Friday April 26, 2024

4.7.5 Charitable Remainder Trusts

Charitable Remainder Trusts

NIMCRUTs and FLIP Unitrusts:  A charitable remainder unitrust (CRUT) is an excellent option for donors with appreciated real estate.

Safety Recommendations for Split Gifts:  Although hundreds of split gifts are completed annually and the IRS has to date not contested the concept of split transfers on any of these transactions, it is prudent to evaluate options that increase the safety of prospective transactions.

$250,000/$500,000 Home Exclusion:  In certain situations, a taxpayer may exclude $250,000 of capital gain (or $500,000 if married) from the sale of taxpayer's principal residence.

Debt and CRTs:  Mortgaged real estate and CRTs do not mix well together.

Debt Removal Options:  There are at least five solutions to the debt and CRTs problem.

NIMCRUTs and FLIP Unitrusts
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. This tax-free sale of the real estate inside the trust allows the trustee to reinvest the full sale proceeds, providing investment diversification without payment of any capital gains tax.

Because real estate cannot always be sold immediately, a net income plus makeup charitable remainder unitrust (NIMCRUT) or FLIP CRUT is usually recommended. With either type of CRUT, the trustee is not forced to make a trust distribution unless there is actual trust income. A straight CRUT or a charitable remainder annuity trust (CRAT) generally is not recommended when real estate is the only trust property, because both types of trusts require trust distributions irrespective of actual trust income. In fact, if the trustee does not make the required distributions, the trustee runs the risk of disqualifying the trust.

A popular strategy for real estate is the sale and unitrust plan. With this plan, a donor transfers an undivided percentage of the property into a CRUT and retains the remaining undivided percentage. For example, a donor may transfer 60% of the real estate into the CRUT and retain 40%. Afterwards, the real estate is sold and the sale proceeds are divided between the CRUT and the donor in proportion to their ownership interests. This plan is an effective way for a donor to fund a CRUT and receive cash from a single piece of property. Furthermore, in many cases, this plan can provide a zero tax sale solution.

Example 4.7.5A

Roger Realty owns a $1 million commercial building. At the age of 70, he is ready to retire from the property management business. He therefore is contemplating a sale of the building. However, Roger's cost basis is only $100,000 and thus he is facing a potentially very large tax bill when he decides to sell. Roger would like to sell the property with little or no tax and accomplish some retirement planning as well.

As a result, Roger elects the sale and unitrust option. Based upon his current financial goals, he transfers 70% of the building into a FLIP CRUT. He continues to own the remaining 30% of the building. Soon thereafter, the building is sold to a third party for $1 million. The CRUT will receive $700,000 and Roger will receive $300,000.

Because 30% of the building was sold personally by Roger, the $300,000 is subject to capital gains tax. Specifically, Roger will have $270,000 of capital gains ($300,000 - $30,000 prorated cost basis). However, the $700,000 will not be subject to any tax upon sale. In fact, it will generate a $320,000 charitable tax deduction that will offset all of Roger's $270,000 of capital gains. Assuming he can use his charitable tax deduction, this results in a zero tax sale for Roger. Finally, Roger will receive a lifetime income stream from his $700,000 CRUT and therefore satisfy his retirement planning goals.

Safety Recommendations for Split Gifts
Although hundreds of split gifts are completed annually and the IRS has to date not contested the concept of split transfers on any of these transactions, it is prudent to evaluate options that increase the safety of prospective transactions. While no strategy short of a private letter ruling (PLR) for a specific transfer promises 100% safety, several actions may increase safety levels for a split gift.

1. No Personal Use

Trustees must ensure that donors do not have use in any manner of trust property. For personal residences, this means that donors must move out before any portion of that property is transferred to a unitrust.

2. Independent Trustee

Split gifts and self-trustees are an overly aggressive strategy. The IRS in PLR 9114025 repeatedly emphasizes that the "independent trustee acts independently" in order to avoid price manipulation that could increase value received by donors upon sale of their retained interest. Self-trustees who have authority to sell trust assets as trustee and retain assets as owner obviously could manipulate sale terms in a prohibited manner. Independent trusteeship is essential to minimize such potential problems.

3. Revocable Trust and Unitrust

An easy method for reducing self-dealing risk is to transfer an undivided interest into a unitrust with an independent trustee and the remaining interest into a revocable trust with that same independent trustee. Donors have rights to income from the unitrust and revocable trust and the right to revoke and recover principal from the revocable trust. However, an independent trustee has both legal title and fiduciary responsibility for both trusts. Given the trustee's ability to control sale terms for both trusts, there is reduced likelihood of a self-dealing violation.

