Monday January 17, 2022
Article of the Month
Charitable Gifts of Real Estate - Part V
Real estate is a unique asset, and each gift must be properly tailored to the property and the donor's expectations, while protecting the charity from any issues that may arise. Charities and donors must ensure they are informed about the benefits and pitfalls of gifts of real estate.
This series about donating real estate will discuss the definition of real estate, charitable deductions for real estate gifts, charitable gift options and some best practices. This article will discuss using real estate assets to fund charitable remainder trusts.
Structuring Real Estate Gifts
Real estate can be an excellent asset to donate to charity. Usually, a donor will receive a greater tax benefit by gifting real estate, rather than donating the cash proceeds from a sale of the real estate. If a donor sells the real estate first and then donates the cash proceeds, the donor will be taxed on the gain from the sale. When the donor transfers the property to a charity before the sale, the capital gain may be bypassed. One exception to the bypass of gain is when there is a prearranged sale. Part I of this series touched on the prearranged sale rules. If the IRS deems a transaction a prearranged sale, the donor will not bypass the gain.
There are several ways a donor can structure a charitable transfer of real estate to charity, each with differing benefits and risks for the charity and donor. A charitable remainder trust (CRT) is a planned gift vehicle that provides the donor with an income stream. The income stream can be structured for a life, lives or a term up to 20 years. Donors may also choose to have the income stream benefit another individual.
i. Charitable Remainder TrustsA charitable remainder trust is an irrevocable tax-exempt trust that can be funded with real estate. The donor funds the trust with real estate, and the donor or named beneficiaries receive income for the duration of the CRT. Upon the expiration of the trust term, the charity receives the remainder interest.
There are two types of charitable remainder trusts— charitable remainder annuity trusts (CRAT) and charitable remainder unitrusts (CRUT). Both CRATs and CRUTs can be issued for a life, lives, a term up to 20 years or a life or lives plus a term of years, with a vested remainder interest in one or more qualified charities. The major difference between the two is that a CRAT pays a fixed percentage of the trust's initial funding amount, while a CRUT pays a fixed percentage of the trust principal as revalued each year. For example, a CRAT with a 5% payment funded with $100,000 will pay out $5,000 each and every year; a CRUT with the same funding value and payment percentage will pay out $5,000 the first year and then 5% of the trust's value, as revalued each year thereafter. When funding a trust with real estate assets, CRUTs are favorable due to the ability to create more flexible payment structures.
When a charitable remainder trust is funded, the donor will receive an income tax deduction equal to the present value of the remainder interest to charity. The present value is calculated using the factors published by the IRS and the applicable federal rate (AFR) for the current month or one of the two prior months.
While CRTs are tax-exempt trusts, the payments to beneficiaries are subject to the four-tier accounting rules from Sec. 664 when distributed. Under this structure, the first tier is ordinary income, then capital gain, then tax-free income and finally the trust principal. Ordinary income must be paid out in its entirety before moving to the next tier with more favorable tax treatment and so on for each tier. The taxation of payments from charitable remainder trusts can be complex and donors should consult with a financial advisor or tax professional.
Charitable remainder unitrusts and annuity trusts have many similarities, but also have distinct differences that may be of note to the donor. Both types of CRTs are subject to the 10% minimum deduction interest test to qualify as a CRT. Under this test, the charity's remainder interest must be at least 10% of the initial value of the trust. The trusts must also make payments of at least 5%, but no more than 50% to qualify as a charitable remainder trust.
CRATs are subject to additional requirements due to their structure as a fixed dollar amount payment. CRATs are required to pass the 5% or greater probability of exhaustion test. In Rev. Rul. 77-374, the Service stated that charitable remainder annuity trusts must not have a greater than 5% probability of exhausting the trust principal. An alternative for CRATs under Rev. Proc. 2016-42 is the 10% corpus test. A CRAT may avoid falling under the 5% probability test if it is a qualified trust that includes specific IRS language. If the annuity trust document includes the Rev. Proc. 2016-42 language and the trust corpus declines to 10% of the initial trust corpus (with discounting at the initial applicable federal rate), the annuity trust will terminate and the corpus must be distributed to the specified charities.
Alternatively, CRUTs are not required to comply with the 5% probability of exhaustion test. Because CRUTs are revalued each year to determine the unitrust payment amount, donors may contribute additional assets or funds to the trust. Additional contributions are not permissible with CRATs because the fixed percentage of the annuity payment is valued at the time of funding the trust.
