What Is a Retained Interest?
A Split Interest in Property
A retained interest (also called an actuarial interest) is an interest in property that is kept by the grantor (also called the transferor or donor) when property transferred during the grantor's lifetime. When property is split into two interests, one interest is the life or term interest (both further referred to here simply as term interests because that is what the IRS calls them), and the other is the remainder interest. Either the term interest or the remainder interest may be the retained interest.
This type of property ownership may also be arranged with property that you purchase together with another party. This is called a split interest purchase. One purchaser owns the term interest and the other owns the remainder interest. Example of a retained term interest. Assume that you transfer your home to your children, but keep an interest in the home that allows you to live in it for the rest of your life. Your children will receive the home upon your death. You have a retained an interest in the home which is called a life estate. Your children have the remainder interest in the home. They are called the remainder persons.
Example of a retained remainder interest. Assume that you transfer $500,000 to a trust. Your children receive an income stream from the trust for ten years after which time the principal reverts back to you. In this case, your children have the term interest and you retain the remainder interest, or, more accurately, the "reversionary" interest. Example of a split interest purchase. Assume that you and your son buy an apartment building together. You retain the right to receive the rental income generated by the apartment building for five years. Your son owns the remainder interest in the building.
After five years, your son may either continue to receive the income or transfer ownership of the building as he desires. With these types of property ownership arrangements, the interests in the property are split between the parties (grantor and beneficiaries or co-purchasers). The interests are completely separate. Each interest may be encumbered, assigned, gifted, sold (although all co-owners must consent to the sale), or purchased by one or more parties.
Additionally, each interest has its own value. The values are determined using actuarial tables issued by the Treasury and depend upon the value of the property itself, the current interest rate, the length of time each interest is owned, and mortality factors. The value of each interest is important because it determines any transfer taxes that might apply as well as the purchase price that must be paid by co-purchasers in a split interest purchase. Additionally, certain types of retained interests using trusts (these are called "nonqualified interests" by the IRS) are treated in a special way for transfer tax purposes. This discussion is merely a summary that addresses an extremely complex legal area that involves many fact-specific determinations. You should consult a tax advisor regarding your individual situation.
Once Used to Avoid Transfer Taxes
Until 1990, it was common to arrange a property transfer as a retained interest transfer to avoid transfer taxes. Here is an example of how this worked:
Example(s): Fred transfers property worth $2 million to a trust. He receives income from the trust for life and then the principal passes to his children upon his death. Fred's retained interest is valued at $800,000. Fred pays no gift tax on this amount. Assuming no other variables, Fred pays gift tax on $1.2 million ($2 million - $800,000) only. The retained interest is includible in Fred's estate upon his death. However, at that time, the retained interest is valued at only $500,000. Fred saves taxes on $300,000 ($800,000 - $500,000).
How the IRS Treat Certain Retained Does Interests Today?
In 1990, Congress closed the loophole for so-called "estate freezes" by enacting Section 2702. Generally, this rule states that if the donor gives property to a family member while retaining an interest in the transferred property, the donor is treated as having given away the entire property. More specifically, the rule states that if: (1) the grantor "transfers" property to a trust, (2) any beneficiary of the trust is a "member of the grantor's family", and (3) the grantor (or any "applicable family member") retains an "interest in the trust", then the value of the retained interest will be disregarded for gift tax purposes. In other words, in the example above, Fred is taxed on the whole $2 million at the time the trust is created, regardless of the value of the retained interest.
A "transfer" includes a transfer to a new or existing trust, as well as an assignment of an interest to an existing trust. Thus, a lapse of a withdrawal power may qualify as a "transfer" under this rule. A "transfer" also may include a split interest purchase of property by two or more members of the same family. In such cases, the party acquiring the term interest is treated as having acquired the entire property and then transferred the remainder interest to the other party or parties.
A "member of the grantor's family" includes the grantor's spouse, any ancestor or lineal descendant of the grantor or the grantor's spouse, any sibling of the grantor, and any spouses of any such ancestors, descendants, and siblings. An "applicable family member" includes the grantor's spouse, the ancestors of the grantor and the grantor's spouse, and the spouses of the ancestors.
An "interest in the trust" may be an interest for life or a term of years, remainder or reversionary interests, or a power of appointment. For example, Gary transfers property to a trust and retains the power to appoint the income among the beneficiaries for ten years. Gary is considered to have retained an interest in the trust because the IRS treats this arrangement as though Gary had retained a right to the income and paid it to the beneficiaries after receiving it. However, rights in the trust held by a creditor for a bona fide debt is not an "interest in the trust". Therefore, a right to receive payments from the trust under a bona fide note, lease, or employment contract is not a retained interest.
