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Sunday, May 5, 2024
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Case Studies |
A Like-kind Exchange with Debt-encumbered Property
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Case:
Robert Boone purchased a rental house in 1990 for $100,000. As a result of depreciation on the property, his depreciated cost basis is $65,000 and the property, until recently, was free and clear. The real estate market has done very well in his locality and the property has appreciated in value to $250,000. However, to help fund a Grandchild's education, he secured a personal credit line with First National Bank using the property as security. The current balance on the line of credit is $10,000.
Robert recently attended a financial and estate planning seminar sponsored by the local hospital. He has been very involved in serving as a volunteer for the hospital over the years and would like to consider making a major gift to the hospital. In the seminar, he was presented with the concept of a charitable remainder trust. He would like to use the property to fund a charitable trust with income payable for his life and then perhaps income to be paid to his child for a period of years after his passing.
However, in a meeting with the Gift Planning Director at the hospital, he was informed that because of the nature of the outstanding debt on the property, he would be unable to transfer the property to a unitrust. Robert does not wish to use other assets to pay off the debt at this time from his savings or investments. Another alternative to pay off the debt might be to secure a "bridge" loan on another parcel of property, but he owns no other rental real estate at this time.
Over the past year, he has had various conversations with his neighbor regarding selling this property. His neighbor, who is very interested in purchasing the rental house, has proposed to Robert that they enter into a like-kind exchange under Section 1031 of the Internal Revenue Code. His neighbor owns an acre lot in a very nice subdivision, the value of which is $240,000. The proposal is for Robert to exchange his equity in his rental property for this acre lot. The problem is that Robert has little or no interest in owning a vacant lot and therefore, has been reluctant to discuss this proposal further.
Question:
Based on this scenario, is there a way in which a charitable trust can still be funded and fulfill not only Robert's objectives, but the desire of his neighbor as well?
Solution:
The Gift Planning Director, in discussing this situation with Robert, states that there is a solution to this problem. He proposes that Robert exchange his debt-encumbered property for his neighbor's acre lot under the like-kind exchange rules, taking advantage of the non-recognition of gain rules. When the exchange is completed, Robert will then own the lot free and clear which can now be utilized to fund a charitable remainder trust.
The results of this transaction are as follows:
(1) By exchanging his rental house for the acre lot, Robert will be required to treat the $10,000 debt relief as 'boot' resulting in capital gain recognition of $10,000. Therefore, Robert's basis in the lot will be $75,000 (original basis plus $10,000 of gain recognition). As a result of transferring the lot to the unitrust, which may in turn sell the property, Robert will avoid tax on the $165,000 capital gain.
(2) Robert, who is 75 years of age, decides to fund a 7% unitrust for his life plus a term of ten years for his Grandchild. Therefore, his charitable income tax deduction will be $63,005. Based on his income tax bracket, this will result in tax savings of almost $20,000.
(3) Robert has fulfilled his desire to make a substantial gift to the hospital through the charitable trust and through the like-kind exchange has solved the debt-encumbered problem.
(4) Lastly, Robert is pleased that he is able to pass on a stream of income to his Grandchild for a term of years after his passing.
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