall be designated as the __________ [name of trust] Trust, and all property shall be taken in the name of __________ [name], Trustee, and that Trustee shall perform all acts and execute all instruments necessary to accomplish the purpose of this Trust in accordance with the terms of this agreement.

2. The principal office of the Trust shall be at __________ [address].

3. The Trustee named above shall serve for the entire term of the trust, unless __________ [his or her] tenure shall be terminated by death, resignation, or incapacity to serve. The death, resignation, or incapacity of the Trustee shall not terminate the Trust or in any way affect its continuity. In the event of the death, resignation, or inability of the Trustee to serve, a successor Trustee shall be appointed by the Beneficiaries to this agreement.

4. The interests of the Beneficiaries shall consist solely of the following rights respecting the Trust Property:

a. The right to direct the Trustee to convey or otherwise deal with the title to the Trust Property;

b. The right to share in the profits or losses which may occur during the term of this trust.

The foregoing rights shall be deemed to be personal property and may be assigned or otherwise transferred as such. No Beneficiary shall have any legal or equitable right, title, or interest in or to any real property held in trust under this agreement or the right to require partition of the real property, but shall have only the rights set out above, The death of a Beneficiary shall not terminate this Trust or in any manner affect the powers of the Trustee.

5. The Trustee assumes and agrees to perform the following active and affirmative duties:

a. To purchase or acquire real property, and to sell, exchange, lease, mortgage, grant easements, pledge, or in any manner dispose of, encumber, improve, or deal with the property of the Trust or any part of the property or any interest in the property on such terms and for such consideration as directed by the Beneficiaries.

b. To borrow or lend money or incur indebtedness with or without security; enter into contracts; execute, accept, discount, negotiate, and deal in commercial paper and evidences of indebtedness; and execute conveyances, mortgages, leases, and any other instruments.

6. The objects and purposes of this Trust shall be to hold title to the Trust Property and to protect and conserve it until its sale or other disposition or liquidation. The trustee shall not manage or operate the Trust Property nor undertake any other activity not strictly necessary to the attainment of the foregoing objects and purposes; nor shall this agreement be deemed to be or create or evidence the existence of a corporation, de facto or de jure or a Massachusetts Trust, or any other type of business trust, or an association in the nature of a corporation or a co-partnership or a joint venture by or between the Trustee and the Beneficiaries.

7. The Trustee shall not be personally liable for any error of judgment or for any loss arising out of any act or omission to act in the execution of any of the powers conferred by this agreement, so long as __________ [he or she] acts in good faith. All persons dealing with the Trustee shall look only to the Trust Property for the payment of their claims, and every instrument to which the Trustee shall be a party or on account of which any liability may be chargeable against the Trust Property shall in substance so provide.

8. A resolution of the Trustee authorizing a particular act shall be conclusive evidence in favor of strangers to the Trust that such act is within the powers of the Trustee. No purchaser from the Trustee shall be bound to see to the application of the money or other consideration paid by the purchaser to the Trustee.

9. The Trustee shall be indemnified by and receive reimbursement from the Trust Property against and from any and all loss, liability, expense, or damage arising out of any action or omission to act as a Trustee under this agreement, except to the extent that such loss, liability, expense, or damage shall result from __________ [his or her] own willful misconduct. Such indemnity or reimbursement shall be limited to the Trust Property, and no Beneficiary shall be personally liable for any indemnity or reimbursement.

10. No Beneficiary shall have the authority to contract for or in the name of the Trustee or any other Beneficiary or to bind the Trustee or any other Beneficiary personally.

11. This Trust shall continue until 10 years from date of establishment of the Trust unless terminated earlier by the sale or transfer of the Trust Property to a third party and a disposition to each of the Beneficiaries of their pro-rated interest in this Trust as provided below.

12. The Beneficiaries' interest in this Trust are as follows: __________ [set forth the percentage investment of each beneficiary].

13. By agreement, the Beneficiaries under this trust hereby agree that, on call by the Trustee, they shall make further contributions to the trust for the purpose of making note, tax, and insurance payments as they may come due. It is further agreed that should each Beneficiary, at the time of a call by the Trustee, fail to make the contribution, that Beneficiary will then be offered the opportunity of withdrawing from the Trust and shall be liable only for __________ [his or her] original investment in the Trust and shall not participate in any accrued or future profits of the trust.

14. The Beneficiaries agree to pay to the Trustee as compensation for acting as Trustee __________ per cent (_____%) of the cash flow through the Trust account, not including cash contributions made by the Beneficiaries, but no less than $ _____ per month.

