Technical Notes

The Personal Residence Life Estate Trust: A New Planning Tool
By Andrew J. De Maio, Esq.
Copyright 1997 De Maio & De Maio All Rights Reserved

/1/ Estate of Rose D'Ambrosio v. Commissioner, ___ F. 3d ____, 78 AFTR2d Par. 96-5602 (3rd Cir. 1996), cert. den. under S. Ct. Dkt. No. 96-1486; Wheeler v. U.S. ____ F. 3d ____, (Fifth Cir. 1997).

/2/ Theoretically, it should be possible to sell the remainder interest without using a trust. A transfer is excluded from the reach of Sec. 2702 " if such transfer involves the transfer of an interest in trust all the property in which consists of a residence to be used as a personal residence by persons holding term interests in such trust..." Section 2702(a)(3)(A)(ii). Section 2702(c) provides that "the transfer of an interest in property with respect to which there is 1 or more term interests shall be treated as a transfer of an interest in a trust." Sec. 2702(c)(3) defines a term interest as a life interest in property or an interest in property for a term of years.

Nevertheless, a trust complying with the governing instrument requirements of Reg. 25.2702-5 seems the prudent way to ensure that the transaction is excluded from Chapter 14. Consider this excerpt from Footnote 25 of the Wheeler decision:

We again emphasize that we take no position as to how section 2702 would affect this particular transaction had it been entered into after October 8, 1990 (transfers prior thereto being excluded from section 2702; see note 21, supra). Although the special valuation rules do not apply where the holder of a life or term interest uses the property as his personal residence, I.R.C. section 2702(a)(3)(A)(ii), the Treasury Regulations provide that the personal residence exception applies only where the residence is placed in an irrevocable trust, 26 C.F.R. section 25.2702-5(b) (1996) ("A [personal residence] trust does not meet the requirements of this section if . . . 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.").

/3/ The calculations assume a transfer during July, 1997, when the Sec. 7520 rate was 8.0%. The exact figures are:

Value of life estate: 82.303%, or $246,909
Value of remainder: 17.697%, or $53,091

All calculations made using Brentmark Software's Estate Planning Tools.

/4/ It should be possible to further reduce the purchase price by retaining a reversion in the grantor. For example, the trust could provide that if Jack does not survive for 15 years, the residence passes to his estate, or pursuant to a general testamentary power of appointment. The value of a 15-year reversion based on Jack's age is 8.425% of the home's value, or $25,275. Reversionary interests are typically retained in traditional QPRTs to reduce the amount of the gift on creation of the trust. The same subtraction methodology should apply to calculation of the purchase price in a remainder interest sale. Thus, the total retained interests would be $246,909 (value of life estate) plus $25,275 (value of reversion), or $272,184. Subtracting those interests from the home's market value ($300,000) produces a purchase price of $27,816, slightly more than one-half of the purchase price that must be used if only a life estate is retained.

Of course, the use of a reversion introduces the risk of lost tax benefits from premature death. The home will be included in the estate if the grantor fails to survive the term of the reversion.

This combination of life estate and reversion was not present in the Wheeler or D'Ambrosio decisions.

/5/ For example, Gradow v. United States, 11 Cl.Ct. 808 (1987).

/6/ The conclusion reached in the recent D'Ambrosio and Wheeler decisions fits more neatly into the estate and gift tax system than the opposing cases. As the D'Ambrosio court points out, the amount of consideration that must be paid for the remainder interest, growing at the Sec. 7520 rate in effect at the time of the sale, will at the end of the grantor's statistical life expectancy equal the full market value of the home ($300,000 in our example).

Consider this passage from the Wheeler opinion:

The sale of a remainder interest for its actuarial value does not deplete the seller's estate. "The actuarial value of the remainder interest equals the amount that will grow to a principal sum equal to the value of the property that passes to the remainderman at termination of the retained interest. To reach this conclusion, the tables assume that both the consideration received for the remainder interest and the underlying property are invested at the table rate of interest, compounded annually." Jordan, Sales of Remainder Interests, at 692-93 (citing Keith E. Morrison, The Widow's Election: The Issue of Consideration, 44 Tex. L. Rev. 223, 237-38 (1965)). In other words, the actuarial tables are premised on the recognition that, at the end of the actuarial period, there is no discernible difference between (1) an estate holder retaining the full fee interest in the estate and (2) an estate holder retaining income from the life estate and selling the remainder interest for its actuarial value -- in either case, the estate is not depleted. This is so because both interests, the life estate and the remainder interest, are capable of valuation. Recognizing this truism, the accumulated value of a decedent's estate is precisely the same whether she retains the fee interest or receives the actuarial value of the remainder interest outright by a sale prior to her actual death. Id. at 691-92; Morrison, The Issue of Consideration, at 237- 38.

