[Code of Federal Regulations]
[Title 26, Volume 14]
[Revised as of April 1, 2004]
From the U.S. Government Printing Office via GPO Access
[CITE: 26CFR25.2702-5]

[Page 660-666]
 
                       TITLE 26--INTERNAL REVENUE
 
    CHAPTER I--INTERNAL REVENUE SERVICE, DEPARTMENT OF THE TREASURY 
                               (CONTINUED)
 
PART 25_GIFT TAX; GIFTS MADE AFTER DECEMBER 31, 1954--Table of Contents
 
Sec.  25.2702-5  Personal residence trusts.

    (a)(1) In general. Section 2702 does not apply to a transfer in 
trust meeting the requirements of this section. A transfer in trust 
meets the requirements of this section only if the trust is a personal 
residence trust (as defined in paragraph (b) of this section). A trust 
meeting the requirements of a qualified personal residence trust (as 
defined in paragraph (c) of this section) is treated as a personal 
residence trust. A trust of which the term holder is the grantor that 
otherwise meets the requirements of a personal residence trust (or a 
qualified personal residence trust) 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 (or qualified personal residence 
trusts) of which the term holder was the grantor. For this purpose, 
trusts holding fractional interests in the same residence are treated as 
one trust.
    (2) Modification of trust. A trust that does not comply with one or 
more of the regulatory requirements under paragraph (b) or (c) of this 
section will, nonetheless, be treated as satisfying these requirements 
if the trust is modified, by judicial reformation (or nonjudicial 
reformation if effective under state law), to comply with the 
requirements. In the case of a trust created after December 31, 1996, 
the reformation must be commenced within 90 days after the due date 
(including extensions) for the filing of the gift tax return reporting 
the transfer of the residence under section 6075 and must be completed 
within a reasonable time after commencement. If the reformation is not 
completed by the due date (including extensions) for filing the gift tax 
return, the grantor or grantor's spouse must attach a statement to the 
gift tax return stating that the reformation has been commenced or will 
be commenced within the 90-day period. In the case of a trust created 
before January 1, 1997, the reformation must be commenced within 90 days 
after December 23, 1997 and must be completed within a reasonable time 
after commencement.
    (b) Personal residence trust--(1) In general. A personal residence 
trust is a trust the governing instrument of which prohibits the trust 
from holding, for the original duration of the term interest, any asset 
other than one residence to be used or held for use as a personal 
residence of the term holder and qualified proceeds (as defined in 
paragraph (b)(3) of this section). A residence is held for use as a 
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 as a personal residence. A trust does not meet the requirements 
of this section if, during the original duration of the term interest, 
the residence may be sold or otherwise transferred by the trust or may 
be used for a purpose other than as a personal residence of the term 
holder. In addition, the trust does not meet the requirements of this 
section unless the governing instrument prohibits the trust from selling 
or transferring the residence, directly or indirectly, 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 duration of the term 
interest during which the trust is a grantor trust. For purposes of the 
preceding sentence, a sale or transfer to another grantor trust of the 
grantor or the grantor's spouse is considered a sale or transfer to the 
grantor or the grantor's spouse; however, a distribution (for no 
consideration) upon or after the expiration of the original duration of 
the term interest to another grantor trust of the grantor or the 
grantor's spouse pursuant to the express terms of the trust will not be 
considered a sale or transfer to the grantor or the grantor's spouse if 
such other grantor trust prohibits the 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. In the

[[Page 661]]

