IRS Letter Casts Doubt on 'Sale with Debt Forgiveness' Technique

Many tax and estate planning practitioners use a technique, generally known as a "sale with debt forgiveness" to establish a step-up in basis for the buyer. Usually such transactions take the form of a parent "selling" their home to their child for a promissory note and then later "forgiving" the debt. The hoped-for consequences are:

1. The debt forgiveness will constitute a gift of a present interest that will be fully or partially shielded by the parents' annual gift tax exclusion; and
2. The child will be treated as having purchased the house for the amount of the note and will receive a basis in the house equal to the face amount of the promissory note.

The question always lurking in the back of everyone's mind is 'Does this technique really work or will the IRS collapse it as being prearranged, and just how much time must elapse between the sale and later debt forgiveness if this technique is to succeed?'

We now have some clarification. In IRS Private Letter Ruling 200603002, the taxpayer made a sale of life insurance policies to a trust in year 1 and forgave the debt "a few months later" in year 2 "before any payments were made on the note."

The IRS considered this part of a prearranged plan wherein the parents knew all along that they would be forgiving the debt. The IRS ruled that a gift was made in year 1 for the face amount of the note. The IRS ruling was particularly troublesome for the parents because the parents had already used up their annual exclusions to their children by making other gifts in year 1 and now, with the note being treated as a gift in year 1, the parents would be utilizing some of their federal gift tax exemption.

The lesson: Although there still is no "bright line" as to how much time must elapse between the sale and forgiveness, the more time that elapses the better, and "a few months" is not enough. Safety also dictates that the children ought to make some payments on the note to make the transaction appear bona fide.

Paul T. Czepiga is an ElderLawAnswers member in Newington, CT.