Take-Away: A family that is considering the acquisition of real property might consider the use of a Split Purchase Annuity Trust [SPLAT] to take title, as an alternative to a qualified personal residence trust (QPRT) or a grantor retained annuity trust (GRAT.)

Background: A donor is treated for gift tax purposes as transferring the entire value of the property the donor has transferred to a trust, or a trust equivalent for the benefit of members of the grantor’s family, undiminished by the value of the interest in the trust the donor retained. The way to avoid this rule, and the hidden gift tax consequence of this rule, is with a split purchase.

IRC 2702: Under IRC 2702, a retained interest in a life estate, or a trust, i.e. a split purchase, has zero value if family members hold the remainder interest. While IRC 2702(a)(1) applies to a transfer of an interest in trust, IRC 2702(c)(1) and (2) treats a joint purchase as property held in trust. Accordingly, if an individual acquires a term interest in property and, in the same transaction, or a series of related transactions, one or more members of the individual’s family acquire a ‘nonterm’ interest in the same property, the individual is treated as acquiring the entire property, and then transferring to each of those family members the interest acquired by that family member in exchange for any consideration paid by that family member. [Treasury Regulation 25.2702-4(c).]

  • Example: Charlotte purchases a life estate in a cottage from her father, Fred,  for $100,000. Charlotte’s daughter, Darla, purchases a remainder interest in the cottage for $50,000. The value of the cottage is $300,000. The value of Charlotte’s life estate determined under IRC 7520 is $250,000. The value of Darla’s remainder interest, therefore, is $50,000. Charlotte is treated as acquiring the entire cottage  from Fred and transferring the remainder interest to Darla. However, the amount of Charlotte’s gift is limited to $100,000, the amount of consideration furnished by Charlotte for her interest in the cottage. Fred has made a gift to Charlotte of $150,000. [Treasury Regulation 25.2702-4(d), example 4.]
  • Example: Paul purchases a 20-year term interest in an apartment building. Paul’s son, Charlie, purchases the remainder interest in the apartment building. Paul is treated as acquiring the entire apartment and transferring the remainder interest to Charlie in exchange for the portion of the purchase price provided by Charlie. [Treasury Regulation 25.2702-6(a)(2).]

IRC 2702 can also apply in situations where one family member purchases a temporary interest in an asset, such as an income interest for life, and another family member purchases another temporary interest in the same asset, e.g. a secondary life income interest. Thus, it can cause some surprising gift tax problems that were never anticipated by a family.

GRAT: Only a couple of special rules apply to IRC 2702’s zero transfer tax valuation treatment where the transferor’s acquired or retained interest is valued at $0.00. One exception is if the property transferred is a personal residence, which is the basis for the gift tax benefit associated with a qualified personal residence trust, or QPRT. The other exception is with regard to the interest retained in a unitrust or annuity trust, which is the basis for the gift tax benefit associated with a grantor retained annuity trust, or GRAT. There are detailed requirements that must be satisfied to quality a retained annuity for qualified annuity treatment. [Treasury Regulation 25.2702-3.] During this past year GRATs have been extensively covered, so this discussion with regard to SPLATs will not spend much time summarizing the tax virtues of a GRAT. The principal negatives to the use of a GRAT are that: (i) there is no GST leverage; the grantor’s GST exemption is only allocated after the annuity stream paid to the grantor comes to an end; and (ii) there is some estate tax inclusion exposure if the grantor has a relatively short life expectancy and dies during the annuity payment period. The positives associated with the use of a GRAT is that the current low IRC 7520 interest rates lead to a higher value of the grantor’s retained interest, with results in a lower taxable gift of the remainder interest. The estate tax exposure problem with the use of a GRAT can be avoided through the use of a split purchase annuity trust, or SPLAT.

Split-Purchase Annuity Trusts: IRC 2702 causes the value of interests retained in certain trusts to be subject to gift tax. As noted above, IRC 2702 also applies to split-purchases, such as an acquisition by a parent of a life estate in an asset when a member of the parent’s family, like a child, acquires a remainder interest in the same asset. This application of IRC 2702 in this setting is referred to as the joint purchase rule. [IRC 2702(c)(2.)] However, the joint purchase of a personal residence should fall under the exceptions to IRC 2701. [IRC 2701(a)(3)(A)(ii).] Thus, the normal valuation principles determined under IRC 7520 should apply, and the value of the remainder in the personal residence will be determined by subtracting from the value of the residence the fair market value of the temporary, or life estate, interest using the IRS’s Tables and the applicable IRC 7520 interest rate. Therefore, nether family member who makes a joint purchase of a personal residence, subject to the terms of a personal residence trust, should be deemed to have made a gift to the other where each pays the actuarial value of the interest that he/she purchases. [Private Letter Rulings 200919002 and 200840028.]

  • SPLAT Basics: An individual (parent and spouse?) and a GST-exempt trust enter into an agreement. The parent purchases a life estate interest in the residence. The GST exempt trust purchases the remainder interest through a split purchase trust.) The parent) purchases an annuity for life (or a term of years) in the residence. The GST-exempt trust purchases a remainder interest in the residence (although the trust might also be used to take title to tangible personal property, like artwork.) Values are determined using the standard IRS actuarial Tables, which means that there is no gift by the parent if the underlying property is correctly valued. With the low IRC 7520 rates the parent pays a significant amount for he/her annuity interest. The value of the parent’s retained annuity interest in the trust will drop as the IRC 7520 rates increase. However, the remainder interest in the SPLAT cannot be zeroed out if an annuity is retained for life by the parent.
  • Example: Fred purchases a life estate interest in a Florida condo. Fred’s daughter Debra purchases the remainder interest in the Florida condo in the same transaction. Fred will be treated as having acquired both interests (the life estate and the remainder interest) and having then transferred the remainder interest to Debra in exchange for the price Debra paid for the remainder interest in the condo. The zero value rule of IRC 2702(a) will apply to treat Fred has having made a gift to Debra of the value of the life estate interest in the condo, resulting in a taxable gift under this split purchase rule. Had Fred’s interest in the Florida condo been in the form of a qualified annuity interest, like the SPLAT, this rule that assigns a zero value to Fred’s acquired life estate interest will not apply.

