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Sunday, May 5, 2024
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Case Studies |
Should a CRT be Funded with an Installment Note?
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Case:
Gayle Goodman sold 10 acres of real estate she had owned for a number of years on an installment sale. The total sales price for the property was $500,000. She received $50,000 down and carried the balance of the purchase price on a 10% note amortized over a period of 25 years with a balloon payment due at the end of five years. Gayle had originally purchased the property for $100,000 and, therefore, will ultimately be required to report a gain of $400,000 on the sale of the property. Four-and-a-half years ago, when she sold the property, she reported a gain of $40,000 as a result of receiving a 10% down payment upon sale of the property. Since then she has reported another $10,000 of gain as a result of receiving principal payments on the note. Therefore, $350,000 of gain still remains to be reported on her tax return.
Gayle was wise in selling the property on the installment sale as the gain is "spread" over the lifetime of the note. Through an installment note, she is able to take advantage of one of the primary concepts oftentimes emphasized by her accountant - that of deferring taxes. However, since selling the property, Gayle has learned that she could have funded a charitable remainder trust with the property prior to the sale and thereby could have avoided the capital gains tax consequences on the sale of the property.
Gayle, who recently turned 70 years of age, is desirous of funding a charitable remainder trust to benefit the local children's hospital where she has volunteered for the past 25 years. Gayle is known as the "teddy bear lady" at the hospital because each time a child is admitted to the hospital, she delivers a special teddy bear just for that particular child. She is beloved by both the staff of the hospital and the children for her undying love for the many children with terminal illnesses and other special needs. She feels deeply that she should leave a substantial gift for the care of the children that will continue after she is gone.
Gayle has recently received an inquiry from the buyer of her property that she consider extending the balloon payment on the note another three years. Apparently, the buyer of the property has run into financial difficulties and will not be able to pay off the note within the next six months, as scheduled. The buyer had considered refinancing the note, but with his credit problems, was not able to obtain financing. He had been in the papers a couple months ago and had been described as a "real estate tycoon who is highly leveraged and has lost many of his properties to foreclosure" due to downturns in the local real estate markets over the past five years. The market is beginning to rebound and he told Gayle he needed additional time to work out of his financial problems.
The problem with this request is that the buyer has not made any payments on the note for the past three months. She fears that if she renegotiates the note, any foreclosure action could be delayed for over a year. She feels that if she complies with his request, the foreclosure would only be postponed.
Question:
In a recent meeting with her attorney, Gayle raised the question as to whether or not the note could be used to fund a charitable trust. In this way, could the remaining gain on the note be avoided? Further, if the buyer did not make any additional payments on the note, would it be advantageous for the trust to foreclose on the property and then resell?
Solution:
Her attorney, Thomas Atkinson, told Gayle that if she transferred the installment note to a charitable trust, the transfer would be considered a "disposition" under Section 453(d) of the Internal Revenue Code. Accordingly, such a disposition would result in the recognition of all of the remaining gain of $350,000 from the original sale. Therefore, Thomas advised against transferring the note at this time to a charitable trust.
Thomas went on to discuss with Gayle the merits of the buyer of the property. Thomas had read another more recent article in the local newspaper describing the buyer's financial situation as extremely poor with bankruptcy "imminent." His counsel was that he did not see the buyer ever fulfilling the terms and obligations of the initial sale. Thomas advised that the foreclosure proceedings begin immediately and further stated that "If the buyer was able to pay the note in full in six months, fine, but I doubt this will happen because of the buyer's current financial problems."
Gayle thought long and hard about beginning the foreclosure proceedings and reluctantly decided to follow the counsel of her attorney. A few months later she was glad she did because shortly after the foreclosure process was completed, the buyer did file for bankruptcy. Had she not initiated the foreclosure process when she did, the property could have been tied up in the bankruptcy courts for months and even years. She is now able to use her property to fund a charitable trust for the benefit of the children's hospital. Since the real estate market was beginning to rebound, the trust is able to sell the property to a developer on a $500,000 cash sale. The capital gains taxes are avoided on the sale, Gayle will receive lifetime income and the children's hospital will receive the trust assets after she is gone - a good ending to a difficult situation.
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