event the grantor dies prior to the expiration of the original duration 
of the term interest, this paragraph (b)(1) does not apply to the 
distribution (for no consideration) of the residence to any person 
(including the grantor's estate) pursuant to the express terms of the 
trust or pursuant to the exercise of a power retained by the grantor 
under the terms of the trust. Further, this paragraph (b)(1) does not 
apply to any outright distribution (for no consideration) of the 
residence to the grantor's spouse after the expiration of the original 
duration of the term interest pursuant to the express terms of the 
trust. For purposes of this paragraph (b)(1), a grantor trust is a trust 
treated as owned in whole or in part by the grantor or the grantor's 
spouse pursuant to sections 671 through 678, and control is defined in 
Sec.  25.2701-2(b)(5)(ii) and (iii). Expenses of the trust whether or 
not attributable to trust principal may be paid directly by the term 
holder of the trust.
    (2) Personal residence--(i) In general. For purposes of this 
paragraph (b), a personal residence of a term holder is either--
    (A) The principal residence of the term holder (within the meaning 
of section 1034);
    (B) One other residence of the term holder (within the meaning of 
section 280A(d)(1) but without regard to section 280A(d)(2)); or
    (C) An undivided fractional interest in either.
    (ii) Additional property. 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). The fact that a residence is subject to a mortgage does not 
affect its status as a personal residence. The term personal residence 
does not include any personal property (e.g., household furnishings).
    (iii) Use of residence. A residence is a personal residence only if 
its primary use is as a residence of the term holder when occupied by 
the term holder. The principal residence of the term holder will not 
fail to meet the requirements of the preceding sentence merely because a 
portion of the residence is used in an activity meeting the requirements 
of section 280A(c) (1) or (4) (relating to deductibility of expenses 
related to certain uses), provided that such use is secondary to use of 
the residence as a residence. A residence 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). A residence is not a personal residence 
if, during any period not occupied by the term holder, its primary use 
is other than as a residence.
    (iv) Interests of spouses in the same residence. If spouses hold 
interests in the same residence (including community property 
interests), the spouses may transfer their interests in the residence 
(or a fractional portion of their interests in the residence) to the 
same personal residence trust, provided that the governing instrument 
prohibits any person other than one of the spouses from holding a term 
interest in the trust concurrently with the other spouse.
    (3) Qualified proceeds. Qualified proceeds means the proceeds 
payable as a result of damage to, or destruction or involuntary 
conversion (within the meaning of section 1033) of, the residence held 
by a personal residence trust, provided that the governing instrument 
requires that the proceeds (including any income thereon) be reinvested 
in a personal residence within two years from the date on which the 
proceeds are received.
    (c) Qualified personal residence trust--(1) In general. A qualified 
personal residence trust is a trust meeting all the requirements of this 
paragraph (c). These requirements must be met by provisions in the 
governing instrument, and these governing instrument provisions must by 
their terms continue in effect during the existence of any term interest 
in the trust.
    (2) Personal residence--(i) In general. For purposes of this 
paragraph (c), a personal residence of a term holder is either--
    (A) The principal residence of the term holder (within the meaning 
of section 1034);

[[Page 662]]

    (B) One other residence of the term holder (within the meaning of 
section 280A(d)(1) but without regard to section 280A(d)(2)); or
    (C) An undivided fractional interest in either.
    (ii) Additional property. 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). The fact that a residence is subject to a mortgage does not 
affect its status as a personal residence. The term personal residence 
does not include any personal property (e.g., household furnishings).
    (iii) Use of residence. A residence is a personal residence only if 
its primary use is as a residence of the term holder when occupied by 
the term holder. The principal residence of the term holder will not 
fail to meet the requirements of the preceding sentence merely because a 
portion of the residence is used in an activity meeting the requirements 
of section 280A(c) (1) or (4) (relating to deductibility of expenses 
related to certain uses), provided that such use is secondary to use of 
the residence as a residence. A residence 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). A residence is not a personal residence 
if, during any period not occupied by the term holder, its primary use 
is other than as a residence. A residence is not a personal residence 
if, during any period not occupied by the term holder, its primary use 
is other than as a residence.
    (iv) Interests of spouses in the same residence. If spouses hold 
interests in the same residence (including community property 
interests), the spouses may transfer their interests in the residence 
(or a fractional portion of their interests in the residence) to the 
same qualified personal residence trust, provided that the governing 
instrument prohibits any person other than one of the spouses from 
holding a term interest in the trust concurrently with the other spouse.
    (3) Income of the trust. The governing instrument must require that 
any income of the trust be distributed to the term holder not less 
frequently than annually.
    (4) Distributions from the trust to other persons. The governing 
instrument must prohibit distributions of corpus to any beneficiary 
other than the transferor prior to the expiration of the retained term 
interest.
    (5) Assets of the trust--(i) In general. Except as otherwise 
provided in paragraphs (c)(5)(ii) and (c)(8) of this section, the 
governing instrument 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 (within the meaning of paragraph (c)(7)(i) of this 
section) as a personal residence of the term holder (the ``residence'').
    (ii) Assets other than personal residence. Except as otherwise 
provided, the governing instrument may permit a qualified personal 
residence trust to hold the following assets (in addition to the 
residence) in the amounts and in the manner described in this paragraph 
(c)(5)(ii):
    (A) Additions of cash for payment of expenses, etc.--(1) Additions. 
The governing instrument may permit additions of cash to the trust, and 
may permit the trust to hold additions of cash in a separate account, in 
an amount which, when added to the cash already held in the account for 
such purposes, does not exceed the amount required:
    (i) For payment of trust expenses (including mortgage payments) 
already incurred or reasonably expected to be paid by the trust within 
six months from the date the addition is made;
    (ii) For improvements to the residence to be paid by the trust 
within six months from the date the addition is made; and
    (iii) For purchase by the trust of the initial residence, within 
three months of the date the trust is created, provided that no addition 
may be made for this purpose, and the trust may not hold any such 
addition, unless the trustee has previously entered into a contract to 
purchase that residence; and
    (iv) For purchase by the trust of a residence to replace another 
residence,

