What the trust document has to say. Paragraph (c) of the regulation is a list of drafting requirements, and they are requirements of the governing instrument rather than of conduct. The instrument "must require that any income of the trust be distributed to the term holder not less frequently than annually." It "must prohibit distributions of corpus to any beneficiary other than the transferor prior to the expiration of the retained term interest." It "must prohibit commutation (prepayment) of the term holder's interest," so the grantor cannot cash out early. And except for narrow permitted items, it "must prohibit the trust from holding, for the entire term of the trust, any asset other than one residence to be used or held for use ... as a personal residence of the term holder."
The permitted extras are tightly drawn. The trust may hold cash for expenses already incurred or reasonably expected within six months, for improvements to be paid within six months, and for the purchase of an initial or replacement residence within three months where the trustee has already contracted to buy it. Excess cash must be swept out to the term holder at least quarterly. The trust may hold improvements, sale proceeds in a separate account, and insurance on the residence together with proceeds of damage or destruction.
What counts as a residence. The regulation defines a personal residence as the principal residence of the term holder, or one other residence, or an undivided fractional interest in either, so a vacation home qualifies and a third home does not. Three further points defeat most assumptions. "The fact that a residence is subject to a mortgage does not affect its status as a personal residence," so a financed home is eligible, though the continuing payments raise their own issues. "The term personal residence does not include any personal property (e.g., household furnishings)," so the contents stay outside. And a property "is not used primarily as a residence if it is used to provide transient lodging and substantial services are provided in connection with the provision of lodging (e.g., a hotel or a bed and breakfast)."
The two-trust ceiling. The regulation provides that a trust otherwise meeting the requirements "is not a personal residence trust (or a qualified personal residence trust) if, at the time of transfer, the term holder of the trust already holds term interests in two trusts" that are personal residence trusts of which the term holder was the grantor, with trusts holding fractional interests in the same residence treated as one. So a grantor can run two, and a common design uses that allowance to split one house between spouses or across two terms.
The mortality risk is the whole gamble. Section 2036(a) includes in the gross estate property the decedent transferred "under which he has retained for his life or for any period not ascertainable without reference to his death or for any period which does not in fact end before his death ... the possession or enjoyment of, or the right to the income from, the property." A grantor who does not outlive the retained term has retained possession for a period that did not in fact end before death, so the residence comes back into the gross estate at its date-of-death value. The gift tax paid or exclusion used at funding is credited, but the exercise has achieved nothing except cost and complexity. The longer the term, the smaller the gift and the larger the risk, and there is no way to have both.
After the term, the grantor is a tenant. The remainder beneficiaries own the house. If the grantor stays on, the arrangement that keeps the property out of the estate is a genuine lease at fair market rent, because continuing to occupy a house one has given away, for free, is the "possession or enjoyment" section 2036(a)(1) describes, retained for a period that does not in fact end before death. The rent itself is often described as a further benefit, since it moves money to the children without being a gift, and it is also a real cash obligation an older grantor may not want.
What happens if the house is sold or destroyed. The instrument must provide that the trust ceases to be a qualified personal residence trust as to sale proceeds "not later than the earlier of: (A) the date that is two years after the date of sale; (B) the termination of the term holder's interest in the trust; or (C) the date on which a new residence is acquired by the trust." A parallel rule runs on damage or destruction that renders the residence unusable, with the same two-year outer limit unless repairs are completed or a new residence is acquired. Within 30 days of the trust ceasing to qualify as to particular assets, the instrument must require that those assets either be distributed outright to the term holder or "be converted to and held for the balance of the term holder's term in a separate share of the trust meeting the requirements of a qualified annuity interest," or leave the choice to the trustee. That conversion is to a different structure with its own rules, and it is the reason a sale inside a qualified personal residence trust is a decision to take with counsel rather than a routine transaction.
One drafting escape. A trust that does not comply with the regulatory requirements will still be treated as satisfying them "if the trust is modified, by judicial reformation (or nonjudicial reformation if effective under state law), to comply." For a trust created after 1996 the reformation must be commenced within 90 days after the due date, including extensions, of the gift tax return reporting the transfer, and completed within a reasonable time.
The basis trade-off. Because the house leaves the estate when the plan works, it does not receive a new basis at the grantor's death. The remainder beneficiaries take the grantor's basis, so a long-held home with a large unrealized gain can produce a capital gains bill on sale that offsets much of the transfer-tax saving. That trade is the same one every lifetime-gifting technique makes, and it has grown more important as the estate tax has reached fewer families: for an estate that will never be taxable, giving up the basis adjustment buys nothing.
