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Monday, May 6, 2024
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Case Studies |
A Lead Trust Story with a Charitable Ending
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Case:
Rodney Edwards, age 60, is a real estate mogul and owns a number of income-producing properties. One of his prime properties is a 30-unit apartment building valued at $2 million. His net annual income return on the property is $200,000 per year. The property is located in a very upscale retirement community and has been appreciating by 4% per year. He expects that both the annual income yield and appreciation rates, at 10% and 4%, respectively, will continue for many years to come. The retirement community continues to grow and the demand for housing in this Sun Belt area is very strong. Rodney owns one of only three apartment buildings in this community and senior adults have been pleased with the care and attention he gives to his property. Because of these factors, most of the tenants have signed long-term leases and, therefore, the apartment building is fully leased.
Rodney, a widower, has an estate valued at $10 million that is primarily invested in real estate. The properties generate over $500,000 annually and he realized long ago that he did not need this kind of income to support his very frugal lifestyle. Many years ago, he and his wife made the decision that if their income ever reached $50,000 annually they would begin to contribute at least 10% of the income to their favorite charities. Well, as their income grew over the years, they continued to raise this percentage of giving. Currently, Rodney gives well over the amount that he can write off on his tax return - much to the dismay of his CPA! In fact, just this year he was presented the "Philanthropist of the Year" award for the impact he has had as a philanthropist in the local community.
Rodney has two sons, ages 25 and 30. He has been concerned about transferring his wealth to them, as they have not yet (at least in his mind) shown that they can handle money effectively. Not yet married, they have been influenced by the "you can have it all now" philosophy and have incurred a fair amount of credit card debt. However, Rodney has been using his annual exclusion to make gifts to them each year, primarily to see how they handle the money. They have used the money to pay down some of the debt and have invested a small amount in the markets, but continue to use most of the money for "stuff."
Rodney has attended a number of financial and estate planning seminars sponsored by the many charities he supports. Recently, he heard of a concept called the charitable lead trust. He felt that this would work well for his 30-unit apartment building. He could transfer the property to a lead trust, receive an up-front charitable gift tax deduction and have income paid to charity for a term of years. At the end of the term, the property would be transferred to his two sons. This was attractive for Rodney because he does not necessarily need the income from the apartment building and his charitable gifts now exceed his AGI limitations each year. However, if the building continues to appreciate as projected at 4% per year, a substantial asset will pass to his sons at the end of the trust term - an asset that they may still not be able to "handle," even at their increased ages. For instance, if Rodney creates a 10% lead trust for a term of 15 years, the apartment building would be projected to be worth over $4.5 million upon distribution to the two sons - a value much too high for Rodney's comfort zone.
Question:
Rodney decided to pose his concerns to the Director of Gifts and Estates, Julie Knox, at one of his favorite charities. He asked her if there was a way to transfer the lead trust assets upon termination into another trust that would ultimately govern the distributions to his sons. He was concerned about the substantial lump-sum distribution from the lead trust and would prefer to see the distribution to his sons spread out over a period of time. Further, his desire was for the principal of this particular trust to ultimately pass to charity.
Solution:
Julie stated that there may be a nice solution that addresses Rodney's concerns and objectives. To her knowledge there was no IRS precedent for this solution, but she thought it should work well. Rodney would set up the lead trust just as he had originally planned, with a 15 year term and 10% payout using an annuity lead trust. The charitable gift tax deduction would be approximately $1.9 million, resulting in a taxable gift of only $100,000. Upon the termination of the lead trust, the apartment building would be transferred to a charitable remainder unitrust (CRUT) for a term of years (up to 20 years). The income from the CRUT would be paid to his two sons for the selected term. Then, upon the expiration of the CRUT term, the trust assets would pass to charity. Julie stated that this would work especially well since the apartment building (which would have very low cost basis) could be sold inside the CRUT without payment of capital gain taxes. The CRUT could then diversify its investments and, with $4.5 million of value, the trust would distribute well in excess of $100,000 per year to each son, even if the lowest allowable payout of 5% was selected.
Rodney loved this idea. He could spread out the inheritance from the lead trust over a period of time and ultimately give the assets to charity. One final note - Julie emphasized that he needed to run this idea by his advisors for final review and approval.
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