The following types of retained interests are exceptions to the general rule, because the donor does not retain rights in a manner that can affect the value of the transferred interests (these are referred to by the IRS as "qualified interests"):
- Interests retained after an incomplete gift.
- Term income interests in certain tangible property.
- Interests in a qualified annuity.
- Interests in a unitrust.
- Noncontingent remainder interests after a qualified annuity.
- Noncontingent remainder interests after a unitrust.
- Interests in a charitable remainder trust.
- Interests in a charitable lead trust.
- Interests in a pooled income fund.
- Qualified income interests in certain personal residences.
- Interests as a permissible recipient of distribution of income that is in the sole discretion of the trustee.
- Interests retained by a spouse in a trust established for the other spouse if the transfer is deemed to be for full and adequate consideration by reason of Section 2516.
- Interests retained by a spouse after certain transfers to a qualified domestic trust.
Each of these exceptions is fairly limited and has different tax consequences, so you should consult with a tax advisor regarding the best way to structure a gift.
How Does the IRS Treat a Subsequent Transfer of a Retained Interest Valued Under Section 2702?
Inter Vivos Transfers
If you retain an interest that is valued under Section 2702's general rule, and then give that interest to another party, gift taxes are not imposed on the subsequent transfer. This is accomplished by reducing the amount of the "adjusted taxable gifts" you made during the calendar year in which the subsequent transfer takes place.
The amount of the reduction is the lesser of: (1) the increase in your taxable gifts which results from the valuation assigned to the remainder interest at the time of the initial transfer, or (2) the increase in your taxable gifts which results from the subsequent transfer of the interest. In plain English, this means that the reduction is equal to the value of the interest at the time it is kept or at the time it is subsequently transferred, whichever is less. The result is that no additional transfer taxes are due, but you do not actually save transfer taxes if the value of the interest declines.
Example(s): Assume that you transferred $2 million to a trust eight years ago. Your parents received the right to income from the trust for 10 years, and then the principal reverts back to you. Your retained interest was valued at $1.2 million. However, under Section 2702, you paid gift tax on the entire $2 million (assuming no other variables). This year, you gift your retained interest to your children, and you make other gifts amounting to $50,000. Assume that the current value of the retained interest is $1 million. Your adjusted taxable gifts for this year before reduction is $1,050,000. However, because the retained interested was treated according to the general rule of Section 2702, you are entitled to a reduction of your adjusted taxable gifts of the lesser of the value of the interest at the time it is kept ($1.2 million) or now ($1 million). Thus, you are entitled to a reduction of $1 million. Your adjusted taxable gifts for the current year amount to $50,000.
An estate is entitled to a reduction in the decedent's adjusted taxable gifts if a retained interest in a trust is included in the decedent's gross estate and the interest was previously valued under Section 2702. The valuation rules that apply to subsequent inter vivos transfers apply equally to testamentary transfers.
This material was prepared by Broadridge Investor Communication Solutions, Inc., and does not necessarily represent the views of The Retirement Group or FSC Financial Corp. This information should not be construed as investment advice. Neither the named Representatives nor Broker/Dealer gives tax or legal advice. All information is believed to be from reliable sources; however, we make no representation as to its completeness or accuracy. The publisher is not engaged in rendering legal, accounting or other professional services. If other expert assistance is needed, the reader is advised to engage the services of a competent professional. Please consult your Financial Advisor for further information or call 800-900-5867.
The Retirement Group is not affiliated with nor endorsed by fidelity.com, netbenefits.fidelity.com, hewitt.com, resources.hewitt.com, access.att.com, ING Retirement, AT&T, Qwest, Chevron, Hughes, Northrop Grumman, Raytheon, ExxonMobil, Glaxosmithkline, Merck, Pfizer, Verizon, Bank of America, Alcatel-Lucent or by your employer. We are an independent financial advisory group that focuses on transition planning and lump sum distribution. Please call our office at 800-900-5867 if you have additional questions or need help in the retirement planning process.
The Retirement Group is a Registered Investment Advisor not affiliated with FSC Securities and may be reached at www.theretirementgroup.com.
Tags: CAM Annuity, Chevron, ERB, ESRO, ExxonMobil, Financial Planning, Hewitt, In Service Withdrawal, Lump Sum, Northrop Grumman, Option 1 Withdrawal, Pension, Pension Options, Retirement, Retirement Planning, Verizon, 401K, 72t, Age Penalties, Benefit Commencement Date, Workshops, TRG