4. Limited Partnership

Some conservative attorneys might choose to parallel the fact situation of PLR 9114025 by creating a limited partnership as was done in that ruling. Although, with respect to self-dealing issues, undivided interests held in co-ownership would seem to have very similar characteristics to a limited partnership, a partnership does indeed fit the specific fact pattern of that ruling.

5. Partial Sale to Charity

Finally, one completely avoids the self-dealing issue by selling the partial interest to a public charity prior to funding the unitrust. After sale of part, the donor transfers the balance of the real property to a unitrust.

$250,000/$500,000 Home Exclusion
In certain situations, a taxpayer may exclude $250,000 of capital gain (or $500,000 if married) from the sale of taxpayer's principal residence. In order to qualify for this home exclusion, a taxpayer must own and occupy the principal residence for two of the past five years. See Sec. 121. A sale and unitrust plan is an excellent strategy for maximizing a donor's home exclusion, especially since the home exclusion does not have to be prorated between the sale and unitrust. In other words, the home exclusion can fully apply to the sale portion of the transaction.

Example 4.7.5B

Harry and Harriet Homeowner live in a beautiful $1 million home. They purchased the home 20 years ago for $200,000. However, the home is too large for just the two of them now. Therefore, Harry and Harriet want to sell their home, downsize to a smaller home, and invest some of the proceeds for retirement. Furthermore, they want a zero tax sale solution.

Harry and Harriet qualify for the $500,000 home exclusion because they have owned and occupied the home for two of the past five years. Indeed, they have owned and occupied the home for the past 20 years. However, Harry and Harriet have $800,000 of potential capital gain. In other words, the $500,000 home exclusion would not provide a zero tax sale, since $300,000 would be subject to tax.

Instead of an outright sale, Harry and Harriet select the sale and unitrust plan. With this plan, they transfer approximately 23% of the home into a unitrust and retain the remaining 77%. With respect to the 23% of the home, or $230,000, Harry and Harriet will bypass up to $184,000 of capital gain, receive a $94,962 charitable deduction and receive lifetime income of approximately $291,443.

With respect to the 77% of the home, or $770,000, Harry and Harriet will receive this amount in cash. This sale is subject to capital gains tax. However, after applying the home exclusion and prorating the $200,000 cost basis, Harry and Harriet will have only $116,000 of capital gain to report. Assuming they can use the $94,962 charitable deduction, Harry and Harriet will not owe any tax at all because the tax savings will completely offset the capital gain tax due. Therefore, Harry and Harriet have a zero tax solution plus the benefits of retirement income and charitable giving!

Debt and CRTs
Mortgaged real estate and CRTs do not mix well together. The transfer of debt-encumbered property into a CRT triggers two potential problems: 1) grantor trust status which results in disqualification of the trust, and 2) debt-financed income which subjects the CRT to a 100% excise tax on the amount of debt-financed income.

If the debt 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." In most cases, the debt is recourse. The IRS has ruled that the transfer of recourse debt into a CRT will reclassify the trust as a grantor trust. See PLR 9015049. Since a CRT cannot be a grantor trust, the trust will cease to qualify as a CRT. Reg. 1.664-1(a).

If the debt is deemed non-recourse, there is no personal liability under Sec. 677 and, accordingly, no grantor trust status problem. Thus, in the event of non-recourse debt, it should be permissible to transfer the real estate into the CRT without disqualifying the trust.

To avoid a debt-financed income problem to the CRT, it is imperative that the mortgaged property pass the "5 and 5" rule. Simply put, the debt needs to be more than five years old and the property owned for more than five years. See 514(c). (For a review of the "5 and 5" rule, see GiftLaw Pro 2.1.2.) If the 5 and 5 rule is not met, the CRT may have debt-financed income (unrelated business taxable income, or UBTI) upon sale of the property. If this occurs, the CRT is fully taxable. Any trust income would, therefore, be subject to trust tax rates. Accordingly, debt-financed income inside a CRT should be avoided at all costs.