15. The death of a Beneficiary to this Trust shall not terminate this Trust or in any manner affect the powers of the Trustee. The Beneficiaries shall by Will or by other written document direct the Trustee as to disposition of the Trust Estate after the Beneficiary's death.

16. At the termination of this Trust, monies received by the Trustee shall be distributed as follows:

a. Payment of real estate commissions and expenses in disposing of the Trust Property;

b. Payment of Trustee's fees;

c. The remainder shall be divided into __________ equal parts and distributed in accordance with the Beneficiaries' interest as set out in Paragraph 12 above, to the Beneficiaries or to their heirs, executors, administrators, or assigns.

EXECUTED IN MULTIPLE COUNTERPARTS, each of which shall have the full force and effect of an original.

SIGNED, ACCEPTED and AGREED TO this __________ day of __________, 19_____.

________________________

Trustee

Beneficiaries: (owners)

________________________

EXHIBIT "A"

Real Property held in trust estate: __________ [legal description and street address, if any, of property]

Transfers of Interests in Trusts --[In General]

Trusts and term interests.--

Code Sec. 2702 provides rules to determine whether and in what amount the transfer of an interest in trust to a member of the transferor's family constitutes a gift. Generally, under these rules the retained or income interest is valued at zero unless the interest consists of the right to receive fixed payments or a fixed percentage of the trusts property, payable at least annually. Thus, it would appear that the use of grantor retained interest trusts (GRITs) are effectively curtailed unless the retained interest consists of an annuity or unitrust interest. However, it should be noted that these valuation rules do not apply with respect to an incomplete gift nor to a transfer of an interest in a personal residence that is inhabited by the holder of the term interest. There is a specific definition of whether a transfer of an interest in trust to a member of the transferor's family is a gift, and the amount of the gift. Generally, the amount of the gift is the value of the transferred property less the value of any interests retained by the transferor or an applicable family member. Only transfers made after October 8, 1990, are subject to these rules. A transfer in trust includes a transfer to a new or existing trust and a beneficiary's transfer of an interest in an existing trust. Neither a qualified disclaimer nor the exercise, release or lapse of a limited power of appointment is treated as a transfer in trust. The retention of a term interest in property is treated as the retention of an interest in trust. An interest includes a power if retention of the power prevents the transfer of an interest in property from being a completed gift. The value of an interest retained by the transferor or an applicable family member is zero unless that interest is a qualified interest.

These rules do not apply if the transfer is an incomplete gift. For example, the rules do not apply to the creation of a revocable or living trust. The rules do not apply to charitable remainder trusts, charitable lead trusts or pooled income funds. The rules also do not apply to specified assignments of remainder interests or specified property settlements under a divorce.

The following is the tax law regulation as of June 1997. This is the authority which grants permission to accomplish any provisions of a QPRT.

§25.2702-5 Personal residence trusts.-- Paragraph (a) In general.

Section 2702 does not apply to a transfer in trust meeting the requirements of this section. A transfer in trust meets the requirements of this section only if the trust is a personal residence trust (as defined in paragraph (b) of this section). A trust meeting the requirements of a qualified personal residence trust (as defined in paragraph (c) of this section) is treated as a personal residence trust. A trust of which the term holder is the grantor that otherwise meets the requirements of a personal residence trust (or a qualified personal residence trust) is not a personal residence trust (or a qualified personal residence trust) if, at the time of 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. For this purpose, trusts holding fractional interests in the same residence are treated as one trust

25.2702-5 Personal residence trusts.-- Paragraph (b) Personal residence trust--

(1) In general. A personal residence trust is a trust the governing instrument of which prohibits the trust from holding, for the original 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 (as defined in paragraph (b)(3) of this section). A residence is held for use as a personal residence of the term holder so long as the residence 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. A trust does not meet the requirements of this section if, during the original duration of the term interest, the residence may be sold or otherwise transferred by the trust or may be used for a purpose other than as a personal residence of the term holder. Expenses of the trust whether or not attributable to trust principal may be paid directly by the term holder of the trust.

(2) Personal residence--(i) In general. For purposes of this paragraph (b), a personal residence of a term holder is either--

(A) The principal residence of the term holder (within the meaning of section 1034);

(B) One other residence of the term holder (within the meaning of section 280A(d)(1) but without regard to section 280A(d)(2)); or

(ii) Additional property. A personal residence may include appurtenant structures used by the term holder for residential purposes and adjacent land not in excess of that which is reasonably appropriate for residential purposes (taking into account the residence's size and location). The fact that a residence is subject to a mortgage does not affect its status as a personal residence. The term personal residence does not include any personal property (e.g., household furnishings).

