A Dirt, Dirty Shame
Malpractice Coverage – VIII
Don’t Leave Home Without It
eighth in a series on design and implementation issues)
One of most popular assets contributed to a charitable remainder trust is dirt, better known as real estate. Why? Commonly owned, occasionally wildly appreciated; it often underperforms as an income-producing asset; and under the right circumstances it can be converted to a retirement income stream while minimizing capital gains liabilities.
Unfortunately, very few planners understand the traps and dead ends associated with the use of real property inside a CRT.
Ed Thomas was encouraged to use a §664 trust as financial planning tool in order to avoid capital gains liabilities. Persuaded by his stockbroker that contributing his appreciated farmland to a charitable remainder trust would be the perfect tool to avoid (although it was improperly suggested he could evade tax with a CRT) capital gains tax. Ed jumped on this technique as a solution to his problems. Since the highest and best use of the land hinged on its significant development potential, selling it through the CRT made sense. Inheriting this land years ago, Ed had a tenant farmer managing it, only rarely saw the property since it was located out of state, and had no interest in farming. None of Eds children had any interest in the farm and there was no emotional attachment, so it sounded like a perfect solution for a client who had some charitable interests and a desire to minimize tax. Where it went wrong was in depending on bad advice from people who had little real world experience with charitable trusts funded with hard to value assets.
Problem 1 Ed had an old appraisal from a realtor who listed the property last year and believed after consulting his broker that the sale price would set the value of the income tax deduction, and that he needed no new appraisal.
The IRS requires a qualified appraisal (dated no earlier than 60 days prior to the transfer) for any contributed real property valued at greater than $5,000 [Treas. Reg. §1.170A-13(c)(2)]. There will also be an IRS 8283 form completed to back up the claim for an income tax deduction, and when the property is sold by the trustee an IRS 8282 reports the sale proceeds.
Problem 2 Ed sold the land and contributed the sale proceeds believing he had avoided a capital gains liability.
Gain on the sale of an appreciated asset is not attributable to the donor if the sale occurs after the asset transfers to the CRT. If the donor retains either direct or indirect control over the asset, or if there is an express or implied prearranged obligation on the part of the CRT to sell the property, then the subsequent sale is taxable. In this case, Ed has a real problem since he never bothered to transfer title to the CRT and he sold it as an individual. Since the CRT never legally owned the real estate, capital gains liabilities were triggered [Reg. §664-1(a)(3);Rev. Rul. 60-370, 1960-2 C.B. 203
If he had a buyer in the wings, with either an escrow agreement or an obligation to sell, even if he had contributed the real estate to the CRT before the sale, he would still have recognized the taxable gain. Avoiding assignment of income, prearranged sales, and step transactions is a valid concern with real property, caution and competent counsel is necessary to avoid unnecessary tax problems. [Palmer v. Commissioner, 62 T.C. 684 (1974), affirmed, 523 F.2d 1308 (8th Cir. 975).] As for the capital gains avoidance, a CRT is primarily a capital gains deferral tool the tax is not completely avoided, since income distributions to Ed will retain the character (basis and holding period) of the contributed asset.
Problem 3 Ed wanted the charitable remainder to be a soon to be created private foundation.
Normally, a charitable remainder trust funded with cash or appreciated, publicly traded securities would create an income tax deduction equal to the fair market value of the donated asset. However, if a CRT funded with real property and, upon termination, transfers its interest to a private foundation, then the income tax deduction is just limited to basis, not fair market value. In Eds unfortunate case, because he already made several errors, he wound up funding the CRT with cash (net proceeds from the improper sale) and not his appreciated land. The only bright spot in this disaster is that cash to a CRT with a private foundation remainder interest generates a fair market value deduction available for use against 30% of Eds adjusted gross income (AGI). If the CRT does not have a permissible charitable remainder beneficiary or an eligible successor charity, the CRT will not qualify as a §664 remainder trust.
Problem 4 Ed wanted his children to draw a salary from the foundation and use the foundation accounts to subsidize his childrens expenses for college.
Reasonable and necessary compensation for legitimate service to a private foundation is allowed, but paying for their educational expenses is out. The IRS has a number of regulations that create obstacles (quid pro quo, self-dealing, private inurement) for a taxpayer trying to use an exempt organization for personal purposes. Because few donors have the interest or background to manage a private foundation, most commentators recommend a $5 million to $10 million funding threshold before considering the use of a private foundation over the more structured donor advised funds operated by a public charity.
Problem 5 Eds advisor suggested that a CRAT (annuity trust) was the best tool.
A CRAT may have only one contribution, so liquidity is a serious problem inside an annuity trust. If the land does not sell quickly, then expenses for maintenance, taxes, insurance, and the required income payouts are made with in-kind distributions. Generally, a FLIP-CRUT, NIMCRUT/NICRUT, or an SCRUT with additional cash contributions would be a better choice for any hard to value asset like real estate.
So many traps, so little time take extra care to avoid the common problems associated with accepting real estate and funding a CRT, and seek experienced planners for guidance.