Letter Ruling 9735035, June 2, 1997

Uniform Issue List Information:
UIL No. 2036.01-00
Transfers with retained life estate
- Benefit enjoyed but not reserved
UIL No. 2702.00-00

Code Secs. 2036 and 2702

This is in response to your letter dated December 20, 1996, and other submissions in which you request rulings that the proposed trust, holding the property described below, will be a qualified personal residence trust satisfying the requirements of §25.2702-5(c) of the Gift Tax Regulations, and that the property placed in the trust will not be includible in the taxpayer's gross estate if the taxpayer survives the term of the trust.

You represent that the taxpayer, through his nominee trust, owns three adjoining parcels of property. He proposes to create an irrevocable trust. The trustee of the nominee trust will distribute one of the parcels of property to the taxpayer and the taxpayer will then transfer the parcel to the irrevocable trust. The terms of the proposed irrevocable trust are intended to satisfy the requirements for a qualified personal residence trust as set forth in §25.2702-5(c) .

The taxpayer purchased the three parcels of property in 1987. The single parcel of property to be transferred to the proposed trust includes a residence, guest house, two detached garages, a boathouse, two sheds, and a pond. The taxpayer uses the property as a weekend and vacation residence.

The property constitutes a watershed area for the pond and surrounding streams. The deed for the parcel that is to be transferred to the proposed trust includes substantial restrictions with respect to the subdivision of the property. The restrictions were placed on the property because of concerns that subdivision and development would disrupt the natural waterflow in the region.

In 1991, the taxpayer applied for a certification by the local government that the property would qualify as forestland within the meaning of a state statute. Under this state statute, local governments may impose a products tax on the stumpage value of all forest products cut with the authorization of the owner, and a land tax based on the local rate applicable to commercial property on a percentage of the fair market value of the property. These taxes are an alternative to the standard real property tax. Under the taxpayer's forest management plan, the first cutting of forest products will take place no earlier than the year 2000. The taxpayer represents that the sole purpose for applying for this certification is to reduce property taxes, and that any revenue generated from the forest management plan will be limited and incidental.

The terms of the proposed irrevocable trust provide that the taxpayer will be entitled to the use and occupancy of the residence for a 20-year term. If the taxpayer and his spouse survive the 20-year term, the property held in the trust is to pass in further trust for the benefit of his spouse and children. Under the terms of this latter trust, the spouse is to have the right to use and possess the residence during her lifetime. At her death, the property is to pass outright to the taxpayer's children. If the taxpayer survives the 20-year term but his spouse does not survive the term, the property is to pass outright to the taxpayer's children. The taxpayer represents that, if he decides to use or possess the property after the 20-year term of the trust during any time in which his children own the property, he will enter into a lease agreement with his children, renting the property from his children at fair market value rental for the periods of use or possession. It is represented that the children are under no obligation to lease the property to the taxpayer. If the taxpayer dies during the 20-year term, the property will pass pursuant to the will of the taxpayer. The terms of both the residence trust and the trust that is created if the taxpayer's spouse survives the 20-year term of the residence trust, prohibit the trusts from selling or transferring the residence, directly or indirectly, to the taxpayer, the taxpayer's spouse, or an entity controlled by the taxpayer or the taxpayer's spouse.

If, for any reason, the residence ceases to be held as the taxpayer's personal residence during the retained term and prior to his death, the trust will either terminate and all assets will be distributed to the taxpayer, or the trustee may, within 30 days, convert the personal residence trust into a qualified annuity trust as described in §25.2702-3(b) . The amount of the annuity to be paid to the taxpayer at least annually after the conversion is to be the greater of an amount determined under §25.2702-5(c)(8) (ii)(C), or an amount determined by multiplying the value of the property in the trust at the date of conversion by the applicable federal rate at the date of conversion.

You request that we rule as follows:

  1. The parcel of property that the taxpayer proposes to transfer to the proposed trust is a personal residence within the meaning of §25.2702-5(c)(2) .

  2. The proposed residence trust satisfies the exception to §2702(a)(2) of the Internal Revenue Code set forth in §2702(a)(3)(A)(ii) , and the trust constitutes a qualified personal residence trust within the meaning of §25.2702-5(c) .

