Tax Matters

INDIVIDUAL

Home Sale Exclusion Limited

More and more individuals are using living trusts to avoid probate court and transfer their property to named beneficiaries upon their death. A new letter ruling exposes a potential problem if a married couple’s revocable trust becomes irrevocable after the first spouse dies and the trust then sells the surviving spouse’s home.
In letter ruling 200104005, a husband and wife established a revocable living trust and transferred most of their assets to it, including their principal residence. Upon the wife’s death, the revocable trust was split into two: (1) a revocable trust funded with the marital deduction amount and (2) an irrevocable trust that received the balance, including the residence. The surviving husband was the beneficiary of each trust.

The husband had the right to occupy the home and to direct its sale and replacement. The irrevocable trust gave the husband a noncumulative power to withdraw each calendar year, from the principal of the trust, an amount not to exceed the greater of $5,000 or 5% (the “five-or-five” power) of the then aggregate market value of all property included in the trust.

After living in the home for more than 30 years, the husband was forced to move into an assisted living facility. The trustee wanted to sell the residence and asked the IRS if the beneficiary (the husband) could exclude the first $250,000 of gain under IRC section 121.

The husband argued that, since he had the right to occupy the home and the power to force the trustee to rent, lease, sell or replace it, he should be deemed the home’s owner.

The IRS disagreed. Under IRC section 121, the $250,000 exclusion of gain on the sale of a principal residence is available only if the taxpayer owns and uses the home as a principal residence for two of the five years preceding the sale. According to the IRS, there is no question that the husband fulfilled the use requirement. The problem was “Who owns the residence?”

The service ruled the husband could use the home sale exclusion only to the extent he was deemed to own a portion of the residence through his five-or-five power. The rest of the gain was taxable. The IRS said that the power vested a portion of the corpus of the irrevocable trust in the husband. Each year in which he failed to exercise this power resulted in his owning an increased portion of the trust corpus and being, therefore, eligible to exclude a larger portion of the gain.

Observation. This ruling has little effect on taxpayers whose spouses recently died and where a trust obtained the property with a partial or full stepped-up basis. However, for taxpayers who have outlived their spouses for several years or those who have had substantial gains, the gains may not be fully excludable under the home sale rule.
As an alternative, homeowners should consider the advantages of establishing a qualified personal residence trust (QPRT). The home is transferred to the QPRT, but the owner reserves the right to live in it rent-free during the trust’s term. The owner may have to pay a small gift tax, but if he or she survives the term, the home “passes” to his or her children estate tax-free.

If the owner dies during the term of the QPRT, the residence reverts to his or her estate where it would have been taxed anyway. But the probate process is avoided and the home transfers directly to the named beneficiaries.

If the home is sold during the trust’s term, the exclusion amount is still available to the owner. And, for income tax purposes, he or she can still deduct the interest on the mortgage and the real estate taxes.

—Michael Lynch, Esq.,
professor of tax accounting at
Bryant College, Smithfield, Rhode Island.

Use Annuity Tables to Value Lottery Payouts

In a case this year (Gribauskas, 116 TC no. 12), the Tax Court ruled that future payments of lottery winnings must be valued for estate tax purposes using the IRC section 7520 valuation tables. This ruling specifically rejected a California district court’s 1999 decision in Shackleford Est. v. United States, which held using the section 7520 tables was unreasonable because the lottery winnings’ lack of liquidity was not taken into account (“Court Rules on Lottery Payoffs,” JofA, May00, page 85).

In 1992 Gribauskas and his wife won approximately $16 million in the Connecticut lottery, payable in 20 annual installments of about $790,000 each. After they received the first payment, they divorced; the settlement provided each spouse with one-half of the remaining installment payments. In June 1994, Gribauskas died, still entitled to 18 annual payments of approximately $395,000 each.

Gribauskas’ estate tax return included the lottery payments as an unsecured debt obligation due from Connecticut and listed them with a present value of approximately $2.6 million. Instead of considering the payments to be an annuity, the estate, using the estate tax principle of fair market value, had decided the payments were not marketable because they were nonassignable and could not be accelerated and had, therefore, discounted them.

The IRS determined the present value of the payments should have been $3.5 million, based on the tables. It concluded the installments, regardless of whether they constituted an annuity under the estate tax inclusion rules of IRC section 2039, fell under section 7520. Furthermore, no regulatory exceptions or features—such as lack of marketability—exempted applying the valuation tables to the winnings.

The Tax Court agreed with the IRS, concluding the payments were an annuity under section 7520. The court rejected the estate’s arguments that the annuity table value was unrealistic and unreasonable because it did not take into account the unsecured nature of the payment obligation, the lack of a corpus to draw on or the estate’s inability to assign, sell or transfer the interest.

Furthermore, the Tax Court specifically disagreed with the district court’s decision in Shackleford, stating that it offered no support for considering marketability in valuing annuities and that Congress’ enactment of section 7520 showed it was strongly in favor of standardized actuarial valuation. The court also said that, as a practical matter, the value of an annuity is distinct in nature from interests to which a marketability discount is typically applied, such as closely held stock. The annuity’s value exists solely in the anticipated payments. The inability to liquidate those installments does not diminish the value of an enforceable right to a specific payment for a given number of years.

Observation. In light of this decision by the Tax Court, practitioners should reconsider any planning that relied on Shackleford.

—James Ozello, Esq.,
Ozello Tax and Legal Consulting,
Ringwood, New Jersey.