The trust payments in CRUTs can be structured four different ways: (1) standard unitrust, which pays the unitrust percentage stated in the trust document; (2) net income unitrust (NICRUT), which pays the lesser of net income or the stated unitrust percentage; (3) net income plus makeup unitrust (NIMCRUT), which operates in a similar way as a NICRUT but includes an additional provision allowing the trustee to pay make up payment when the trust earns more than the stated unitrust percentage if there were deficits in previous years due to the net income limitation on payments; and (4) FLIP Unitrust, which first operates as a NIMCRUT, then later flips to a standard unitrust on the happening of a trigger event or date. When drafting a charitable remainder trust, the donor and his or her attorney should be knowledgeable about the similarities and differences of each type.
Donors can choose to self-trustee a CRT, but it may not be advisable when funding with real estate. The risk of a transaction being deemed a prearranged sale may increase with this structure. It may be more favorable to have an independent trustee negotiate the sale of the property. The donor can be designated as the successor trustee. While a donor can retain an aspect of control by selecting themselves as the trustee or another person, it is important not to run afoul of the self-dealing prohibitions in Sec. 4941. Under the Sec. 4941 self-dealing rules, excise taxes are imposed upon direct or indirect transactions between the trust and disqualified persons. Some examples of disqualified transactions involving real estate are the sale, exchange or leasing of property with disqualified persons. Those persons disqualified include the donor, trustee, beneficiaries, as well as lineal descendants, including children, grandchildren and spouses of disqualified persons. The excise taxes imposed can be severe and donors should consult with an attorney when administering the trust.
Sarah is an 80-year-old donor who plans to donate her vacation home to her favorite charity while providing an income stream for herself. Sarah purchased the vacation home many years ago for $200,000 and it is now valued at $750,000. She is interested in a charitable remainder trust, but is unsure if she prefers a CRUT or CRAT. Her legal advisor informs her the major difference is the fixed percentage payment in a CRUT and the fixed dollar amount payment in a CRAT. Sarah asks her advisor for a comparison of the two trust types.However, standard payout type CRTs are generally disfavored when funding with real estate assets because the funding asset is not liquid. The trustee is required to make payments according to the frequency listed in the trust document of at least 5%. Unless the real estate asset in the trust is generating sufficient income to make the payment, such as rental income, the trustee may not have other liquid assets to satisfy the required payments. If the trust structure is not respected, then the IRS may review the CRT and deem it a non-charitable trust.
If the trust is drafted as a CRUT, Sarah will receive a charitable income tax deduction of $506,910, which based on her 32% tax bracket may save $162,211. The partial bypass of $550,000 gain may save $130,900. She will receive $37,500 in the first year based on the home's $750,000 valuation and will receive payments of 5% for the rest of her life. However, it should be noted that a CRUT is revalued every year to determine the payment amount based on the unitrust percentage. If the value of the trust assets were to increase, that same 5% payment could increase above $37,500. With a CRUT, the donor may experience the benefit and burden of market values fluctuating.
If drafted as a CRAT, she will receive a smaller charitable deduction of $447,255 which may save $143,122. The partial bypass of capital gains remains the same. Her annuity payments remain fixed at $37,500 for her life. Regardless of the trust assets increasing or decreasing in value, the trust must pay out $37,500 annually. Sarah likes the larger charitable income tax deduction and the possibility of higher annual payments with the CRUT and decides to fund a CRUT with her vacation home.
ii. Net Income Plus Makeup UnitrustsThe two best structures for CRTs that are funded with real estate are a Net Income Plus Makeup Unitrust and a FLIP Unitrust. A NIMCRUT pays the lesser of the trust income or a standard fixed percentage of the value of the trust to the income beneficiary. With the NIMCRUT structure, the trust will keep a running total of the deficit payment. Deficit payments are payments based on the net income limitation of the NIMCRUT meaning the payment made is less than the stated unitrust payment percentage. The trust is permitted to make up for prior deficit payments when the trust earns more than the fixed percentage. These are referred to as makeup payments.
The real estate asset may not earn sufficient income prior to the sale to allow the trustee to make the required payments if the trust is drafted as a standard CRUT. The flexibility of a NIMCRUT allows the trustee time to sell the real estate asset, with appropriate payments based on net income to satisfy the payment requirement. Once the property has sold and the proceeds reinvested, the trust can begin paying the stated unitrust percentage if the net investment earnings are greater than or equal to the trust payment percentage. If there are excess earnings over the unitrust percentage amount after the reinvestment, any shortfalls in previous pay periods can be repaid.
