More and more individuals are using living trusts to avoid probate court and transfer their property to named beneficiaries upon their death. A new letter ruling exposes a potential problem if a married couple's revocable trust becomes irrevocable after the first spouse dies and the trust then sells the surviving spouse's home.
In letter ruling 200104005, a husband and wife established a revocable living trust and transferred most of their assets to it, including their principal residence. Upon the wife's death, the revocable trust was split into two: (1) a revocable trust funded with the marital deduction amount and (2) an irrevocable trust that received the balance, including the residence. The surviving husband was the beneficiary of each trust.
The husband had the right to occupy the home and to direct its sale and replacement. The irrevocable trust gave the husband a noncumulative power to withdraw each calendar year, from the principal of the trust, an amount not to exceed the greater of $5,000 or 5% (the "five-or-five" power) of the then aggregate market value of all property included in the trust.
After living in the home for more than 30 years, the husband was forced to move into an assisted living facility. The trustee wanted to sell the residence and asked the IRS if the beneficiary (the husband) could exclude the first $250,000 of gain under IRC section 121.
The husband argued that, since he had the right to occupy the home and the power to force the trustee to rent, lease, sell or replace it, he should be deemed the home's owner.
The IRS disagreed. Under IRC section 121, the $250,000 exclusion of gain on the sale of a principal residence is available only if the taxpayer owns and uses the home as a principal residence for two of the five years preceding the sale. According to the IRS, there is no …