[[Page 663]]

within three months of the date the addition is made, provided that no 
addition may be made for this purpose, and the trust may not hold any 
such addition, unless the trustee has previously entered into a contract 
to purchase that residence.
    (2) Distributions of excess cash. If the governing instrument 
permits additions of cash to the trust pursuant to paragraph 
(c)(5)(ii)(A)(1) of this section, the governing instrument must require 
that the trustee determine, not less frequently than quarterly, the 
amounts held by the trust for payment of expenses in excess of the 
amounts permitted by that paragraph and must require that those amounts 
be distributed immediately thereafter to the term holder. In addition, 
the governing instrument must require, upon termination of the term 
holder's interest in the trust, any amounts held by the trust for the 
purposes permitted by paragraph (c)(5)(ii)(A)(1) of this section that 
are not used to pay trust expenses due and payable on the date of 
termination (including expenses directly related to termination) be 
distributed outright to the term holder within 30 days of termination.
    (B) Improvements. The governing instrument may permit improvements 
to the residence to be added to the trust and may permit the trust to 
hold such improvements, provided that the residence, as improved, meets 
the requirements of a personal residence.
    (C) Sale proceeds. The governing instrument may permit the sale of 
the residence (except as set forth in paragraph (c)(9) of this section) 
and may permit the trust to hold proceeds from the sale of the 
residence, in a separate account.
    (D) Insurance and insurance proceeds. The governing instrument may 
permit the trust to hold one or more policies of insurance on the 
residence. In addition, the governing instrument may permit the trust to 
hold, in a separate account, proceeds of insurance payable to the trust 
as a result of damage to or destruction of the residence. For purposes 
of this paragraph, amounts (other than insurance proceeds payable to the 
trust as a result of damage to or destruction of the residence) received 
as a result of the involuntary conversion (within the meaning of section 
1033) of the residence are treated as proceeds of insurance.
    (6) Commutation. The governing instrument must prohibit commutation 
(prepayment) of the term holder's interest.
    (7) Cessation of use as a personal residence--(i) In general. The 
governing instrument must provide that a trust ceases to be a qualified 
personal residence trust if the residence ceases to be used or held for 
use as a personal residence of the term holder. A residence is held for 
use as a 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 as a personal residence. See Sec.  25.2702-5(c)(8) for 
rules governing disposition of assets of a trust as to which the trust 
has ceased to be a qualified personal residence trust.
    (ii) Sale of personal residence. The governing instrument must 
provide that the trust ceases to be a qualified personal residence trust 
upon sale of the residence if the governing instrument does not permit 
the trust to hold proceeds of sale of the residence pursuant to 
paragraph (c)(5)(ii)(C) of this section. If the governing instrument 
permits the trust to hold proceeds of sale pursuant to that paragraph, 
the governing instrument must provide that the trust ceases to be a 
qualified personal residence trust with respect to all proceeds of sale 
held by the trust 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.
    (iii) Damage to or destruction of personal residence--(A) In 
general. The governing instrument must provide that, if damage or 
destruction renders the residence unusable as a residence, the trust 
ceases to be a qualified personal residence trust on the date that is 
two years after the date of damage or destruction (or the date of 
termination of the term holder's interest in the trust, if earlier) 
unless, prior to such date--

[[Page 664]]

