Retained Interest: Valuation for Gift and Estate Tax

A retained interest represents a part of property ownership that an individual holds back after transferring that property to another person or entity. This is a common tool in estate planning to transfer wealth in a structured manner. When a person transfers property but retains an interest, they split the property’s value into two parts: the interest they keep and the future interest they have given away. This division is central to how these transfers are treated for tax purposes.

Common Applications of Retained Interests

Grantor Retained Annuity Trusts

One prevalent application of a retained interest is the Grantor Retained Annuity Trust (GRAT). An individual, the grantor, transfers assets into an irrevocable trust and retains the right to receive a fixed annual payment, or annuity, for a set number of years. The objective of a GRAT is to transfer the future appreciation of the trust’s assets to beneficiaries with minimal or no gift tax. If the assets in the trust grow at a rate higher than the interest rate assumed by the IRS, that excess growth is transferred to the beneficiaries free of additional estate or gift tax.

Qualified Personal Residence Trusts

Another vehicle is the Qualified Personal Residence Trust (QPRT), designed for transferring a primary or vacation home. A homeowner transfers the title of their house into an irrevocable trust but retains the right to live in it for a specified number of years, which is the retained interest. The purpose is to transfer the home to beneficiaries at a reduced gift tax cost and remove its future appreciation from the grantor’s taxable estate. When the trust term ends, ownership passes to the beneficiaries, and if the grantor continues living in the home, they must pay fair market rent to the new owners.

Gift and Estate Tax Implications

The tax consequences of transferring property with a retained interest are governed by the Internal Revenue Code (IRC). When such a transfer occurs, it is a gift to the beneficiaries, and the value of this taxable gift is the fair market value of the property minus the value of the interest kept by the grantor. This calculation is subject to rules under IRC Section 2702, which distinguishes between “qualified” and “non-qualified” retained interests.

A qualified interest is a right to receive fixed payments, like an annuity, or payments that are a fixed percentage of the trust’s value determined annually. If an interest is non-qualified, the “zero-value rule” applies, treating its value as zero for gift tax purposes. This makes the taxable gift equal to the entire property value and forces grantors to structure their retained interests in specific, predictable ways to ensure they have a calculable value.

Retained interests also have estate tax implications under IRC Section 2036. This section dictates that if a grantor transfers property but retains rights like possession or income and dies during that term, the full value of the property is included in the grantor’s gross estate. For example, if a grantor of a QPRT dies before the trust term ends, the residence’s value is included in their taxable estate as if the trust never existed.

Valuation of Qualified Retained Interests

Calculating the value of a qualified retained interest is a technical process that relies on two main components provided by the IRS to determine the amount of the taxable gift.

The Section 7520 Rate

The first component is the Section 7520 rate, an interest rate published monthly by the IRS used to determine the present value of annuities and other interests. The rate in effect for the month of the transfer is used in the valuation. A higher Section 7520 rate increases the present value of a retained annuity, which increases the value of the retained interest. This results in a smaller remainder interest and a lower taxable gift, while a lower rate has the opposite effect.

IRS Actuarial Tables

The second component is the set of actuarial tables published by the IRS, such as Table S and Table B. These tables provide factors that, when combined with the Section 7520 rate, translate future payments into a present-day value. The tables account for variables like the length of the trust term or the age of the person holding the interest. To value a retained interest, an annuity payment is valued by applying a factor from these tables to determine its total present worth. This calculated value is then subtracted from the property’s fair market value to arrive at the taxable gift amount.