Friday April 19, 2024
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5.1.2 Debt and Unitrusts
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Generally, property with debt on it should not be transferred to a charitable remainder unitrust. If possible, one of the various strategies should be used to clear the debt.
If there is personal liability on the debt, then the IRS position is that transfer of that property to a charitable remainder trust will disqualify the unitrust.
IRS Position on Debt and Unitrust
In PLR 9015049, the IRS determined that it would not be appropriate to transfer recourse debt property into a charitable remainder trust. Reg. 1.664-1(a)(4) requires a unitrust to operate exclusively as a charitable remainder trust. Under this regulation, if the unitrust becomes a grantor trust under Secs. 671-678 of the Code, it is disqualified.
Reg. 1.677(a)-1(d) states that a person will become a grantor of the trust if the trust may discharge a legal obligation of that person. Since the debt with personal liability is a legal obligation of the donor, if the unitrust receives property with recourse debt, then the unitrust becomes a grantor trust and is disqualified.
Several commentators have questioned the appropriateness of this position by the Service. However, no counsel has volunteered his or her client to be the test case in Tax Court. Therefore, most donors will seek other solutions for property that has recourse debt.
Debt Solutions
There are five general solutions to the debt problem. These are to pay off the debt, to obtain a release, to use a bridge loan to transfer the debt, partial sale to charity with debt repayment, or personal guarantee. See GiftLaw Pro 5.1.3.
Five and Five Unitrust Non-Recourse Exception
If a donor has owned property for more than five years and the debt is more than five years old, then the exception of Sec. 514(c)(2)(B) for "five and five" property should apply. For non-recourse property that passes the five and five test, the transfer to the charitable trust will be a combination of a bargain sale for the debt amount and a unitrust for the value of the equity.
Once again, the trustee may not assume the debt. Rather, to qualify for the five and five exception, the trustee receives the property subject to the debt. To defend the trustee's position with respect to title, the trustee may make payments on the debt. Normally, property transferred into a charitable remainder trust under this exception is sold well before the expiration of the ten-year exception period.
Example 5.1.2A Debt Property To Unitrust
John and Mary Wilson purchased land ten years ago for $100,000. They refinanced six years ago and the current debt obligation on the property is $100,000. The property has appreciated in value to $400,000.
John and Mary desire to sell the property and discuss transferring it to a FLIP unitrust with their attorney. Since the debt is five years old, they have owned it for five years and it is a non-recourse mortgage (no personal liability), they qualify for the unitrust debt exception.
John and Mary transfer the property by deed into the unitrust. The unitrust then advertises the property for sale and sells within approximately two months. As a result of the transfer, John and Mary have obtained a release from $100,000 of debt. The prorated basis on the $100,000 is $25,000.
The $300,000 in equity is transferred to the unitrust. The potential $225,000 gain on this portion is bypassed during the year of the sale. There is a tax deduction based on their age of $122,442. The tax deduction is an appreciated property deduction limited to 30% of adjusted gross income. They estimate that this write-off will be reported over two to three years.
At closing, the buyer pays $400,000. $100,000 is allocated to the mortgage and the $300,000 balance is transferred to the charitable remainder unitrust. The 6% unitrust will pay an estimated $390,867 over their projected life expectancy. At the end of two lives, the charity should receive $386,724.
Installment Sale Promissory Note
An installment sale is one in which at least part of the payment is due in another year than the tax year in which the sale took place. Installment sales are most common when a seller acts as the lender in a real property sales transaction. When this method is used, the buyer typically executes a promissory note in which he or she promises to pay the seller over a period of time.
A donor may make a gift of a promissory note from an installment sale to charity. However, there is a downside to assigning a promissory note to charity or a charitable remainder trust. Under Sec. 453B(a)(2), all gain on the note will be accelerated to the date of the gift whether or not it has been actually received by the donor. As a result, the donor must report all of the capital gain on his or her tax return in the year of the gift. The reportable gain will be equal to the fair market value of the obligation less any basis in the property. The reportable gain must then be recognized by the donor, meaning that he or she will be taxed on the gain.
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Case Studies on Debt and Unitrusts
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.
Unitrust Debt - Are There Other Solutions?:
Several years ago Mother and Father built a very 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.
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Private Letter Rulings
PLR
201115025 Sham Organization Loses Tax-Exempt Status:
Org, a State non-profit corporation, was formed for the purposes of achieving world peace through international student exchange and providing scholarships and work-study programs to qualified students.
PLR
201420010 IRS Rules on Consolidation of Trusts:
A and B created Trust A and Trust B as two life charitable remainder unitrusts under Sec. 664 of the Code. A and B are both trustees and income beneficiaries of Trust A and Trust B.
PLR
201426006 Reformation of Trust Won't Result in Self-Dealing:
A and B created Trust with the intention that it would qualify as a standard charitable remainder unitrust (CRUT) that paid a fixed percentage of its assets each year. Trust was to make annual distributions to settlors along with their two children, C and D, for each of their lifetimes.
PLR
201434026 Trading Activities Won’t Result in Acquisition Indebtedness:
Trust is a qualifying Charitable Remainder Unitrust under Sec. 664 of the Code. As part of its investment strategy, Trust will invest in a number of funds that will be treated as partnerships for tax purposes.
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.
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