Tom, age 70, plans to fund a charitable remainder trust. He has numerous assets, such as a vacant lot, stock and cash to fund the trust. The vacant lot is valued at $2 million, with a cost basis of $1.2 million. He prefers to use the vacant lot to fund the trust. He is interested in making a large gift to charity at the end of his life. Tom is hopeful to find an option to sell the lot tax-free and create an income stream using the asset. Tom's attorney informs him a NIMCRUT would allow for a tax-free sale. The NIMCRUT would pay out the lesser of the trust income or the unitrust percentage, which is a good option and will allow the trustee time to sell the vacant lot.
Tom will receive a charitable income tax deduction of $1,040,500 in the year of the gift, which based on his 24% income tax bracket may save $249,720. He will bypass up to $800,000 in capital gain, saving $150,400. Tom will receive $101,972 from the trust in the first year after the lot is sold and 5% of the trust as it is revalued every year. Regardless of the payout structure of the CRUT payments, the charitable deduction and capital gain savings remain the same. The major benefit of the NIMCRUT is the trust will pay the lesser of the trust income or the 5% unitrust percentage. In Tom's case, the lot is not currently being rented, so it is not generating income. If the vacant lot cannot be sold in the first year, the trustee can make payments as appropriate based on the net income generated from the trust. Tom likes the benefits of the NIMCRUT and decides to proceed with the trust.
iii. FLIP UnitrustsA FLIP Unitrust begins as a NIMCRUT, then the trust "flips" to a standard payment type unitrust based on a triggering event stated in the trust document. The trust will "flip" from a NIMCRUT to a standard unitrust on the January 1 following the trigger event. The trigger event may be the sale of an unmarketable asset, such as the sale of real estate, a future date or an event such as marriage, divorce, retirement or other similar occurrences not within the control of the trustee. The structure of a FLIP Unitrust is a favored model when the funding asset is real estate. A FLIP Unitrust allows the trustee the flexibility to pay the lesser of the net income or the stated payment percentage. This is especially beneficial when the trust does not have liquid assets or income producing assets. This gives the trustee time to list and sell the property, but also allows for flexibility and income control. In many FLIP CRUTs, the triggering event is the sale of the unmarketable asset. With the triggering event, after the property is sold the trust "flips" to a standard payment percentage type trust using the sale proceeds.
Jon, age 72, and Alice, age 70, own an office building valued at $500,000 that they purchased years ago for $200,000 and, with straight line depreciation, have an adjusted basis of $100,000. They would like to donate the property to charity and want annual income in return. The property is currently producing rental income that fluctuates from time to time. Jon and Alice would like to exit the property management business, but are mindful of the capital gains tax that would be generated if they were to sell the office building. Their estate planning attorney suggested the creation of a trust with a 5% annual payment. Their attorney strongly urges they consider the FLIP CRUT structure to ensure the trustee has adequate time to list and sell the building without running afoul of the trust structure. The trust would pay the lesser of the net income or 5% until the office building is sold. The sale of the property will be drafted as the triggering event in the trust document. The January 1 following the sale will mark the first year the trust will make the standard 5% payments.FLIP Unitrusts and NIMCRUTs are great options for donors looking to fund charitable remainder trusts with real estate. If the donor is contemplating funding a standard unitrust with appreciated property, it is typically preferred by the donor's attorney to draft the trust as a FLIP CRUT or NIMCRUT.
They like the idea of a FLIP Unitrust and decide to fund the trust with the office building. In the year of the gift, they receive a charitable income tax deduction of $179,670. Based on their 32% income tax bracket, it may save $57,494. The bypass of up to $400,000 in capital gain may save $95,200. If Jon and Alice create the trust in March and it takes about a year for the trustee to sell the office building due to market factors, the trust will pay out the net rental income of approximately 3% in the first year. After the property is sold, the trust "flips" to a standard unitrust. The following January 1 will commence the 5% standard unitrust payments. The trust will make a payment of $30,588 for the first year after the property is sold and will continue to pay 5% of the trust as revalued each year for the lives of Jon and Alice. Based on a life expectancy of 24.5 years, Jon and Alice may receive total lifetime income of $769,472. Happy with the potential, they decide to proceed with the FLIP Unitrust.
iv. Unitrust and SaleCombining a unitrust with a partial sale is a popular method to create a tax-free outcome when a donor would like to receive a lump sum from a portion of the sale of real estate. The donor transfers an undivided portion of the real estate into a unitrust and retains the remaining portion of the property outright. The trustee and donor will jointly sell the property, with the proceeds of the sale being apportioned between the donor and the unitrust based on the percentage of property owned by each. The donor will bypass capital gain and receive a charitable deduction on the portion transferred to the unitrust.
The donor's sale of their undivided portion will result in a taxable event, which may be offset in full or in part by the bypass of capital gains in the trust and the charitable deduction. To achieve a zero-tax outcome, the tax savings from the charitable deduction on the portion transferred to the unitrust will need to equal or exceed the taxes owed on the portion sold by the donor.
If the donor has owned and used the home as their primary residence for at least two years out of the previous five-year period, the "home sale" exclusion may be claimed. The home sale exclusion allows qualifying homeowners to exclude either $250,000, or $500,000 if married filing jointly, of gain from the sale of an eligible home, under Section 121. The gain exclusion in Section 121 can be elected even if the home is sold under an installment sales contract.
An important note is the donor's charitable deduction for the transfer of real estate is subject to a deduction limitation of 30% of the donor's adjusted gross income (AGI) in the year of the gift. However, the charitable deduction may be carried forward for up to an additional five years at the same limitations. This gives the donor a total of six years to claim the entire charitable deduction. The zero-tax outcome may not occur in the year of the gift, but will likely be realized within six years.
Mary, age 77, plans to donate her home to charity and hopes for favorable tax benefits. She purchased the home many years ago for $400,000. Since then, she has used the home as her primary residence and it is now valued at $1 million. In addition to favorable tax benefits, she is hoping for a large lump sum of cash. She contacts her attorney, who recommends a charitable remainder unitrust to offset the gain from receiving a large cash sum. He informs her that if the home can be apportioned correctly to the trust, the sale of the home can result in a tax-free outcome. The attorney informs her that she is qualified to exclude $250,000 in capital gain from the sale of her home. Excited about the possibility, Mary asks him to draft the charitable remainder unitrust document and structure the deed to the property accordingly. Mary's CRUT should be drafted as a NIMCRUT or a FLIP CRUT for the best results.Structuring the sale of the property to include the CRUT can provide a zero-tax sale. This is a popular option, but the gift does not need to be structured as such. If the donor is not concerned with owing tax on the sale and prefers more cash proceeds from the sale, the apportionment of the real estate retained and transferred to the trust can be adjusted to meet the donor's goals.
Mary's attorney must be careful to get the timing of the transfer correct. The attorney drafts the CRUT and property deed for Mary to execute. The attorney then records the deed prior to listing the property for sale. If the home were to sell for $1 million, $227,364 must be transferred to the CRUT to achieve a tax-free outcome. She would receive a charitable income tax deduction of $137,385, which based on her 37% income tax bracket may save $50,832. The remaining $772,636 of the sale price is retained by Mary as cash proceeds. Considering the $250,000 home exclusion, the adjusted basis on the sale portion retained by Mary is $559,054, which results in $213,582 of long-term capital gain. Based on her 23.8% capital gain tax bracket, Mary would owe $50,832 in capital gains tax. However, her charitable income tax deduction will offset that capital gains tax owed. Depending on how long it takes the home to sell, Mary may receive little to no income while the home is listed for sale because her CRUT is structured as a FLIP CRUT.
At a 5.5% unitrust percentage, Mary will also receive a payment of $12,505 after the CRUT flips to a standard CRUT. Over her life expectancy of 15.3 years, Mary may receive $191,327 from the CRUT, if the home sells quickly. In total, Mary can sell her home tax-free, retain $772,636 in cash proceeds from the sale and receive $12,505 in the first year the CRUT operates as a standard CRUT, with payments for her life. Excited about the gift Mary asks her attorney to proceed. It is important to note that the zero-tax result may not be realized in the year of the gift due to the deduction limitations on appreciated property, but Mary's charitable deduction can be carried forward for up to an additional five years.
Charitable remainder trusts are a great option with varied flexibility for a donor looking to donate real estate. The payments for charitable remainder trusts can be structured a number of different ways to best fit the donor's needs. Although FLIP Unitrusts and NIMCRUTs are preferred for gifts of real estate, a standard charitable remainder unitrust or charitable remainder annuity trust may be appropriate for the donor. The flexibility of charitable remainder trusts allows a donor and his or her advisor to find a structure that best fits their needs.