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Friday, May 3, 2024
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Case Studies |
Casino Next Door
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Case:
Stephen and Diane Clarke, both age 65, have resided in town for many years. However, Stephen inherited the family farm from his mother in 1985. The farm consists of an old home and a barn plus 40 acres of surrounding property. A diesel fuel tank once used by his parents sits behind the barn. At the time of inheritance, the farm property was valued at $100,000. The farm is primarily grazing property which John has leased to a local rancher over the years. Currently, Stephen receives an annual lease payment from the rancher of $3,000. A couple of years ago, an Indian organization built a casino on the adjacent property. Since the farm is also located next to a major Interstate highway, the value of the property has skyrocketed. The operators of the casino have approached Stephen with an offer to purchase the property for $1 million.
Stephen and Diane are very philanthropic and have been considering placing the property into a charitable remainder trust to ultimately benefit the local symphony. They recently attended an estate planning seminar sponsored by the symphony and were pleased to learn that the property could be used to fund a charitable trust. The trust would then sell the property, capital gains taxes would be bypassed and they would receive lifetime income from the trust. When they pass away, the trust assets would then be distributed to the symphony. Stephen and Diane are very impressed with the benefits of the charitable trust. However, there is just one problem - there is a mortgage on the property of $65,000.
Question:
Can Stephen still create a unitrust? Is there a prearranged sale problem? What can be done with the mortgage?
Solution:
Fortunately, there are favorable options to resolve these questions. First, the basic rule on a prearranged sale is that there must be a willing buyer and willing seller. In essence, the trustee of the charitable trust must be able to choose the purchaser and choose the selling price. If Stephen transfers the property into a charitable trust, the trustee is not legally bound at this point and may sell to whomever at the agreed price between the trustee and the prospective buyer.
If the debt is nonrecourse (no personal liability on Stephen's part), then this property could be transferred to a charitable remainder trust if the property has been owned for over five years and the debt is more than five years old. See Sec. 514 (c)(2)(B). However, as is typically the case, the note signed many years ago by Stephen holds him personally liable. As was set forth by the IRS in Private Letter Ruling 9015049, it is not permissible to transfer debt-encumbered property into a charitable trust if the donor is personally liable on the debt. Repayment by the trust of a loan, for which the donor is personally liable, could disqualify the unitrust. Therefore, a means for clearing the debt must be found.
Fortunately, the debt is only a small percentage of the current value. Since there is an old home and barn on the property, this should provide ample security for the debt. Therefore, assuming the bank is agreeable, all of the 40-acre parcel except the two acres of land with the home and barn, could be released from the indebtedness and then transferred to the charitable trust.
There is one further complication - the diesel fuel tank. While there is minimal environmental risk for the remainder of the property that has been used for grazing for many years, the old diesel tank could have leaked diesel fuel into the ground. What is the solution? Since the diesel tank is located behind the barn and because Stephen will retain the property with the mortgage, any potential environmental liability will remain with Stephen. If the property (house and barn) retained is valued at approximately $200,000, then there will be sufficient proceeds from the sale to pay off the mortgage and provide Stephen with liquidity for any potential environmental clean-up of the property. The balance of the property, in this case 80%, could be transferred to the charitable trust and sold free of capital gains taxes.
As an additional safeguard for the charity, Stephen will serve as initial trustee. The 38 acres will be deeded from Stephen and his wife as individuals to Stephen as trustee. He may then sell the property. After the sale, the charity will then be appointed successor trustee and will manage the trust.
This is a very good result for Stephen. He is able to bypass the gain on the sale of the property, receive a substantial income for both him and his wife, benefit from a significant charitable deduction and ultimately make a substantial gift to the local symphony. The retained property is sufficient to pay off the mortgage and provide additional liquidity. From the standpoint of the trustee, the asset transferred to the charitable trust does not retain any debt or environmental liability.
Originally, Stephen fought tooth and nail with the Indian Organization over the development of the casino. However, he now sees that there is indeed a "silver lining in every cloud."
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