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Wednesday, May 1, 2024
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Case Studies |
Baroness Edna and the Depreciation Dilemma, Part 2
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Case:
Will Rogers has been credited with saying "Buy land. They ain't making any more of the stuff." These words were not lost on Edna Appleby. Edna began purchasing parcels of land around her southern California home many years ago. She purchased only investment properties and these properties have paid off handsomely over the years. It was not long before Edna became known in her community as "Baroness Edna."
One property Edna owns is an office building. The building was purchased years ago for $200,000 and is now valued at $1,000,000. Edna, who has learned a thing or two about owning investment properties, has depreciated the building. The basis in Edna's building has been depreciated by $100,000 ($60,000 of which is attributable to the straight-line method of depreciation and $40,000 of which is attributable to the accelerated method).
Although the office building has been profitable for Edna, she decided to diversify her holdings. Edna approached her accountant and asked about the feasibility of donating the office building to Favorite Charity, the nonprofit school her boys attended some many years ago.
Question:
Edna met with Kate, her CPA, and said, "We previously have spoken about either selling my office building or exchanging it for a charitable gift annuity. This time I want to discuss the ramifications of funding a charitable remainder trust (CRT) with my property."
Solution:
Kate explained to Edna that when a property on which accelerated depreciation has been taken is used to fund a CRT, the difference between accelerated depreciation and straight-line depreciation is taxed to the seller as ordinary income.
"As you know, your building has a fair market value (FMV) of $1,000,000 and an original cost basis of $200,000," Kate said. "You have taken $100,000 in depreciation and $40,000 of that was accelerated depreciation. In total, your new basis in the property is $100,000 ($200,000 original basis less $100,000 in depreciation)."
"If you use the building to fund a CRT with Favorite Charity you will receive a tax deduction and a stream of income for the remainder of your life," Kate said. "When a CRT is funded with property on which accelerated depreciation has been taken, the amount of the deduction is reduced," Kate explained. "In your case the situation is this. You have a $1,000,000 property depreciated by $100,000, $40,000 of which is accelerated depreciation. If you donate the property to Favorite Charity, your deduction will be based on $960,000 ($1,000,000 - $40,000 of accelerated depreciation) not the full $1,000,000. This is because of that annoying recapture issue I mentioned. This is the same result whether you donate the property, exchange it for a gift annuity or use it fund a CRT."
"I have to tell you, Kate," replied Edna, "So far it does not sound all that different than a gift annuity."
"Ah, but it is," sighed Kate. "Depreciated property has an effect on the payments from the CRT." Kate explained that payments from a CRT are taxed according to a system of four-tier accounting. "Payments received from the CRT will first be paid out of ordinary income, then capital gain, return of basis and finally tax-free income. Every tier must be exhausted before paying out the next."
"Four-tier accounting sounds difficult," Edna groaned.
"Depreciation recapture and four-tier accounting are among the most complex and technically difficult areas of tax law to understand," said Kate. "And using depreciated property to fund the trust further complicates the capital gain payouts from tier-two. I have summarized the following points of interest for you."
1. Capital gains are taxed in one of three ways: short term (taxed at 43.4%); long term (taxed at 23.8%) or attributable to straight-line depreciation (taxed at 28.8%).
2. Trust payments retain the character of the gifted asset. Therefore, if money can be traced to a capital gain asset that funded the trust, it is taxed as such upon being paid out of the trust. Likewise, if money can be traced to an ordinary income asset, it is taxed as ordinary income when it is paid out of the trust.
3. If ordinary income is used to fund a trust, the first payment is taxed as ordinary income. If the trustee re-invests after the first payment is made as to make the character of the asset inside the trust a capital gain asset, then the subsequent payments will be taxed as capital gain.
"Your tier two payments would be taxed as part long-term capital gain taxed at 23.8% and part capital gain attributable to straight-line depreciation taxed at 28.8%. In addition," Kate told Edna, "the portion of capital gains, both long-term and the amount attributable to depreciation, is bypassed by funding the CRT instead of selling the property." Remembering that Edna prefers numbers to theory, Kate quickly wrote down some figures and passed a notepad to her.
Property Information
| $1,000,000 | - | FMV |
| $200,000 | - | Original Cost Basis |
| $100,000 | - | Total Depreciation |
| $60,000 | - | Straight-Line Depreciation |
| $40,000 | - | Accelerated Depreciation |
Funding a CRT
| $1,000,000 | - | Trust Funding |
| $960,000 | - | Charitable Deduction ($1,000,000 less $40,000 of accelerated depreciation) |
| Four-Tier Accounting Initial Values (assuming property is sold inside of trust) |
| $0 | - | Ordinary Income |
| $900,000 | - | Capital Gain |
| $40,000 | - | Accelerated deprecation recaptured as ordinary income (43.4%) |
| $60,000 | - | Capital Gain Attributable to Straight Line Depreciation (28.8%) |
| $800,000 | - | Long Term Capital Gain (23.8%) ($1,000,000 less $200,000 basis) |
| $100,000 | - | Principal |
"I hope this explains the issues associated with funding a CRT with your building," Kate said. "Now that we have discussed selling the building, funding a CGA and a CRT I will let you think these options over. Please do not hesitate to contact me if I can be of any further assistance."
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