Advantages to a SPLAT: A joint purchase is normally done with a GST exempt trust structure to facilitate compliance with the current QPRT (or GRAT) Regulations. The two individuals, e.g. parent and child, each contribute funds to the GST exempt trust; their contributions to the trust are in proportion to the relative values of their interests, i.e. annuity and remainder, in the trust. A split purchase annuity trust offers an advantage over a QPRT for the following reasons.

  • QPRT Rules: In order to avoid estate tax inclusion of the value of the residence, the retained interest by the parent in the QPRT must be short, and if the parent survives the exclusive use term of the QPRT, the parent must move from the residence or pay rent. Those limitations associated with a QPRT are avoided with a SPLAT.
  • GRAT Inclusion Exposure: A GRAT might be successful, even if its grantor dies soon after the GRAT is created, but the GRAT will not likely have been a success, since its earnings must exceed the ‘IRC 7520 hurdle’ interest rate that was used to determine the grantor’s annuity amount in order to successfully transfer wealth gift tax-free. Accordingly, GRATs are often not used if the grantor has a diminished life expectancy and dies while the annuity is being paid. If the remainder beneficiary of a SPLAT pays full value for the remainder interest IRC 2036 will not apply to the trust if the term-holding parent dies before the term expires. Since IRC 2036 does not apply to a split purchase annuity trust, it is possible for the parent to acquire an annuity that is payable for life without concern over the estate inclusion of anything other than the present value of the parent’s right to receive the remaining annuity payment. [Treasury Regulation 20.7520-3(b)(3).]
  • Lifetime Enjoyment: The acquisition of an annuity that is payable for life may be important to older parents who want to achieve the estate planning goal to shift wealth, but who are reluctant to surrender their interest in the acquired assets. Like the QPRT, the parent can reside in the home for life without having to pay any rent
  • No IRC 2036 Estate Tax Exposure: Estate tax exposure can be avoided by a joint purchase of a personal residence using a SPLAT. Unlike a QPRT, a conventional joint purchase does not involve a transfer from one individual to another, because the parent acquires a life estate (or term interest) from a third party, and the other child acquires the remainder interest separately from a third party. Thus, IRC 2036 does not apply to cause estate inclusion of the SPLAT’s asset in the parent’s taxable estate, since it applies only if there is a transfer and a retained interest by the parent.
  • GST Exemption Leverage: As noted, the grantor of a GRAT or QPRT cannot leverage his/her GST tax exemption on the initial transfer of assets to the GRAT or QPRT. The GST exemption can only be applied to the transfer of assets or the interest in the trust to the remainder beneficiaries after the annuity payment period has ended (the estate tax inclusion period, or ETIP.) If the assets held in the GRAT or QPRT appreciate in value, then more of the grantor’s GST exemption will have to be applied to the transferred remainder interest at the end of the ETIP. With the SPLAT the grantor-annuitant’s GST exemption can be leveraged from the initial transfer of assets to the SPLAT.
  • Individuals with Short Life Expectancies: The risk of the parent dying during the annuity payment could result in the inclusion of most of the GRAT’s (or QPRT’s) assets in the parent’s taxable estate under IRC 2036. A SPLAT can be used for individuals with short life expectancies if their death is not imminent, i.e. within the following year.

Disadvantages with a SPLAT: As with most estate planning techniques, a SPLAT has a couple of drawbacks.

  • Source of Funds to Purchase Remainder Interest: The IRS has determined that the child’s purchase of the remainder interest must not have acquired the funds to purchase the remainder interest from their parent,  the purchaser of the life estate. [Technical Advise Memorandum 9206006.] It would thus be wise to have a child acquire funds for the purchase of a remainder interest from a source other than their parent who has acquired the life estate interest (or a term of years interest.) Yet, in the same Technical Advice Memorandum, the IRS said that it will not deem a transfer to have occurred, otherwise causing estate tax inclusion under IRC 2036(a)(1), if no gift is involved, i.e. the funds are loaned by the parent to the child who is the prospective purchaser of the remainder interest, and interest is payable by the child at the applicable AFR rate under IRC 7872 on that bona fide
  • Not a Grantor Trust: A SPLAT formed by family members to purchase the temporary (e.g life estate or term of years) and remainder interests in a personal residence will not be a wholly grantor trust with regard to the parent, the purchaser of the temporary interest, because the parent will have contributed only a portion of the assets to the SPLAT. Therefore, the existence of the SPLAT will not be completely ignored with regard to the parent’s transactions with the SPLAT, and they will not be tax-free as they would if it was a grantor
  • No Contingent Reversionary Interest in the SPLAT: Unlike a QPRT where the parent can further reduce the value of the remainder interest by retaining a contingent reversionary interest in the QPRT, the SPLAT’s remainder interest value cannot be further reduced.

SPLAT Tips: (i) A trust that purchases the remainder should be a grantor trust; (ii) it is better to use an existing, i.e. old and cold, trust or have the grantor’s spouse create the trust; (iii) the parent should purchase a term of years for more value in the part of the purchase price, and which leads to a lower remainder value; (iv) and existing residence or condo can be used for the SPLAT.