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Thursday, May 2, 2024
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Case Studies |
An Installment Sale Transfer without Capital Gain Taxation
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Case:
Richard Andrews, age 60, and his two college buddies decided to purchase a 10-acre parcel of property on the outskirts of San Francisco 30 years ago. Their idea at the time was, "Let's buy the property and use it as our retirement." Never did they imagine 30 years ago what a good idea this was! Well, as the story goes, they formed a partnership, with each retaining a 1/3 interest in the partnership. Since they basically had no money to pay the $10,000 necessary to purchase this parcel, they decided to solicit a local bank to lend them 100% of the purchase price. The banker reluctantly agreed to lend them the funds, but felt that the property was excellent security for the loan. They were charged what seemed to them a usurious rate of interest, but they were able to pay off the loan in two years.
Over the years, the property has appreciated substantially in value due to its prime location. Two years ago, a developer came to them and made an offer they couldn't refuse - $3.3 million! Therefore, their dream to use this property as their retirement actually had come true. There was only one catch in the developer's offer: he wanted to purchase the property via an installment sale - $300,000 down with a carryback note on the property of $3 million. The terms of the note were as follows: interest only at 10%, all due and payable in five years with no prepayment penalties. Therefore, over the past two years, the partnership has been receiving interest installments of $300,000. The interest payments flow through the partnership to each of the three partners, including Richard, at $100,000 apiece.
Richard and his buddies liked the idea of the installment sale because they had to report only the gain on the down payment of $300,000. In other words, each had to report a gain of $100,000 (less a minor basis element). However, they realized that "payday" would come, and when the loan was eventually paid off in five years, they would be required to report the remaining $3 million in gain. Just this past week, Richard received a phone call from the developer, who stated that his company is beginning the preliminary plans to develop the property. As a result, the developer was pleased to inform Richard that the $3 million loan would probably be paid in full by year-end. Richard had two different reactions to this news. The first was one of elation because he would receive the $1 million in cash; the other was one of dread because he would be required to report, and pay tax on, capital gain of $1 million on this year, as would both of the other partners.
Since making the investment in this property 30 years ago, Richard has become an active philanthropist. When he made the investment, he was planning on using the proceeds from the property for himself and his own personal needs, but now feels that he has a "higher calling" for his good fortune - to use the proceeds for charitable purposes. He has a number of charities in mind that could benefit greatly from a million dollars, but he needs the income from this investment to sustain him throughout his retirement years. He was thinking that he may transfer the million dollars to those charities after his passing through some type of bequest arrangement.
Question:
Richard ideally would like to bypass the capital gains taxes of approximately $150,000 when the developer pays off the note. He had recently met with the Director of Estate Planning, Susan Owens, at one of his favorite charities to discuss the transfer of an installment note to charity. He was hoping that possibly the note (or his interest in the note) could be used to fund a charitable remainder trust. However, Susan correctly stated that the transfer of this note to charity would be considered a disposition under Sec. 453(d) of the Code. Accordingly, the disposition of the note is treated the same as a payoff of the note requiring recognition of all the remaining gain. Richard stated, "How can this be? Can't you avoid capital gains tax inside a charitable trust?" Susan replied, "Yes, in cases where the actual property is transferred to a charitable trust and then sold. In your case, the property has already been sold and the gain is now 'trapped' inside the installment note."
Solution:
Susan went on to ask some probing questions of Richard because he had not told her the installment note was held inside a partnership in which he had a 1/3 interest. After finding this out, she said, "I have a wonderful idea!" She went on to explain that Richard could transfer his partnership interest into a charitable remainder trust. Transferring the partnership interest to a charitable trust would not trigger the gain on the installment note. Then, when the note was paid off, his $1 million would flow through from the partnership to the trust. The capital gain on the note would flow through to the trust as well and, therefore, would not be subject to capital gains taxation. Therefore, the entire $1 million would be available for reinvestment inside the trust.
As a result of Susan's recommendations, Richard decided to fund a 7% unitrust with his partnership interest. The developer did, in fact, pay off the note by year end. Richard was very pleased that he did not end up sending $200,000 of capital gains taxes to Washington. The entire $1 million is now at work inside the trust for Richard's benefit and will eventually pass to his favorite charities upon his death.
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