IRS Section 2702: GRATs, QPRTs, and the Zero Valuation Rule

IRS Section 2702 is a gift tax valuation rule: when you transfer property into a trust for family members and keep an interest for yourself, the IRS treats your retained interest as worth zero unless it fits one of a few defined exceptions. That default rule inflates the taxable gift to the full value of what you put in. The exceptions, particularly the grantor retained annuity trust (GRAT) and the qualified personal residence trust (QPRT), are the reason Section 2702 still comes up constantly in estate planning: they define the exact shape a retained interest has to take if you want to subtract its value from the gift.¹

What the Zero Valuation Rule Does

Normally, when you gift property through a trust while keeping an interest for yourself, the taxable gift equals the full value of the property minus the actuarial value of whatever you retained. Put $5 million into a trust, keep a stream of payments worth $3.5 million on paper, and the reported gift is $1.5 million.

Section 2702 overrides that math for family transfers. Unless your retained interest meets strict structural requirements, its value is treated as zero. In the same example, the entire $5 million becomes a taxable gift reported on Form 709. The rule was enacted to shut down arrangements where grantors retained vaguely defined income interests, assigned them generous actuarial values, and passed future appreciation to heirs at a fraction of its real gift tax cost.¹

When Section 2702 Applies

Three conditions have to line up. You make a transfer in trust. You or a family member retain an interest in that trust. The beneficiary is a “member of the transferor’s family.” If the beneficiary is unrelated, Section 2702 doesn’t apply and normal valuation methods control.¹

The family definition covers your spouse, any ancestor or lineal descendant of you or your spouse, any brother or sister, and the spouse of any of those people.² Nieces, nephews, and cousins fall outside it because they are not lineal descendants, brothers, or sisters of the transferor.

The rule reaches past formal trusts. Certain “term interests” in property, such as an arrangement where you and a family member jointly buy property and one of you gets use of it for a period while the other gets it afterward, can be recharacterized as trust transfers subject to zero valuation. Avoiding trust formalities does not avoid the rule.

Narrow Exception for Tangible Property

A retained term interest in tangible property like artwork, antiques, or undeveloped land can escape zero valuation if your failure to exercise your rights during the term would not meaningfully affect the value of the remainder. In that case, the retained interest gets valued at what an unrelated buyer would pay for it.¹ The exception exists because a painting doesn’t lose value the way a mismanaged investment portfolio can. In practice it comes up rarely compared to the qualified interest exceptions.

The Qualified Interest Exceptions

If your retained interest qualifies as a “qualified interest,” you can subtract its full actuarial value from the transfer. Section 2702 recognizes three types.¹

A qualified annuity interest is the right to receive a fixed dollar amount, or a fixed percentage of the initial trust value, paid at least once a year.³ The payment is locked in when the trust is created. Fund a trust with $10 million and retain a 7% annuity, and you receive $700,000 per year whether the trust grows or shrinks. This is what drives GRATs.

A qualified unitrust interest works the same way, except the payment recalculates each year as a fixed percentage of the trust’s current fair market value.³ Payments rise when the trust grows and fall when it shrinks. Annual revaluation adds administrative complexity, so this type is less common.

A qualified remainder interest is a non-contingent remainder, but only if every other interest in the trust is itself a qualified annuity or unitrust interest.¹ It rarely drives planning on its own, because most planning aims to minimize the remainder’s value, not maximize it.

Drafting Requirements That Keep an Interest Qualified

The regulations impose strict conditions. Missing any of them triggers zero valuation for the whole retained interest.

The payment period must be for the holder’s life, a specified number of years, or the shorter of those two. Using the longer of the two, or building in discretionary extensions, disqualifies the interest.³
The trust instrument must prohibit commutation, meaning no prepayment or early termination of the interest.³
No additional contributions can be made after the trust is funded.
No distributions can go to other beneficiaries during the qualified interest term.
The trustee cannot satisfy annuity or unitrust payments with a promissory note or other debt instrument; payments must be actual cash or property.⁴
If the annuity is expressed as a percentage of initial fair market value and that value later proves wrong, the trust must require the difference to be paid or refunded.³

How the Section 7520 Rate Sets the Value

Once an interest qualifies, its present value is calculated using the Section 7520 rate, equal to 120% of the federal mid-term rate for the month of transfer, rounded to the nearest two-tenths of a percent.⁵ For early 2026, the rate has been running between 4.6% and 4.8%. A higher rate makes the retained annuity worth more on paper and shrinks the taxable gift; a lower rate does the opposite.

Grantor Retained Annuity Trusts

A GRAT is the standard structure built on the qualified annuity exception. You put assets into an irrevocable trust, keep the right to receive a fixed annuity for a set number of years, and whatever remains passes to your beneficiaries. The taxable gift is the value of what you put in minus the actuarial value of the annuity stream.

The planning value comes from the gap between the Section 7520 rate and the trust’s actual return. The IRS assumes the trust will earn the 7520 rate. If it earns more, the excess appreciation passes to beneficiaries without additional gift tax. If it underperforms, the annuity payments simply return your property and no one is worse off from a tax perspective.

Zeroed-Out GRATs

Most GRATs are drafted so the annuity payments are large enough that their present value nearly equals the value of the transferred assets. That produces a taxable gift at or near zero and preserves the grantor’s lifetime exemption. The entire bet is that the assets outperform the 7520 rate.

Annuity payments can increase over the GRAT term, but each year’s payment cannot exceed 120% of the prior year’s.³ A schedule that steps up by exactly 20% each year keeps more assets inside the trust in the early years, when compounding does the most work.