(iii) Use of residence. A residence is a personal residence only if its primary use is as a residence of the term holder when occupied by the term holder. The principal residence of the term holder will not fail to meet the requirements of the preceding sentence merely because a portion of the residence is used in an activity meeting the requirements of section 280A(c)(1) or (4) (relating to deductibility of expenses related to certain uses), provided that such use is secondary to use of the residence as a residence. A residence is not used primarily as a residence if it is used to provide transient lodging and substantial services are provided in connection with the provision of lodging (e.g. a hotel or a bed and breakfast). A residence is not a personal residence if, during any period not occupied by the term holder, its primary use is other than as a residence.

(iv) Interests of spouses in the same residence. If spouses hold interests in the same residence (including community property interests), the spouses may transfer their interests in the residence (or a fractional portion of their interests in the residence) to the same personal residence trust, provided that the governing instrument prohibits any person other than one of the spouses from holding a term interest in the trust concurrently with the other spouse.

(3) Qualified proceeds. Qualified proceeds means the proceeds payable as a result of damage to, or destruction or involuntary conversion (within the meaning of section 1033) of, the residence held by a personal residence trust, provided that the governing instrument requires that the proceeds (including any income thereon) be reinvested in a personal residence within two years from the date on which the proceeds are received.

§25.2702-5 Personal residence trusts.-- Paragraph (c) Qualified personal residence trust--

(1) In general. A qualified personal residence trust is a trust meeting all the requirements of this paragraph (c). These requirements must be met by provisions in the governing instrument, and these governing instrument provisions must by their terms continue in effect during the existence of any term interest in the trust.

(2) Personal residence--(i) In general. For purposes of this paragraph (c), a personal residence of a term holder is either--

(A) The principal residence of the term holder (within the meaning of section 1034);

(B) One other residence of the term holder (within the meaning of section 280A(d)(1) but without regard to section 280A(d)(2)); or

(iv) Interests of spouses in the same residence. If spouses hold interests in the same residence (including community property interests), the spouses may transfer their interests in the residence (or a fractional portion of their interests in the residence) to the same qualified personal residence trust, provided that the governing instrument prohibits any person other than one of the spouses from holding a term interest in the trust concurrently with the other spouse.

(3) Income of the trust. The governing instrument must require that any income of the trust be distributed to the term holder not less frequently than annually.

(4) Distributions from the trust to other persons. The governing instrument must prohibit distributions of corpus to any beneficiary other than the transferor prior to the expiration of the retained term interest.

(5) Assets of the trust--(i) In general. Except as otherwise provided in paragraphs (c)(5)(ii) and (c)(8) of this section, 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 or held for use (within the meaning of paragraph (c)(7)(i) of this section) as a personal residence of the term holder (the "residence").

(ii) Assets other than personal residence. Except as otherwise provided, the governing instrument may permit a qualified personal residence trust to hold the following assets (in addition to the residence) in the amounts and in the manner described in this paragraph (c)(5)(ii):

(A) Additions of cash for payment of expenses, etc.--(1 ) Additions. The governing instrument may permit additions of cash to the trust, and may permit the trust to hold additions of cash in a separate account, in an amount which, when added to the cash already held in the account for such purposes, does not exceed the amount required:

(i ) For payment of trust expenses (including mortgage payments) already incurred or reasonably expected to be paid by the trust within six months from the date the addition is made;

(ii ) For improvements to the residence to be paid by the trust within six months from the date the addition is made; and

(iii ) For purchase by the trust of the initial residence, within three months of the date the trust is created, provided that no addition may be made for this purpose, and the trust may not hold any such addition, unless the trustee has previously entered into a contract to purchase that residence; and

(iv ) For purchase by the trust of a residence to replace another residence, within three months of the date the addition is made, provided that no addition may be made for this purpose, and the trust may not hold any such addition, unless the trustee has previously entered into a contract to purchase that residence.

(2 ) Distributions of excess cash. If the governing instrument permits additions of cash to the trust pursuant to paragraph (c)(5)(ii)(A)(1 ) of this section, the governing instrument must require that the trustee determine, not less frequently than quarterly, the amounts held by the trust for payment of expenses in excess of the amounts permitted by that paragraph and must require that those amounts be distributed immediately thereafter to the term holder. In addition, the governing instrument must require, upon termination of the term holder's interest in the trust, any amounts held by the trust for the purposes permitted by paragraph (c)(5)(ii)(A)(1 ) of this section that are not used to pay trust expenses due and payable on the date of termination (including expenses directly related to termination) be distributed outright to the term holder within 30 days of termination.