The dissenting opinion in D'Ambrosio expresses concern that the consideration received by the grantor may never be subject to estate tax because it may not be owned by the grantor at the time of death. For example, the funds received may not be invested wisely, and may not grow at the rate assumed by the actuarial tables. The Wheeler court responds eloquently to that argument in these words:

Whether an estate holder takes the "talents" received from the sale of the remainder interest and purchases blue chip securities, invests in highly volatile commodities futures, funds a gambling spree, or chooses instead to bury them in the ground, may speak to the wisdom of the estate holder, see Matthew 25:14-30, but it is of absolutely no significance to the proper determination of whether, at the time of the transfer, the estate holder received full and adequate consideration under section 2036(a).

Even if the consideration received grows at the assumed rate, the estate may be depleted if the grantor/seller dies prior to the end of his or her statistical life expectancy. On the other hand, if the grantor/seller lives longer than "expected", the assets received in the purchase will, if not transferred, grow to more than the original purchase price. This does not represent an abuse, but is simply a consequence of using actuarial tables to value life estates and remainders. Of course, the tables may not be used if the grantor has a terminal illness. See, e.g., Treas. Reg. Sec. 25.7520-3(b)(3).

/7/ The Wheeler court points out the anomaly in this passage (footnotes omitted):

Pittman [v. United States, 878 F. Supp. 833 (E.D.N.C. 1994)] (and the Tax Court's decision in D'Ambrosio) presents a conscientious estate planner with quite a conundrum. If the taxpayer sells a remainder interest for its actuarial value as calculated under the Treasury Regulations, but retains a life estate, the value of the full fee interest in the underlying property will be included in his gross estate and the transferor will incur substantial estate tax liability under section 2036(a). If the taxpayer chooses instead to follow Gradow, and is somehow able to find a willing purchaser of his remainder interest for the full fee-simple value of the underlying property, he will in fact avoid estate tax liability; section 2036(a) would not be triggered. The purchaser, however, having paid the fee-simple value for the remainder interest in the estate, will have paid more for the interest than it was worth. As the "adequate and full consideration" for a remainder interest under section 2512(b) is its actuarial value, the purchaser will have made a gift of the amount paid in excess of its actuarial value, thereby incurring gift tax liability. Surely, in the words of Professor Gilmore, this "carr[ies] a good joke too far."

/8/ What is the magnitude of the risk? The Pittman court and the Tax Court in D'Ambrosio held that the asset sold was included in the estate at its date-of-death value, less an offset for the consideration received by the decedent in the sale.

/9/ Promissory notes were used in the Wheeler case. The purchasers, the decedent's sons, were personally liable on the notes and they were secured by deeds of trust on the real estate. The government's contended that the sales were a sham because (1) the sons were not capable of paying cash at the time of the sale; (2) they received bonuses from a family corporation and used part of the bonuses to pay down the note; (3) there were no negotiations regarding the purchase price of the transaction; and (4) the decedent forgave portions of the debt evidenced by the note. The court rejected these arguments and found that the sale was bona fide.

/10/ The sale in D'Ambrosio was in return for a private annuity.

/11/ In calculating the amount of the gain, it appears that Jack's basis must be allocated between the life estate and the remainder based on the actuarial value of each. See Hunter v. Comm'r, 44 T.C. 109 (1965).

/12/ Code Section 121(d)(8), as amended by Section 312 of the Taxpayer Relief Act of 1997, provides:

(8) Sales of remainder interests.--For purposes of this section--

(A) In general.--At the election of the taxpayer, this section shall not fail to apply to the sale or exchange of an interest in a principal residence by reason of such interest being a remainder interest in such residence, but this section shall not apply to any other interest in such residence which is sold or exchanged separately.

(B) Exception for sales to related parties.--Subparagraph (A) shall not apply to any sale to, or exchange with, any person who bears a relationship to the taxpayer which is described in section 267(b) or 707(b).

/13/ Jack's right to use the home and receive any income makes the trust a grantor trust as to income. Reservation of an additional power or right may be required in order to make the trust a grantor trust as to principal as well. Of course, the power should be one that does not cause inclusion in the estate.

/14/ 61 FR 16623, April 16, 1996.

/15/ Treas. Reg. 25.2702-5(c)(8)(ii)(C).

/16/ This assumes that the trust is a grantor trust as to principal as well as income. See Note 13.

/17/ Code Sec. 121, as amended by Taxpayer Relief Act of 1997, Sec. 312.

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