    (1) Replacement of or repairs to the residence are completed; or
    (2) A new residence is acquired by the trust.
    (B) Insurance proceeds. For purposes of this paragraph (C)(7)(iii), 
if the governing instrument permits the trust to hold proceeds of 
insurance received as a result of damage to or destruction of the 
residence pursuant to paragraph (c)(5)(ii)(D) of this section, the 
governing instrument must contain provisions similar to those required 
by paragraph (c)(7)(ii) of this section.
    (8) Disposition of trust assets on cessation as personal residence 
trust--(i) In general. The governing instrument must provide that, 
within 30 days after the date on which the trust has ceased to be a 
qualified personal residence trust with respect to certain assets, 
either--
    (A) The assets be distributed outright to the term holder;
    (B) The assets 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
    (C) In the trustee's sole discretion, the trustee may elect to 
comply with either paragraph (c)(8)(i) (A) or (B) of this section 
pursuant to their terms.
    (ii) Requirements for conversion to a qualified annuity interest--
(A) Governing instrument requirements. For assets subject to this 
paragraph (c)(8) to be converted to and held as a qualified annuity 
interest, the governing instrument must contain all provisions required 
by Sec.  25.2702-3 with respect to a qualified annuity interest.
    (B) Effective date of annuity. The governing instrument must provide 
that the right of the term holder to receive the annuity amount begins 
on the date of sale of the residence, the date of damage to or 
destruction of the residence, or the date on which the residence ceases 
to be used or held for use as a personal residence, as the case may be 
(``the cessation date''). Notwithstanding the preceding sentence, the 
governing instrument may provide that the trustee may defer payment of 
any annuity amount otherwise payable after the cessation date until the 
date that is 30 days after the assets are converted to a qualified 
annuity interest under paragraph (c)(8)(i)(B) of this section (``the 
conversion date''); provided that any deferred payment must bear 
interest from the cessation date at a rate not less than the section 
7520 rate in effect on the cessation date. The governing instrument may 
permit the trustee to reduce aggregate deferred annuity payments by the 
amount of income actually distributed by the trust to the term holder 
during the deferral period.
    (C) Determination of annuity amount--(1) In general. The governing 
instrument must require that the annuity amount be no less than the 
amount determined under this paragraph (C).
    (2) Entire trust ceases to be a qualified personal residence trust. 
If, on the conversion date, the assets of the trust do not include a 
residence used or held for use as a personal residence, the annuity may 
not be less than an amount determined by dividing the lesser of the 
value of all interests retained by the term holder (as of the date of 
the original transfer or transfers) or the value of all the trust assets 
(as of the conversion date) by an annuity factor determined--
    (i) For the original term of the term holder's interest; and
    (ii) At the rate used in valuing the retained interest at the time 
of the original transfer.
    (3) Portion of trust continues as qualified personal residence 
trust. If, on the conversion date, the assets of the trust include a 
residence used or held for use as a personal residence, the annuity must 
not be less than the amount determined under paragraph (c)(8)(ii)(C)(2) 
of this section multiplied by a fraction. The numerator of the fraction 
is the excess of the fair market value of the trust assets on the 
conversion date over the fair market value of the assets as to which the 
trust continues as a qualified personal residence trust, and the 
denominator of the fraction is the fair market value of the trust assets 
on the conversion date.
    (9) Sale of residence to grantor, grantor's spouse, or entity 
controlled by grantor or grantor's spouse. The governing instrument must 
prohibit the trust from selling or transferring the residence, directly 
or indirectly, to the

[[Page 665]]

grantor, the grantor's spouse, or an entity controlled by the grantor or 
the grantor's spouse during the retained term interest of the trust, or 
at any time after the retained term interest that the trust is a grantor 
trust. For purposes of the preceding sentence, a sale or transfer to 
another grantor trust of the grantor or the grantor's spouse is 
considered a sale or transfer to the grantor or the grantor's spouse; 
however, a distribution (for no consideration) upon or after the 
expiration of the retained term interest to another grantor trust of the 
grantor or the grantor's spouse pursuant to the express terms of the 
trust will not be considered a sale or transfer to the grantor or the 
grantor's spouse if such other grantor trust prohibits the 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. In the event 
the grantor dies prior to the expiration of the retained term interest, 
this paragraph (c)(9) does not apply to the distribution (for no 
consideration) of the residence to any person (including the grantor's 
estate) pursuant to the express terms of the trust or pursuant to the 
exercise of a power retained by the grantor under the terms of the 
trust. Further, this paragraph (c)(9) does not apply to an outright 
distribution (for no consideration) of the residence to the grantor's 
spouse after the expiration of the retained trust term pursuant to the 
express terms of the trust. For purposes of this paragraph (c)(9), a 
grantor trust is a trust treated as owned in whole or in part by the 
grantor or the grantor's spouse pursuant to sections 671 through 678, 
and control is defined in Sec.  25.2701-2(b)(5)(ii) and (iii).
    (d) Examples. The following examples illustrate rules of this 
section. Each example assumes that all applicable requirements of a 
personal residence trust (or qualified personal residence trust) are met 
unless otherwise stated.

