IRS ruling casts doubt on sale/debt-forgiveness technique

A common tax and estate planning technique involves a sale of property coupled with debt forgiveness. The idea is to establish a "stepped-up" basis for the buyer.  But, a recent IRS ruling casts doubt on such transactions. The typical scenario is this - a parent "sells" their home to their child for a promissory note and then later "forgives" the debt. The hope is that 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 that 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. But, the questions have always been whether IRS would challenge the transaction as having been prearranged, and how much time had to elapse between the sale and the debt forgiveness. The IRS has now clarified the matter a bit.  In a recent ruling, the parents 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 the children had made any payments on the note. The IRS held that this was all a prearranged plan where the parents knew all along that they would be forgiving the debt. IRS ruled that a gift was made in year 1 for the face amount of the note.

So what's the lesson? Although there is still no bright line as to how much time must elapse between the sale and forgiveness, the more time that elapses the better. A few months is probably not going to cut it. Also, it probably is a good idea that the children make some payments on the note to at least make the transaction appear to be bona fide. Priv. Ltr. Rul. 200603002 (Oct. 24, 2005).