Mortality Risk and Rolling GRATs

The main risk is dying before the annuity term ends. If that happens, some or all of the trust assets get pulled back into your taxable estate as though the transfer never occurred.⁶ Longer terms carry more risk.

Rolling GRATs address this. Instead of one long trust, you set up a series of short-term GRATs, often two-year terms. Each annuity payment funds the next GRAT. If the grantor dies during a term, only that one GRAT fails; the earlier ones have already finished and moved their remaining assets out.

Assets That Fit

GRATs work best with assets likely to appreciate quickly. Pre-IPO stock, founder shares in a growing company, and concentrated equity positions are the classic candidates. You lock in today’s value and the 7520 hurdle rate; everything above that goes to your heirs for free.

Grantor Trust Income Tax Treatment

A GRAT is a grantor trust for income tax purposes, so you personally pay income tax on all trust earnings even after the assets leave your ownership.⁷ That’s actually favorable. Your tax payments effectively transfer additional wealth to the beneficiaries with no gift tax cost, because the trust grows undiluted by taxes.

Many GRATs also include a power of substitution, letting you swap your own assets for trust assets of equal value. This lets you pull appreciated assets back into your personal estate (where they’ll receive a stepped-up basis at death) and push high-basis assets into the trust. Because the swap involves equivalent value, it triggers neither gain nor gift tax.

Qualified Personal Residence Trusts

A QPRT uses a different qualified interest: the retained right to live in a home for a fixed number of years. When the term ends, the residence passes to the remainder beneficiaries.¹

The taxable gift equals the home’s fair market value minus the actuarial value of your right to occupy it for the term, calculated using the Section 7520 rate.⁵ A longer term produces a bigger discount but also a bigger chance you won’t survive it.

What Property Qualifies

Only your principal residence or one other residence qualifies, and the trust can hold an undivided fractional interest in one.⁸ The property has to be used primarily as your residence when you occupy it; a home operated as a bed-and-breakfast or hotel does not qualify. Adjacent land and structures used for residential purposes can be included. Furniture and other personal property cannot.

The trust may hold limited cash for mortgage payments, property taxes, and improvements, but only amounts expected to be spent within six months. Cash held to buy a replacement residence must be spent within three months.⁸ Income-producing assets beyond the residence itself are not allowed.

When the Term Ends

Once the retained term expires, you either move out or start paying the remainder beneficiaries fair market rent. Many grantors pay rent, which shifts more wealth out of the estate without additional gift tax, since rent is payment for use of property you no longer own.

If the home is sold during the trust term, the proceeds have to be reinvested in a replacement residence. Otherwise, the trust either terminates or converts into a qualified annuity trust for the remainder of its term.

The Same Mortality Trap

QPRTs share the GRAT’s central risk: if you die before the term ends, the full fair market value of the home returns to your taxable estate and the planning benefit disappears.⁶ There is no rolling QPRT strategy, so term length is a real trade-off between discount size and survival probability, weighed against life expectancy tables.

Where GRATs Fall Short: The GST and ETIP Problem

If your goal is to benefit grandchildren or later generations, Section 2702 planning collides with the generation-skipping transfer tax. During a GRAT’s annuity term, the trust assets remain potentially includible in your estate because you could die before the term ends. That window is the “estate tax inclusion period,” or ETIP.⁹

You cannot effectively allocate your GST exemption to a GRAT while the ETIP is running. Any allocation waits until the ETIP closes, and at that point the value used for the allocation is the property’s value at the close of the ETIP, not the lower value when the trust was funded.¹⁰ If the whole point of the GRAT was to shift appreciation out, that appreciation has already happened before you can shield it from GST tax. Planners chasing generation-skipping goals typically layer other trust structures around or beside the GRAT rather than relying on the GRAT itself.

What the 2026 Exemption Means for This Planning

The One Big Beautiful Bill Act, signed into law on July 4, 2025, set the federal estate and gift tax exemption at $15 million per individual for 2026, or $30 million for married couples combining their exemptions.¹¹ For estates below that threshold, the immediate urgency of Section 2702 planning is lower.

GRATs and QPRTs still matter above the threshold and for anyone concerned about future legislative changes. Assets moved through a completed GRAT or QPRT stay outside the estate regardless of later law changes. And in a zeroed-out GRAT, every dollar of appreciation transferred consumes no exemption at all, which keeps the structure valuable at any exemption level for taxpayers holding rapidly appreciating assets.

The Section 7520 rate environment shapes the return threshold. With the rate running between 4.6% and 4.8% in early 2026, trust assets need to beat roughly that annual return for a GRAT to move meaningful value to beneficiaries.

1
Office of the Law Revision Counsel. 26 U.S. Code 2702 – Special Valuation Rules in Case of Transfers of Interests in Trusts
2
Office of the Law Revision Counsel. 26 U.S. Code 2704 – Treatment of Certain Lapsing Rights and Restrictions
3
eCFR. 26 CFR 25.2702-3 – Qualified Interests
4
GovInfo. 26 CFR 25.2702-3 – Qualified Interests
5
Internal Revenue Service. Section 7520 Interest Rates
6
Office of the Law Revision Counsel. 26 U.S. Code 2036 – Transfers With Retained Life Estate
7
Office of the Law Revision Counsel. 26 U.S. Code 675 – Administrative Powers
8
eCFR. 26 CFR 25.2702-5 – Personal Residence Trusts
9
eCFR. 26 CFR 26.2632-1 – Allocation of GST Exemption
10
Office of the Law Revision Counsel. 26 U.S. Code 2642 – Inclusion Ratio
11
Internal Revenue Service. What’s New – Estate and Gift Tax