Friday April 19, 2024

4.7.2 Mortgage or Debt

Mortgage or Debt

Bargain Sale Treatment:  The majority of real estate is encumbered by debt.

Debt Financed Income:  If the debt is less than five years old and the donor has owned the property for less than five years, there may be acquisition indebtedness.

Bargain Sale Treatment
The majority of real estate is encumbered by debt. If contributed real estate is subject to a mortgage, the donor will receive a charitable deduction equal to only the equity portion of the gift. In other words, the donor may not claim a deduction for the encumbered portion of the property.

In addition, the transfer of debt-encumbered property to charity is treated as a "bargain sale." Reg. 1.1011-2(a)(3). Specifically, the relief of indebtedness triggers gain to the extent that the debt exceeds the allocated cost basis. In short, the contribution is viewed as a sale to charity with the sale price being equal to the mortgage. Finally, the cost basis in the property is prorated between the debt portion and gifted portion. See Sec. 1011.

In some instances, a transfer of the mortgaged property will accelerate the entire debt obligation immediately. Therefore, a charity and donor should review the loan documents for this "acceleration" clause prior to any transfer. If the acceleration clause is present, the lender may agree to waive this provision in limited cases.

Debt Financed Income
If the debt is less than five years old and the donor has owned the property for less than five years, there may be acquisition indebtedness. Sec. 514(c)(2)(B). In such a case, the charity will pay income tax when it sells the real estate, since the sale proceeds would be deemed unrelated debt-financed income. Sec. 514(b).

There are two ways for charity to avoid payment of this unrelated business income tax (UBIT). First, if the donor has owned the property for five years and the debt is five years old, a 10-year period is permitted to sell the property. Second, if the property fails the "5 and 5" test, then the charity may receive the property, pay the indebtedness and hold the property for at least 12 months. Since the definition of debt-financed income is property on which there has been debt within the 12-month period prior to the sale, the charity should be permitted to sell the debt-free property after the 12-month period with no UBIT. Sec. 514(b).


Example 4.7.2A

Mindy Mortgage purchased a duplex several years ago for $60,000. Her accountant has taken straight-line depreciation and the adjusted basis is now $40,000. The apartment has appreciated in value to $200,000. Debt on the property was created six years ago and has a $50,000 balance.

Mindy Mortgage offers to give the property to her favorite charity. If the charity accepts the property, with an appraised value of $200,000, Mindy will receive a charitable gift receipt for $150,000. This represents the difference between the $200,000 appraised value and the $50,000 mortgage. Since the depreciation was straight line, there is no depreciation recapture. Thus, Mindy's charitable deduction is the full $150,000.

In addition, Mindy would realize $40,000 of income, due to her relief from indebtedness. The $40,000 adjusted basis is prorated between the mortgage and the charitable gift, i.e., $10,000 to the debt. Therefore, Mindy would realize $40,000 of long-term capital gain ($50,000 - $10,000).

Since the debt is more than five years old and Mindy has owned the property for more than five years, the charity is able to receive the property and sell it without payment of UBIT, so long as the sale is within the next 10 years.

Case Studies on Mortgage or Debt

Simon Seys Installment Bargain Sale:   Simon Seys is a longtime supporter of Rydell University, where he attended law school some 20 years ago. He has attributed his success as a famous trial lawyer to the excellent education he received from Rydell University's School of Law. Rydell's School of Law is currently seeking to expand its campus, and, coincidentally, Simon owns investment land right next to the law school. The land would be an ideal fit to fill the University's need for additional land, but, Rydell has limited available funds to purchase the land. Simon purchased the land about eight years ago for $200,000 and it is now worth $800,000.

Exit Strategies for Real Estate Investors, Part 4:   Karl Hendricks was a man with the golden touch. Throughout his life, it seemed every investment idea that he touched turned to gold. By far, Karl was most successful with real estate investments. It was definitely his passion.

Exit Strategies for Real Estate Investors, Part 5:   Karl Hendricks was a man with the golden touch. Throughout his life, it seemed every investment idea that he touched turned to gold. Karl's passion was real estate, and he was very successful in his investments.

Paying off a Mortgage Using a CRT:   John Mark and Sarah Andrews have served with a relief charity in Brazil for the past 40 years. Knowing that their charitable organization, Worldwide Relief Services, Inc. (WRS) would provide only limited funds for retirement when that time came, they began taking what money they had and investing in rental property. When they were on furlough in the late 1950s and early 1960s, they purchased three homes in the Silicon Valley of Northern California. They purchased the first home in 1958 for $25,000. Due to the market conditions in the Silicon Valley, the current value of that home is now $800,000. The other two homes have experienced similar appreciation in value.

Private Letter Rulings

PLR 9015049 Debt Not Permitted on Assets for Unitrust:   In PLR 9015049, the Service set forth a specific requirement concerning any asset encumbered by debt. Previously, it was thought permissible to transfer an asset into a charitable remainder trust so long as the debt was at least five years old and the owner had held title for at least five years. However, in PLR 9015049, the Service took the position that if there is any personal liability on the debt, under Sec. 677(a), the payment of debt with potential personal liability causes the unitrust to become a grantor trust. Since the regulations in Sec. 664 preclude a unitrust from being a grantor trust, the trust is disqualified under the rationale of the Service.

Related Topics on Mortgage or Debt

2.1.2  Gift of Mortgaged Property:    The majority of real estate is encumbered by debt. When the real estate is transferred, the debt previously recorded with the County Registrar of Deeds remains on the property. If the obligation is solely against the property, the debt is termed "non-recourse." If the obligation is against both the property and the owner personally, the debt is termed "recourse."

4.7.5  Charitable Remainder Trusts:    A charitable remainder unitrust (CRUT) is an excellent option for donors with appreciated real estate. A CRUT provides a charitable income tax deduction, an income stream and a tax-free sale of the real estate.

      Quiz-Basic



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