  3. If the taxpayer survives the 20-year term of the proposed residence trust and the taxpayer pays fair market value rental for any periods during which his children own the property and he uses or possesses the property, the property that the taxpayer transfers to the proposed residence trust will not be includible in his gross estate under §2036(a) .

ISSUES 1 & 2 (Qualified personal residence trust)

Section 2702(a) provides special valuation rules for determining the value of a transfer for gift tax purposes where a donor transfers property in trust to or for the benefit of a member of the donor's family, and the donor retains an interest in the trust. Section 2702(a)(3)(A)(ii) provides that §2702 shall not apply to a transfer if it involves the transfer of an interest in trust, all the property of which consists of a residence to be used as a personal residence by persons holding term interests in the trust (i.e., a personal residence trust).

Section 25.2702-5(a) provides, in part, that a qualified personal residence trust as defined in §25.2702-5(c) is treated as a personal residence trust satisfying the requirements of §2702(a)(3)(A)(ii) . Section 25.2702-5(c) provides that the requirements for a qualified personal residence trust must be satisfied in provisions in the governing instrument and these provisions by their terms must continue in effect during any term interest in the trust.

Under §25.2702-5(c)(5) , a qualified personal residence trust is a trust, the governing instrument of which prohibits the trust from holding any assets other than one residence to be used or held fore use as the personal residence of the term holder, and certain other assets specified in §25.2702-5(c)(5) (ii).

Section 25.2702-5(c)(2)(i) provides that a personal residence of a term holder is either, the principle residence of the term holder (within the meaning of §1034 ), one other residence of the term holder (within the meaning of §280A(d)(1) but without regard to §280A(d)(2) ), or an undivided fractional interest in either. 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).

Section 25.2702-5(c)(2) (ii) provides that a residence is the personal residence of the term holder only if its primary use is as a residence of the term holder when occupied by the term holder. Section 25.2702-5(d) , Example 1, involves a situation where a taxpayer maintains his principal place of business in one room of his principal residence. The room satisfies the requirements of §280(c)(1) . The example concludes that the residence constitutes a personal residence. Example 3 involves a 200-acre farm that includes a residence and structures used in the farm operation. The example concludes that the farm includes assets not meeting the requirements of a personal residence and, therefore, the trust to which the farm is transferred is not a qualified personal residence trust.

In the present case, the terms of the proposed residence trust satisfy the requirements for a qualified personal residence trust as set forth in §25.2702-5(c) . In addition, the size of the property to be transferred to the trust is restricted under the 1987 deed and is reasonably appropriate for residential purposes taking into account the residence's size and location.

We conclude that the parcel of property that the taxpayer proposes to transfer to the proposed trust is a personal residence within the meaning of §25.2702-5(c)(2) . In addition, we conclude that the proposed residence trust satisfies the exception to §2702(a)(2) set forth in §2702(a)(3)(A)(ii) , and that the trust constitutes a qualified personal residence trust within the meaning of §25.2702-5(c) .

ISSUE 3 (Includibility in gross estate)

Section 2033 provides that the gross estate shall include the value of all property in which the decedent has an interest at the time of his death.

Section 2036(a) provides that the value of the gross estate shall include the value of any property of which the decedent has made a transfer (except in the case of a bona fide sale for an adequate and full consideration in money or money's worth) in which the decedent has retained for his life the possession or enjoyment of, or the right to the income from the property, or the right to designate the persons who shall possess or enjoy the property or the income from the property.

In Estate of McNichol v. Commissioner, 265 F.2d 667 (3rd Cir. 1959) [59-1 USTC ¶11,868 ], cert. den. 361 U.S. 829 (1960), the court held that "enjoyment" as used in the death tax statute is not a term of art, but is synonymous with substantial present economic benefit. In McNichol, the decedent purportedly conveyed income-producing real estate to his children 9 years before his death. Pursuant to an oral understanding with his children, the decedent continued to receive the rents from the properties until his death. The court held that the properties were includible in his gross estate under the predecessor to §2036 .