    Example 1. C maintains C's principal place of business in one room 
of C's principal residence. The room meets the requirements of section 
280A(c)(1) for deductibility of expenses related to such use. The 
residence is a personal residence.
    Example 2. L owns a vacation condominium that L rents out for six 
months of the year, but which is treated as L's residence under section 
280A(d)(1) because L occupies it for at least 18 days per year. L 
provides no substantial services in connection with the rental of the 
condominium. L transfers the condominium to an irrevocable trust, the 
terms of which meet the requirements of a qualified personal residence 
trust. L retains the right to use the condominium during L's lifetime. 
The trust is a qualified personal residence trust.
    Example 3. W owns a 200-acre farm. The farm includes a house, barns, 
equipment buildings, a silo, and enclosures for confinement of farm 
animals. W transfers the farm to an irrevocable trust, retaining the use 
of the farm for 20 years, with the remainder to W's child. The trust is 
not a personal residence trust because the farm includes assets not 
meeting the requirements of a personal residence.
    Example 4. A transfers A's principal residence to an irrevocable 
trust, retaining the right to use the residence for a 20-year term. The 
governing instrument of the trust does not prohibit the trust from 
holding personal property. The trust is not a qualified personal 
residence trust.
    Example 5. T transfers a personal residence to a trust that meets 
the requirements of a qualified personal residence trust, retaining a 
term interest in the trust for 10 years. During the period of T's 
retained term interest, T is forced for health reasons to move to a 
nursing home. T's spouse continues to occupy the residence. If the 
residence is available at all times for T's use as a residence during 
the term (without regard to T's ability to actually use the residence), 
the residence continues to be held for T's use and the trust does not 
cease to be a qualified personal residence trust. The residence would 
cease to be held for use as a personal residence of T if the trustee 
rented the residence to an unrelated party, because the residence would 
no longer be available for T's use at all times.
    Example 6. T transfers T's personal residence to a trust that meets 
the requirements of a qualified personal residence trust, retaining the 
right to use the residence for 12 years. On the date the residence is 
transferred to the trust, the fair market value of the residence is 
$100,000. After 6 years, the trustee sells the residence, receiving net 
proceeds of $250,000, and invests the proceeds of sale in common stock. 
After an additional eighteen months, the common stock has paid $15,000 
in dividends and has a fair market value of $260,000. On that date, the 
trustee purchases a new residence for $200,000. On the purchase of the 
new residence, the trust ceases to be a qualified personal residence 
trust with respect to any amount not reinvested in the new residence. 
The governing instrument of the trust provides that the trustee, in the 
trustee's sole discretion, may elect either to distribute the excess 
proceeds

[[Page 666]]

or to convert the proceeds into a qualified annuity interest. The 
trustee elects the latter option. The amount of the annuity is the 
amount of the annuity that would be payable if no portion of the sale 
proceeds had been reinvested in a personal residence multiplied by a 
fraction. The numerator of the fraction is $60,000 (the amount remaining 
after reinvestment) and the denominator of the fraction is $260,000 (the 
fair market value of the trust assets on the conversion date). The 
obligation to pay the annuity commences on the date of sale, but payment 
of the annuity that otherwise would have been payable during the period 
between the date of sale and the date on which the trust ceased to be a 
qualified personal residence trust with respect to the excess proceeds 
may be deferred until 30 days after the date on which the new residence 
is purchased. Any amount deferred must bear compound interest from the 
date the annuity is payable at the section 7520 rate in effect on the 
date of sale. The $15,000 of income distributed to the term holder 
during that period may be used to reduce the annuity amount payable with 
respect to that period if the governing instrument so provides and thus 
reduce the amount on which compound interest is computed.

[T.D. 8395, 57 FR 4269, Feb. 4, 1992; T.D. 8395, 57 FR 11265, Apr. 2, 
1992, as amended by T.D. 8743, 62 FR 66988, Dec. 23, 1997]