940 / What special valuation rules apply to the transfer of an interest in a personal residence trust or qualified personal residence trust under Chapter 14?

IRC Section 2702 does not apply to the transfer of an interest in a personal residence trust or a qualified personal residence trust.¹ However, a person is limited to holding a term interest in only two such trusts.² A personal residence trust or a qualified personal residence trust which does not meet the requirements in the regulations may be modified (by judicial modification or otherwise, so long as the modification is effective under state law), if the reformation commences within 90 days of the due date (including extensions) for filing the gift tax return and is completed within a reasonable time after commencement. In the case of a trust created before 1997, the reformation had to commence within 90 days after December 23, 1997, and be completed within a reasonable time after commencement.³

A personal residence is defined as either (1) the principal residence of the term holder, (2) a residence of the term holder which the term holder uses for personal use during the year for a number of days which exceeds the greater of 14 days or 10 percent of the days during the year that the residence is rented at fair market value, or (3) an undivided fractional interest in either (1) or (2). A personal residence includes appurtenant residential structures and a reasonable amount of land (taking into account the residence's size and location). Personal property, such as household furnishings, is not included in a personal residence. A personal residence is treated as such as long as it is not occupied by any other person (other than the spouse or a dependent) and is available at all times for use by the term holder as a personal residence. A personal residence can be rented out if the rental use is secondary to the primary use as a personal residence (but see above). Use of the residence as transient lodging is not permitted if substantial services are provided (e.g., a hotel or a bed and breakfast). Spouses may hold interests in the same personal residence or qualified personal residence trust.⁴

A personal residence trust is a trust which is prohibited for the entire term of the trust from holding any property other than one residence to be used as the personal residence of the term holder(s). A personal residence trust cannot permit the personal residence to be sold, transferred, or put to any other use. Expenses of the trust can be paid by the term holder. A personal residence trust can hold proceeds payable as a result of damage to, or destruction or involuntary conversion of, the personal residence for reinvestment in a personal residence within two years of receipt of such proceeds.⁵ Also, with respect to trusts created after May 16, 1996, a personal residence trust must be prohibited from selling or transferring, directly or indirectly, the residence to the grantor, the grantor's spouse, or an entity controlled by the grantor or the grantor's spouse, at any time after the original term interest during which the trust is a grantor trust. A distribution upon or after the expiration of the original duration of the trust term to another grantor trust of the grantor or the grantor's spouse pursuant to the trust terms will not be treated as a sale or transfer to the grantor or grantor's spouse if the second trust prohibits sale or transfer of the property to the grantor, the grantor's spouse, or an entity controlled by the grantor or the grantor's spouse. This prohibition against a transfer to the grantor or the grantor's spouse does not apply to a transfer pursuant to the trust document or a power retained by the grantor in the event the grantor dies prior to the expiration of the original duration of the trust term. Nor does this prohibition apply to a distribution (for no consideration) of the residence to the grantor's spouse pursuant to the trust document at the expiration of the original duration of the trust term.⁶

A qualified personal residence trust ceases to be a qualified personal residence trust if the residence ceases to be used or held for use as the personal residence of the term holder. A residence is held by the trust for use as the 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. A sale of a personal residence is not treated as a cessation of use as a personal residence if the personal residence is replaced by another within two years of the sale. The trust must provide that if damage to or destruction of the residence renders it unusable as a residence, the trust ceases to be a qualified personal residence trust unless the residence is repaired or replaced within two years.⁷

A qualified personal residence trust must provide that within 30 days of ceasing to be a qualified personal residence trust with respect to any assets, either (1) the assets must be distributed to the term holder; (2) the assets must be put into a separate share of the trust for the balance of the term holder's interest as a qualified annuity interest; or (3) the trustee may elect either (1) or (2). The amount of such an annuity must be no less than the amount determined by dividing the lesser of the original value of all interests retained by the term holder or the value of all the trust assets by an annuity valuation factor reflecting the valuation table rate on the date of the original transfer and the original term of the term holder's interest. If only a portion of the trust continues as a qualified personal residence trust, then the annuity determined in the preceding sentence is reduced in proportion to the ratio that assets which still qualify as a personal residence trust bear to total trust assets.⁸