(B) Improvements. The governing instrument may permit improvements to the residence to be added to the trust and may permit the trust to hold such improvements, provided that the residence, as improved, meets the requirements of a personal residence.

(C) Sale proceeds. The governing instrument may permit the sale of the residence and may permit the trust to hold proceeds from the sale of the residence, in a separate account.

(D) Insurance and insurance proceeds. The governing instrument may permit the trust to hold one or more policies of insurance on the residence. In addition, the governing instrument may permit the trust to hold, in a separate account, proceeds of insurance payable to the trust as a result of damage to or destruction of the residence. For purposes of this paragraph, amounts (other than insurance proceeds payable to the trust as a result of damage to or destruction of the residence) received as a result of the involuntary conversion (within the meaning of section 1033) of the residence are treated as proceeds of insurance.

(6) Commutation. The governing instrument must prohibit commutation (prepayment) of the term holder's interest.

(7) Cessation of use as a personal residence--(i) In general. The governing instrument must provide that a trust ceases to be a qualified personal residence trust if the residence ceases to be used or held for use as a personal residence of the term holder. A residence is held for use as a personal residence of the term holder so long as the residence 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. See §25.2702-5(c)(8) for rules governing disposition of assets of a trust as to which the trust has ceased to be a qualified personal residence trust.

(ii) Sale of personal residence. The governing instrument must provide that the trust ceases to be a qualified personal residence trust upon sale of the residence if the governing instrument does not permit the trust to hold proceeds of sale of the residence pursuant to paragraph (c)(5)(ii)(C) of this section. If the governing instrument permits the trust to hold proceeds of sale pursuant to that paragraph, the governing instrument must provide that the trust ceases to be a qualified personal residence trust with respect to all proceeds of sale held by the trust not later than the earlier of--

(A) The date that is two years after the date of sale;

(B) The termination of the term holder's interest in the trust; or

(iii) Damage to or destruction of personal residence--(A) In general. The governing instrument must provide that, if damage or destruction renders the residence unusable as a residence, the trust ceases to be a qualified personal residence trust on the date that is two years after the date of damage or destruction (or the date of termination of the term holder's interest in the trust, if earlier) unless, prior to such date--

(1 ) Replacement of or repairs to the residence are completed; or

(2 ) A new residence is acquired by the trust.

(B) Insurance proceeds. For purposes of this paragraph (C)(7)(iii), if the governing instrument permits the trust to hold proceeds of insurance received as a result of damage to or destruction of the residence pursuant to paragraph (c)(5)(ii)(D) of this section, the governing instrument must contain provisions similar to those required by paragraph (c)(7)(ii) of this section.

(8) Disposition of trust assets on cessation as personal residence trust--(i) In general. The governing instrument must provide that, within 30 days after the date on which the trust has ceased to be a qualified personal residence trust with respect to certain assets, either--

The assets be distributed outright to the term holder;

(B) The assets be converted to and held for the balance of the term holder's term in a separate share of the trust meeting the requirements of a qualified annuity interest; or

(C) In the trustee's sole discretion, the trustee may elect to comply with either paragraph (C)(8)(i)(A) or (B) of this section pursuant to their terms.

(ii) Requirements for conversion to a qualified annuity interest--(A) Governing instrument requirements. For assets subject to this paragraph (c)(8) to be converted to and held as a qualified annuity interest, the governing instrument must contain all provisions required by §25.2702-3 with respect to a qualified annuity interest.

(B) Effective date of annuity. The governing instrument must provide that the right of the term holder to receive the annuity amount begins on the date of sale of the residence, the date of damage to or destruction of the residence, or the date on which the residence ceases to be used or held for use as a personal residence, as the case may be ("the cessation date"). Notwithstanding the preceding sentence, the governing instrument may provide that the trustee may defer payment of any annuity amount otherwise payable after the cessation date until the date that is 30 days after the assets are converted to a qualified annuity interest under paragraph (c)(8)(i)(B) of this section ("the conversion date"); provided that any deferred payment must bear interest from the cessation date at a rate not less than the section 7520 rate in effect on the cessation date. The governing instrument may permit the trustee to reduce aggregate deferred annuity payments by the amount of income actually distributed by the trust to the term holder during the deferral period.

(C) Determination of annuity amount--(1 ) In general. The governing instrument must require that the annuity amount be no less than the amount determined under this paragraph (C).

(2 ) Entire trust ceases to be a qualified personal residence trust. If, on the conversion date, the assets of the trust do not include a residence used or held for use as a personal residence, the annuity may not be less than an amount determined by dividing the lesser of the value of all interests retained by the term holder (as of the date of the original transfer or transfers) or the value of all the trust assets (as of the conversion date) by an annuity factor determined--

(i ) For the original term of the term holder's interest; and

(ii ) At the rate used in valuing the retained interest at the time of the original transfer.