In Estate of Barlow v. Commissioner, 55 T.C. 666 (1971) [CCH Dec. 30,627 ], acq., 1972-2 C.B. 1, the court held that, if a lessee/decedent is obligated to pay fair market rent from the date that the lessee transferred the property to the lessor, the decedent did not retain, for purposes of §2036 , possession or the enjoyment of, or the right to the income from the property if the decedent did not make the rental payments for a period of time prior to his death. The decedent and his spouse transferred a farm to their children and contemporaneously leased the property from the children at fair market value rent. The decedent and his spouse were legally obligated as tenants to pay this rent and the children were entitled, as landlords, to terminate the lease and oust the decedent and his spouse from the property if the rent was not paid. Although the decedent paid the rent for the first two years, the family agreed that, because of certain medical problems, the decedent need not continue to pay the rent, and the decedent did not pay the rent until his death four years later. Because the decedent was obligated to pay fair market value rent from the date of the transfer and there was no express or implied agreement at the date of the transfer that the decedent could avoid this rent obligation, the court held that the property was not includible in the decedent's gross estate under §2036 .

Rev. Rul. 70-155 , 1970-1 C.B. 189, holds that a donor's continued occupancy of a transferred residence rent free until his death is as much an economic benefit as if he had rented the property and obtained the income therefrom. Under the facts in the ruling, an elderly father continued to live rent-free in a residence that he had transferred to his son and daughter-in-law. The ruling, however, notes that continued occupancy under the facts of the ruling may be distinguished from the spousal cases involving co-occupancy between the donor and donee. Where the donor and donee are spouses, the co-occupancy does not support an inference of an agreement or understanding as to retained possession or enjoyment by the donor. See Estate of Gutchess v. Commissioner, 46 T.C. 554 (1966) [CCH Dec. 28,067 ], acq 1967-1 C.B. 2, where the court held that the value of a residence transferred from the donor spouse to the donee spouse 11 years before the death of the donor spouse is not includible in the gross estate of the donor spouse under §2036 even though the spouses continued to reside in the residence until the donor spouse's death. The court found that no agreement with respect to the occupancy was implied from the fact that the spouses continued to reside in the residence after the transfer.

In the present case, the taxpayer proposes to transfer residential property to a trust for a 20-year term. If the taxpayer and his spouse survive the 20-year term, the property is to pass in further trust. Under the terms of the latter trust, his spouse is granted the right to use and possess the residence during her lifetime. At her death the property is to pass to the taxpayer's children. As set forth in Rev. Rul. 70-155 and Estate of Gutchess, if the taxpayer continues to live in the residence with his spouse after the term of the residence trust and then predeceases his spouse, the property will not be includible in his gross estate under §2036 . No agreement with respect to the occupancy will be implied from the fact that the taxpayer and his spouse continue to reside in the residence.

If the taxpayer survives the term of the residence trust and continues to use or possess the residence when his children own the property after his spouse's death, the taxpayer represents that he will pay fair market value rental for the periods of time for which he has use or possession of the property. If the taxpayer pays fair market value rental for these periods of use or possession, assuming that there is no express or implied understanding that the taxpayer may retain use of the property whether or not rent is paid, the taxpayer's continued use of the property will not result in the inclusion of the property in the taxpayer's gross estate under §2036(a) .

We conclude that, if the taxpayer survives the 20-year term of the proposed residence trust and the taxpayer pays fair market value rental for any periods during which his children own the property and he uses or possesses the property, the property that the taxpayer transfers to the proposed residence trust will not be includible in his gross estate under §2036(a) .

Except as we have specifically ruled herein, we express no opinion under the cited provisions or under any other provision of the Code.

This ruling is based on the facts and applicable law in effect on the date of this letter. If there is a change in material fact or law (local or Federal) before the transactions considered in the ruling take effect, the ruling will have no force or effect. If the taxpayer is in doubt whether there has been a change in material fact or law, a request for reconsideration of this ruling should be submitted to this office.

This ruling is directed only to the taxpayer who requested it. Section 6110(j)(3) provides that it may not be used or cited as precedent.

Sincerely yours, Assistant Chief Counsel (Passthroughs and Special Industries), George Masnik, Branch Chief, Branch 4.