What Is the IRC 2702 Zero-Valuation Rule?

Federal tax law includes a gift tax for transfers made during life and an estate tax for assets transferred at death. These are linked by a lifetime exemption, which is $13.99 million per person for 2025. An individual can transfer up to this amount in total gifts and bequests without incurring federal tax.

A common strategy to manage a taxable estate is making lifetime gifts. The tax code allows an annual gift exclusion of $19,000 per recipient for 2025, which can be given to any number of individuals each year without using the lifetime exemption. The Internal Revenue Service (IRS) has specific regulations for these transfers, particularly when the person making the gift retains some benefit from the property.

The Zero-Valuation Rule Explained

A provision within the Internal Revenue Code, Section 2702, addresses the valuation of gifts when assets are transferred into a trust for family members. This rule is triggered when three conditions are met: there is a transfer of property into a trust, the beneficiaries are members of the transferor’s family, and the person creating the trust (the grantor) retains an interest in the trust’s assets.

When these elements are present, the interest retained by the grantor is valued at zero for gift tax purposes. This means the entire value of the property placed in the trust is considered a taxable gift, even though the grantor is still entitled to a future benefit. This prevents grantors from artificially lowering a gift’s value by claiming a retained interest that lacks a clear, ascertainable value.

The definition of a “family member” under this section is broad and includes:

• The grantor’s spouse
• Any ancestor or lineal descendant of the grantor or their spouse
• Any sibling of the grantor
• The spouse of any of the above family members

To illustrate, consider a parent who transfers a $1 million income-producing property into a trust. The trust terms state the parent will receive all income from the property for 10 years, after which the property passes to their child. If the parent’s right to receive income does not meet specific exceptions, Section 2702 values that retained interest at $0. The parent is then treated as having made a taxable gift of the full $1 million in the year the trust is created.

Qualified Interest Exceptions

The tax code provides exceptions to the zero-valuation rule for a “qualified interest.” A retained interest that meets this definition is not valued at zero. Instead, its present value can be subtracted from the total value of the property transferred, reducing the taxable gift amount.

To be qualified, the retained interest must give the grantor an irrevocable right to receive fixed and determinable payments at least annually. Because the payments are predetermined, their present value can be calculated using prescribed actuarial methods. The two primary forms of qualified interests are a qualified annuity interest and a qualified unitrust interest, which form the basis for specific types of trusts.

Grantor Retained Annuity Trusts

A Grantor Retained Annuity Trust (GRAT) is designed around a qualified annuity interest. When a grantor transfers property to a GRAT, they retain the right to receive a fixed dollar amount each year for a specified number of years. This fixed annual payment is the “annuity” and constitutes a qualified interest. If the assets in the GRAT appreciate at a rate higher than the IRS-specified interest rate used for valuation, that excess appreciation passes to the beneficiaries free of additional gift tax.

Grantor Retained Unitrusts

A Grantor Retained Unitrust (GRUT) is based on a qualified unitrust interest. Instead of a fixed dollar amount, the grantor of a GRUT retains the right to receive a fixed percentage of the trust’s assets, which are revalued annually to determine the payment. This structure also creates a qualified interest. With a GRUT, the annual payment to the grantor fluctuates with the value of the trust’s assets, allowing the grantor to share in that growth.

The Personal Residence Trust Exception

The tax code also provides an exception for personal residences, allowing an individual to transfer a home to a trust for family members without the retained right to live there being valued at zero. The vehicle for this is the Qualified Personal Residence Trust (QPRT). A QPRT permits a grantor to place a personal residence into an irrevocable trust and retain the right to live in it for a specified term of years.

For a property to be eligible, it must be the grantor’s principal residence or one other residence, like a vacation home. A QPRT cannot hold significant assets other than the residence, though it may hold limited cash for expenses.

The trust document must prohibit the trust from selling the residence during the grantor’s retained term and holding the cash. If the residence is sold, the trust must either terminate and distribute the assets to the grantor or convert into a GRAT, paying the grantor a qualified annuity.

If the grantor outlives the trust term, their right to use the home expires, and the property passes to the beneficiaries. If the grantor wishes to continue living in the home, they must pay fair market rent to the new owners, which provides another way to transfer wealth without gift tax.

The value of the taxable gift is the home’s fair market value minus the present value of the grantor’s retained right to live in it. This strategy is contingent on the grantor surviving the trust term; if the grantor dies before the term ends, the full value of the residence is included in their taxable estate, negating the benefit.

Valuation and Gift Tax Reporting Requirements

The present value of a retained interest must be determined using specific actuarial tables and an interest rate published monthly by the IRS, known as the Section 7520 rate. This rate reflects current market conditions and is used to standardize the valuation of annuities, life estates, and remainder interests. A lower Section 7520 rate results in a higher value for the retained interest, thereby reducing the amount of the taxable gift.

The calculated taxable gift must be reported to the IRS by filing Form 709, the United States Gift (and Generation-Skipping Transfer) Tax Return. The return is due on April 15 of the year following the year the gift was made. Filing is required even if no tax is due because the gift amount is covered by the grantor’s lifetime exemption.

Properly completing Form 709 requires detailed documentation. The filer must attach a qualified appraisal of the property to substantiate its fair market value and a copy of the trust document. The return must also include a detailed explanation of how the value of the retained interest was calculated, showing the Section 7520 rate and actuarial computations used.