Debt Removal Options
There are at least five solutions to the debt and CRTs problem:
  1. Payoff - If a debt is small, the donor may have resources to pay the debt off and then transfer the real estate to the unitrust;


  2. Release - If there is a parcel of land that may be divided under zoning rules or there are multiple deeds to the parcel, it may be possible to obtain a release on some of the property, leaving the debt on the balance. The released property may then be transferred to the unitrust;


  3. Bridge Loan - The donor may borrow funds on other property, pay off the existing property and transfer an undivided interest into the trust. When the property is sold, the undivided portion retained by the donor is used to pay back the bridge loan;


  4. Charity Purchase - The charitable organization may be willing to purchase part of the real property from the donor. Following this purchase, the donor has funds to pay off the debt and transfer the balance of the real property into a charitable remainder trust;


  5. Personal Guarantee - While the Service has not approved this method, some counsel have recommended transferring an undivided percentage of encumbered property into a charitable trust. When the property is sold, the balance of the asset is used to pay the debt. The donor gives a personal guarantee that the trust will not be required to pay debt. So long as the transaction works as contemplated, the theory is that the issue is moot after the sale and debt repayment. This is an aggressive strategy not without risk.
Counsel should consider these five potential steps in order. The technical and practical challenges increase with the latter methods. Nonetheless, given these five options, many donors will find a solution to the debt and CRTs problem.

Case Studies on Charitable Remainder Trusts

A Gift of a Home to Family and Charity:   Millie Fleming, age 85, has a modest estate of $450,000. Her daughter Katie is age 60 and recently lost her spouse to an illness that resulted in a difficult financial situation for Katie. She had never worked outside the home and is now faced with living on Social Security and a small amount of investment income. Millie and Katie together decided that the best course of action was for Katie to sell her home and move in with her mother. In this way, Katie has the proceeds of $85,000 from the sale of the house to provide her with some additional income. Millie then could provide Katie with a place to stay rent-free. With the housing expense paid and with the additional income, Katie would be able to live quite comfortably.

Deferred Gift Benefits Children's Hospital Now:   Ever since Theresa and Bob Anderson lost their child many years ago to disease, they have been true champions for children's disease research and care. They immediately started volunteering with the local children's hospital and eventually joined the hospital's foundation board. As active and compassionate board members, Theresa and Bob were commonly found fundraising at local events as well as consoling grieving parents at hospital bedsides.

A Unitrust with a DAF for Education:   Elizabeth Johnson, age 70, was a distinguished professor of biochemistry who devoted countless hours to research, writing and lecturing. During her years of study, she had attended many universities.

Closing a Gift of Real Estate with Little Time Left on the Clock - Year End Gifts - Part 1:   Gregory, 60, is a very control-oriented businessman. In fact, his business philosophy is best summed up as “my way or the highway.” While sometimes difficult to work with, Gregory nevertheless has achieved substantial business success in his life. His quick decision-making skills and solid commitment to a plan has catapulted his company onto the Fortune 1000 list. It seems Gregory’s “way” proved financially fruitful over the past 20 years.

Gregory recently attended a seminar on charitable remainder trusts (CRTs) with his attorney, Bob. After hearing about the tax benefits and increased income potential of a CRT, Gregory turned to his attorney and exclaimed, “I want one of those Bob – and I want one by year’s end.” The date was December 1.

Gregory is now anxious to create a CRT, because he has a significant tax bill looming over his head. The thought of a nice, large charitable income tax deduction excites him. In addition, Gregory has some investment land that would be perfect for the CRT. The land has appreciated significantly but produces little income. Bob is worried that there is not enough time to create and fund a CRT with real property.

Can Gregory create and fund a CRT with real property? What steps need to be completed? What rules govern the timing of charitable deductions?
Peace in the Countryside:   Several years ago, Martha and Frank built a very unique home on 45 acres of beautiful rolling hills and woods. Frank passed away three years ago and now Martha solely owns the 45-acre parcel and home.


Countryside Debt:   Several years ago, Martha and Frank built a very unique home on 45 acres of beautiful rolling hills and woods. Frank passed away three years ago and now Martha solely owns the 45-acre parcel and home.

Dealing with the Five & Dime:   Several years ago, Martha and Frank built a very unique home on 45 acres of beautiful rolling hills and woods. Frank passed away three years ago, and Martha now solely owns the 45-acre parcel and home.

Son's Intentions Paved with Gold, Part 2:   Several years ago Martha and Frank built a very unique home on 45 acres of beautiful rolling hills and woods. Frank passed away three years ago, and Martha now solely owns the 45-acre parcel and home.

Son's Intentions Paved with Gold, Part 4:   Several years ago, Martha and Frank built a very unique home on 45 acres of beautiful rolling hills and woods. Frank passed away three years ago, and Martha now solely owns the 45-acre parcel and home.

Exit Strategies for Real Estate Investors, Part 1:   Karl 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.

Karl continued to buy and sell real estate at the age of 85. About three months ago, Karl discovered a great investment property. It was a “fixer-upper” commercial building in a great area. While other buildings nearby sold for over $2 million, the seller needed to sell quickly and was asking just $1 million.