(3 ) Portion of trust continues as qualified personal residence trust. If, on the conversion date, the assets of the trust include a residence used or held for use as a personal residence, the annuity must not be less than the amount determined under paragraph (c)(8)(ii)(C)(2 ) of this section multiplied by a fraction. The numerator of the fraction is the excess of the fair market value of the trust assets on the conversion date over the fair market value of the assets as to which the trust continues as a qualified personal residence trust, and the denominator of the fraction is the fair market value of the trust assets on the conversion date.

§25.2702-5 Personal residence trusts.-- Paragraph (d) Examples.

The following examples illustrate rules of this section. Each example assumes that all applicable requirements of a personal residence trust (or qualified personal residence trust) are met unless otherwise stated.

Example 1. C maintains C's principal place of business in one room of C's principal residence. The room meets the requirements of section 280A(c)(1) for deductibility of expenses related to such use. The residence is a personal residence.

Example 2. L owns a vacation condominium that L rents out for six months of the year, but which is treated as L's residence under section 280A(d)(1) because L occupies it for at least 18 days per year. L provides no substantial services in connection with the rental of the condominium. L transfers the condominium to an irrevocable trust, the terms of which meet the requirements of a qualified personal residence trust. L retains the right to use the condominium during L's lifetime. The trust is a qualified personal residence trust.

Example 3. W owns a 200-acre farm. The farm includes a house, barns, equipment buildings, a silo, and enclosures for confinement of farm animals. W transfers the farm to an irrevocable trust, retaining the use of the farm for 20 years, with the remainder to W's child. The trust is not a personal residence trust because the farm includes assets not meeting the requirements of a personal residence.

Example 4. A transfers A's principal residence to an irrevocable trust, retaining the right to use the residence for a 20-year term. The governing instrument of the trust does not prohibit the trust from holding personal property. The trust is not a qualified personal residence trust.

Example 5. T transfers a personal residence to a trust that meets the requirements of a qualified personal residence trust, retaining a term interest in the trust for 10 years. During the period of T's retained term interest, T is forced for health reasons to move to a nursing home. T's spouse continues to occupy the residence. If the residence is available at all times for T's use as a residence during the term (without regard to T's ability to actually use the residence), the residence continues to be held for T's use and the trust does not cease to be a qualified personal residence trust. The residence would cease to be held for use as a personal residence of T if the trustee rented the residence to an unrelated party, because the residence would no longer be available for T's use at all times.

Example 6. T transfers T's personal residence to a trust that meets the requirements of a qualified personal residence trust, retaining the right to use the residence for 12 years. On the date the residence is transferred to the trust, the fair market value of the residence is $100,000. After 6 years, the trustee sells the residence, receiving net proceeds of $250,000, and invests the proceeds of sale in common stock. After an additional eighteen months, the common stock has paid $15,000 in dividends and has a fair market value of $260,000. On that date, the trustee purchases a new residence for $200,000. On the purchase of the new residence, the trust ceases to be a qualified personal residence trust with respect to any amount not reinvested in the new residence. The governing instrument of the trust provides that the trustee, in the trustee's sole discretion, may elect either to distribute the excess proceeds or to convert the proceeds into a qualified annuity interest. The trustee elects the latter option. The amount of the annuity is the amount of the annuity that would be payable if no portion of the sale proceeds had been reinvested in a personal residence multiplied by a fraction. The numerator of the fraction is $60,000 (the amount remaining after reinvestment) and the denominator of the fraction is $260,000 (the fair market value of the trust assets on the conversion date). The obligation to pay the annuity commences on the date of sale, but payment of the annuity that otherwise would have been payable during the period between the date of sale and the date on which the trust ceased to be a qualified personal residence trust with respect to the excess proceeds may be deferred until 30 days after the date on which the new residence is purchased. Any amount deferred must bear compound interest from the date the annuity is payable at the section 7520 rate in effect on the date of sale. The $15,000 of income distributed to the term holder during that period may be used to reduce the annuity amount payable with respect to that period if the governing instrument so provides and thus reduce the amount on which compound interest is computed. [Reg. §25.2702-5.]

Bob Parrish

Voice: 941/387-0926; 915/367-3465; 1-800/535-3960; 915/580-4553

Fax: 941/387-0823

E-Mail: BMSarasota@home.net

{Last date letter read} 08/19/97 Last Read By: Last Date Saved: 00/00/00 0:00 AM Last Saved By: