S.E.C. Real Estate Observer

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1031 exchanges are widely known and used almost as a matter of course in commercial and investment real estate transactions to defer capital gains taxes these days. The effective use of the CHARITABLE REMAINDER TRUSTS (CRT), the other method of selling property and ELIMINATING both the capital gains and any estate tax exposure, is just beginning to be widely known and utilized. Although the tax law permitting CRTs has been around since 1917, this strategy has only recently evolved so that it is relatively simple and inexpensive to establish and maintain a self-directed charitable trust.

Whether a CRT should be considered is easy to establish.

If an owner’s purpose for disposition of investment or business property is to acquire additional property, use leverage to build wealth or to obtain cash for other than investment expenditures, the correct strategy is to use a 1031 exchange or sell for cash.

IF THE OWNER’S PURPOSE IS TO:

• ELIMINATE MANAGEMENT, MAINTENANCE AND PROPERTY LIABILITY
• ESTABLISH LONG-TERM PASSIVE CASH INCOME
• ESTABLISH A TAX-FREE CASH INHERITANCE FOR FAMILY
• TOTALLY ELIMINATE CAPITAL GAINS TAXES, ESTATE TAXES, AND EXPOSURE TO PROBATE AND/OR
• SEPARATE GROUP OWNERSHIP WITH CONFLICTING OBJECTIVES

SERIOUS CONSIDERATION SHOULD BE GIVE TO USING A CHARITABLE REMAINDER TRUST/WEALTH REPLACEMENT TRUST STRATEGY.

In very simple language, would the owner trade the property for a lifetime income and a tax-free cash inheritance for family equal to the value of their property if it were a non-taxed transaction? If the answer is yes, read further.

WHAT ARE THE TAXES IF YOU SELL?

Whether it is time to put a property on the market, or there is a buyer making an offer, any prudent owner will want to calculate the tax consequences of selling BEFORE they sign a listing with a broker or a contract with a buyer. The most difficult factor is identifying what the amount of the federal and state taxes will be. The amount of any existing mortgage(s) plays no part in establishing the amount of the recognized gain. Even those of us who handle investment property transactions regularly forget how complex the tax consequences of a sale can be. Once the amount of the recognized gain is established, the appropriate federal and state (if applicable) rates are applied to the recognized gain. This calculation may not be as simple as it might initially appear. There may be several different tax rates that apply to segments of the recognized gain. For example, excess cost recovery deductions taken are taxed at a higher rate than long-term capital gains rates. Some types of transactions such as the sale of dealer property will NOT qualify for the lower long-term capital gains tax rate. If the current owner subdivided a property into lots that would be sold individually, that property would be classified as dealer property. Some states permit the deduction of any federal taxes due before calculating the state tax due. Some states do not allow a deduction for federal taxes. It is recommended that a tax professional be consulted to establish the current adjusted basis in the property and to properly calculate the tax consequences of both a cash sale and an installment sale. From strictly a consideration of total tax amount to be paid, an installment sale very often will NOT save any tax dollars. However, there may be many other reasons to consider an installment sale, which are not appropriate to discuss here.

To get a sense of the impact of the tax consequences of a sale, let us consider a property that should sell for $1 million, which has a current adjusted basis of $100,000. We are going to arbitrarily set the sales costs at 6% of the sale price and assume that this property qualifies for the 15% federal long-term capital gains tax rate. We are going to assume a state tax of 5% of the gross recognized gain.

Here is the calculation result:

Sale Price = $1,000,000
LESS Sales Costs = $ 60,000
LESS Current Adjusted Tax Basis = $ 100,000
RECOGNIZED GAIN ON SALE = $ 840,000
LESS Federal Tax (15%) = $ 126,000
LESS State Tax (5%) = $ 42,000
NET PROCEEDS OF SALE = $ 672,000

If the owner saved and invested the tax amount at a 6% return, he or she would have an additional $10,080 in annual income for the rest of his or her life.

ELIMINATE THE TAX AND KEEP THE INCOME FOR LIFE BY ESTABLISHING A CHARITABLE REMAINDER TRUST AND A COMPANION WEALTH REPLACEMENT TRUST.

It is relatively easy and inexpensive to establish and maintain charitable remainder trusts and wealth replacement trusts. However, the trusts must be established and the title to the property being marketed MUST be transferred to the charitable remainder trust BEFORE a contract or even a letter of intent is executed. Whether the property has been listed and/or otherwise offered for sale is not a consideration. For explanation purposes, we are gong to think of these two trusts as two safety deposit boxes.

We will explore the benefits of the charitable remainder trust (CRT) safety deposit box first. This is the property owner’s personal and individual CRT. Let’s name our property owner Hamilton. After establishing the Hamilton Charitable Trust with the coordination of Hamilton’s legal and tax advisors, the Hamilton property is transferred to the CRT and becomes the Hamilton Charitable Trust property. When the Hamilton Charitable Trust sells the property, there is no tax and the entire proceeds after the commission and closing costs are available for reinvestment. The property can be sold for cash, sold on terms or even exchanged inside the CRT safety deposit box depending upon what Hamilton decides. If the property is an income property or other type of operating business property, the current income from the property can flow through to Hamilton until the property is sold. Upon sale or other disposition of the property, the proceeds are reinvested and the CRT safety deposit box provides an income to Hamilton for life from the investment income.

There are several other benefits from structuring the disposition via the Hamilton Charitable Trust. Hamilton will still participate in directing the reinvestment of the assets inside the CRT safety deposit box. Hamilton will receive a current charitable tax deduction for between 10% and
45% of the value of the property placed into the CRT safety deposit box. The amount of this deduction will depend upon the age of Hamilton and the amount of the quarterly payments Hamilton will receive. The CRT is an irrevocable trust so it cannot be invaded in the event of lawsuit, bankruptcy, divorce or other unforeseen financial difficulties. If Hamilton should need some portion of the assets in the future, it is possible to assign a portion or all of the payment from the CRT safety deposit box to a bank or other lender to obtain the cash needed. If is just like owning a free and clear income property. If cash is needed, one obtains a mortgage and then uses the rental income to pay the mortgage payments.

One requirement is that property placed into a CRT cannot have debt encumbrance. This does not mean that property with an existing mortgage debt is eliminated from using this strategy. If the debt is small (40% of value or less), the equity is transferred into the trust as a percentage undivided interest in the property. The debt portion remains outside of the CRT, which means that some amount of taxes will probably be due on the debt portion of ownership upon disposition. With careful planning and analysis, it is usually possible to use the charitable tax deduction to eliminate the tax consequence. When the debt is a substantial portion of the property value, it is often possible for the owner to reduce the debt from other resources or to move part or all of the debt to some other property or asset. The analysis is relatively simple but is beyond the scope of this article.

When Hamilton (and spouse if also a beneficiary of the CRT) dies, whatever assets remain in the CRT safety deposit box must go to charity. If Hamilton does a self-directed CRT, Hamilton will be able to choose the charity or charities to receive the residual benefits from the CRT safety deposit box. Hamilton may also choose to have the CRT converted to the Hamilton Family Foundation, which would distribute the investment income to the charities of his choice on an annual basis so long as the Hamilton Family Foundation exists. If the CRT is established with most existing charities, they will require that the residual go to that charity and he will not have control of the reinvestment of his trust assets. This is still Hamilton’s choice.

If we stopped here, Hamilton will be disinheriting his family by the value of the property placed into the CRT. We are going to assume that Hamilton wants his family to inherit the value of the property. The easiest method is to establish a wealth replacement trust in the form of an Irrevocable Life Insurance Trust. This becomes the Inheritance Safety Deposit Box. A small amount of the income paid out of the CRT safety deposit box each year is used to acquire a life insurance program that builds up cash value inside the Inheritance Safety Deposit Box. Usually, in somewhere between 10 and 24 years, the Inheritance Safety Deposit Box has cash assets equal to the value of the property that are financially managed to protect the inheritance from inflation. In the event that Hamilton dies prematurely, the insurance company supplies the balance of the funds required to provide an inheritance for the family in the full amount of the property placed into the CRT safety deposit box. There are a number of rules for structuring the payments from the CRT, which we will not go into here. In cases where the value of the property is very large, it is necessary to structure the insurance payments using borrowed funds that are repaid with part of the inheritance insurance proceeds. Borrowing the insurance premiums minimizes the impact on the invested assets in the CRT resulting from the premium payments. IF HAMILTON WAS UNINSURABLE OR OVER AGE 80, THERE ARE SEVERAL METHODS OF PROVIDING THE FAMILY INHERITANCE THAT DO NOT USE INSURANCE. There is not space in this article to address those alternatives.

There are wonderful benefits available to using such an Inheritance safety deposit box. When Hamilton dies, the family receives the payout from the Inheritance safety deposit box TAX-FREE and IN CASH. The same protections available in the CRT are available in the Inheritance trust. The family members cannot lose the assets inside the Inheritance safety deposit box to lawsuit, bankruptcy, divorce and other unforeseen financial problems. The insurance used to fund the Inheritance safety deposit box can be indexed for inflation. The Inheritance trust can function exactly as a will but without the problem of probate. Virtually anything that can be done with a will can be done with the Inheritance trust. For example, Hamilton could provide an income for his children during their life and the capital could be passed on to the grandchildren. Provisions could be made for the education of the grandchildren while the children are still alive. The structuring possibilities are extremely varied.

WHAT IS THE PROCESS AND WHAT IS THE COST?

The trusts should be prepared with the assistance of legal and tax counsel that are knowledgeable and EXPERIENCED with charitable remainder trusts and wealth replacement trusts. IRS proscribes the content of the CRT. Unless one has a complex ownership or family situation, these trusts can usually be prepared for between a few hundred dollars and a couple of thousand dollars. Depending upon what entity is chosen as the trust administrator and as the required Special Trustee when real property is used to capitalize a CRT, the on-going management fees should amount to 1% or less per year depending upon what type of reinvestment assets are maintained in the CRT and the amount of investment activity. Some banks and trust managers charge as much as 3% to 5% per year. It pays to shop. If a CRT is established directly with the charity that will receive the residual from the trust upon the death of the beneficiaries, the charity will probably bear all the cost of establishing the trust and asset management. However, the charity will dictate the amount of quarterly payment to the beneficiary and not permit the beneficiary to direct the investment of the assets inside the CRT.

There are five subcategories of Charitable Remainder Trusts. Each offers a different set of benefits. There is actually great flexibility in the rules for each type of CRT that makes it possible to tailor the CRT structure to a very wide variety of individual situations and objectives. If one has a situation that might benefit from using a CRT program, obtain some professional guidance to analyze the applicability. I will address some of the specific applications of the CRT strategy in future articles. To obtain additional information about CRTs, go to www.nobletrustcompany.com or www.childrenscommunity.org.