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Planning for the Personal Residence

August 10, 2012

Michele DeNuzzo Loughlin

A personal residence is one of the most significant assets owned by many people.   Often people are unwilling to transfer their personal residence outright, and thus they may likely retain a life use or life estate upon transfer.   Such life estate, however, can hinder the desired estate tax savings.  Proper planning must be done to achieve the desired results as well as an understanding of the various estate tax, gift tax and income tax consequences that may be involved in such a transfer.  For example, a transfer with a retained life estate fails to remove the residence from the donor’s gross estate under IRC Section 2036(a), and it is reported at full fair market value for gift tax filing purposes.  If continued occupancy in the transferred residence is desired by the donor and the donor is looking to not have the residence included in their estate, options do exist, some of which are:

  1. Sale of personal residence.  A bona fide sale for adequate and full consideration in money or money’s worth will remove the property from the seller’s estate if the seller vacates the property; however, since the sale proceeds will “replace” the house as a current asset, the sale will only remove the future appreciation in the value of the residence from the gross estate.
  2. Outright gift of personal residence.  A gift of the residence by the donor to a donee will achieve removing the asset out of the estate of the donor if the donor no longer lives there.  The donor’s basis, however, will carry over to the donee.  If the donee lives in the house as a principal residence for two years after the transfer, then the donee will satisfy the IRC Section 121 capital gain exclusion.  This exclusion can shelter all or a part of the capital gains on a future sale by the donee.
  3. Transfer of the personal residence with the retention of a life estate.  Although this is a comfortable option, there are advantages and disadvantages to this arrangement.   One advantage is if the house is not sold during the lifetime of the donor, the donee will receive a step-up in basis upon the death of the donor.   This, however, brings us to one of the disadvantages, because the transfer is not a completed gift for estate tax purposes, and therefore the residence will be included in the donor’s estate.  Another disadvantage is that if a sale of the house occurs during the life estate, then the IRC Section 121 capital gain exclusion will apply (if the requirements are met) only to the life estate value; the exclusion will not apply to the remainder interest value. However, the donor will receive a portion of the sale proceeds determined by the value of the life estate interest.
  4. Transfer of the personal residence to a Grantor Trust.  If the trust is structured properly, then the donor’s IRC Section 121 capital gain exclusion can be preserved if the trust sells the home.  When the donor passes away, the residence can achieve a step-up in basis at the donor’s death.  Again, this is not a complete gift for gift tax purposes, and therefore the asset will be in the donor’s estate.  This vehicle is often utilized for out-of-state real estate to avoid an ancillary probate process.
  5. Transfer of the personal residence to a Qualified Personal Residence Trust (QPRT).  This structure allows the donor to transfer the personal residence to an irrevocable trust the terms of which allow the donor to retain the right to use the residence for a term of years.  For gift tax purposes, only the calculated present value of the remainder interest of the property is taxable rather than the full fair market value of the residence.  If the donor survives the trust term, then the residence will pass per the terms of the trust agreement.  Currently, the donor can continue to live in the residence after the trust term ends by renting it for fair market value rent.  The advantages of this option are that the value of the house is calculated for gift tax purposes at a discount, future appreciation is removed from the taxpayer’s estate, and rent payments made at the end of the trust term reduce the taxpayer’s estate without being considered gifts.  The downfall of a QPRT is that if the donor does not survive the trust term, then the donor’s interest in the property will be in the donor’s estate for estate tax purposes and the gift will be nullified.

As you can see, there are many options that exist when planning on transferring the personal residence.  It is important that the donor consult with a tax advisor in order to understand the consequences of the transfer as it may pertain to estate, gift and income tax.


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