The condition of the building turned many buyers away. It was being sold as is, but Karl was not deterred. He could see great potential with the building and knew it would not take much work to get it into market condition. Karl swooped in, bought the building for $1 million and instantly hired contractors to refurbish the place.

After three months of hard work refurbishing the building, the place looked like new! In the end, Karl invested $250,000 in the building, bringing his total investment in the property to $1.25 million. One month after the completion of the work, Karl was contacted informally by a company that expressed an interest in the building – a $2 million interest! This was no surprise to Karl as he knew the building was a great buy.

There was one downside, however, to the idea of selling. Karl held the property only four months, which meant the gain from the sale would be short-term capital gain. In other words, the applicable tax rate would be 40.8%, not 23.8%. Karl cringed at the thought of paying much of his gain to the government. At the same time, Karl knew the real estate market could change directions in the next year. Although Karl wanted the 23.8% tax rate, he did not want to risk holding the property another eight months.

Can Karl sell the building and bypass the tax on the sale of the property? Karl wants to reinvest the full sale proceeds in an income-producing investment. Is this possible?
Exit Strategies for Real Estate Investors, Part 2:   Karl 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.

Karl continued to buy and sell real estate at the age of 85. His latest venture led him to a great investment property. It was a "fixer-upper" commercial building in a great area. While other buildings nearby sold for over $2 million, the seller needed to sell quickly and was asking just $1 million.

The condition of the building turned many buyers away. It was being sold as is, but Karl was not deterred. He could see great potential with the building and knew it would not take much work to get it into market condition. Karl swooped in, bought the building for $1 million and instantly hired contractors to refurbish the place.

After three months of hard work refurbishing the building, the place looked like new! In the end, Karl invested $250,000 in the building, bringing his total investment in the property to $1.25 million. One month after the completion of the work, Karl was contacted informally by a company that expressed an interest in the building – a $2 million interest! This was no surprise to Karl as he knew the building was a great buy.

There was one downside, however, to the idea of selling. Karl held the property only four months, which meant the gain from the sale would be short-term capital gain. In other words, the applicable tax rate would be 40.8%, not 23.8%. Karl cringed at the thought of paying much of his gain to the government. At the same time, Karl knew the real estate market could change directions in the next year. Although Karl wanted the 23.8% tax rate, he did not want to risk holding the property another eight months.

After Karl learned about the benefits of a FLIP CRUT, he eagerly wanted to move forward. It looked like the perfect solution. However, there were still two potential downsides to this plan.

What are the charitable income tax deduction rules for gifts of short-term capital gain property? If Karl moves forward with this plan, how would the FLIP CRUT payouts be taxed?
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.

Exit Strategies for Real Estate Investors, Part 6:   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.

Exit Strategies for Real Estate Investors, Part 7:   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.

Exit Strategies for Real Estate Investors, Part 8:   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.

Exit Strategies for Real Estate Investors, Part 9:   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.

Exit Strategies for Real Estate Investors, Part 15:   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.

Exit Strategies for Real Estate Investors, Part 16:   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.

Exit Strategies for Real Estate Investors, Part 17 The Double Deferral Solution:   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.

A Restful Retirement Retreat:   Several years ago Mother and Father built a unique home on 45 acres of beautiful rolling hills and woods. Father passed away three years ago and Mother now solely owns the 45-acre parcel and home.

The Ultimate Donor Advised Fund:   Juan and Maria Hernandez, ages 65 and 60 respectively, are successful produce farmers and own 200 acres of prime land on the outskirts of their local community. The land is currently being farmed and produces primarily a variety of fruits and vegetables.

A Solution for the Home Office Deduction:   Jeffrey and Anita Lewis, both age 65, moved into their home 10 years ago. The housing market has escalated considerably over the past few years due to influx of high-tech industry to their area.

Private Letter Rulings

PLR 199952071 UPREIT Solution for Debt-encumbered Real Estate:   Donors who hold encumbered real estate have been significantly limited by PLR 9015049 in their ability to use charitable remainder unitrusts.

PLR 200403049 Partial Use of Home Exclusion Allowed if Unforeseen Circumstances:   Harry Husband and Wendy Wife purchased Principal Residence. One month after the purchase of Residence, Randy Relative was ordered by the court to live in Residence under house arrest.

Related Topics on Charitable Remainder Trusts

3.10.4  Types of Unitrust Payouts:    Payouts are among the most important areas for the advisor to communicate to the recipient. With a charitable remainder unitrust, the basic payout rule is that the unitrust percentage is multiplied times the trust value and that amount is then distributed. The distribution may be monthly, quarterly, semiannually or annually.

      Quiz-Basic



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