Saturday April 1, 2023
Article of the Month
Real Estate Unitrusts and Life Estates
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 asset, 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 a 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%. After the trust is funded, 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 solution.
Roger Realty owns a $1 million commercial building. At the age of 70, he is ready to retire from the property management business. Therefore, he is contemplating a sale of the building. Because his CPA took straight line depreciation, Roger's cost basis in the building is only $100,000 and he could have a 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. Four weeks later, 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 produce tax savings to offset all of Roger's $270,000 capital gain. 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 fulfill his retirement planning goals.
Although hundreds of split gifts are completed annually and the IRS has generally not contested the concept of split transfers, 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.
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.
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. To reduce risk, a nonprofit or financial advisor trustee is a better option than a donor as trustee.
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 the right 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. In addition, because the trustee has title to 100% of the asset and a fiduciary duty to distribute the sale proceeds in proportionate shares to the unitrust and revocable trust, the donor may be able to take the undiscounted deduction on the CRT (this strategy has not been tested in Tax Court but is based upon sound reasoning).
Some conservative attorneys might choose to parallel the fact situation of PLR 9114025 by creating a limited partnership. Although undivided interests held in co-ownership would seem to have very similar self-dealing characteristics to a limited partnership, a partnership does indeed fit the specific fact pattern of that ruling.
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 the charity as trustee of a unitrust. The charity then owns 100% of the asset – part outright and part as trustee of the CRT.
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. Under this rule, home exclusion can fully apply to the sale portion of the transaction.
Harry and Harriet Homeowner live in a beautiful $1 million home. They purchased the home 30 years ago for $200,000. However, the home is too large for just the two of them. Therefore, Harry and Harriet want to sell their home, downsize to a smaller home, and invest some of the proceeds for retirement. Furthermore, they would appreciate 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 30 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.
Because they retain 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 their $500,000 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 because the tax savings 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!
Mortgaged real estate and CRTs do not mix well together. The transfer of debt-encumbered property into a CRT may trigger 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 may 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 even nonrecourse mortgaged property pass the "5 and 5" rule. Simply put, the debt needs to be more than five years old and the property has been owned for more than five years. See 514(c). (For a review of the "5 and 5" rule, see GiftLaw Pro Ch. 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.
The customary option for real estate with debt is to find a method to transfer unencumbered assets to the CRT. There are at least five solutions to the debt and CRT problem:
A donor may receive a charitable deduction for the transfer of a remainder interest in a personal residence, farm or ranch. Sec. 170(f)(3)(B)(i). The donor deeds the personal residence or farm to a qualified exempt charity and reserves a life estate. The life estate may be a personal right for the donor to use the property, or more commonly a right to the use of the property during the donor's lifetime. The latter option enables the donor to lease the property and receive rental payments during his or her lifetime.
A remainder interest may be transferred in any property used by the donor as a personal residence. Personal residence is defined as "any property used by the taxpayer as his personal residence even though it is not used as his principal residence." This may include the taxpayer's vacation or even stock owned by a taxpayer as a tenant-stockholder in a cooperative housing corporation (as those terms are defined in Secs. 216(b)(1) and (2) and if the dwelling which the taxpayer is entitled to occupy as such stockholder is used by him as his personal residence). Reg. 1.170A-7(b)(3).
A remainder interest in a farm also qualifies for a charitable deduction. A farm is property (including the fixtures, buildings, grain bins and other permanent improvements) used by the taxpayer or tenant for the production of crops, fruits, agricultural products or the sustenance of livestock (which includes cattle, hogs, horses, mules, donkeys, sheep, goats, captive fur-bearing animals, chickens, turkeys, pigeons, and other poultry). Reg. 1.170A-7(b)(4). Nearly all property used as a residence or for agricultural purposes will qualify for a life estate gift.
The qualified transfer of a remainder interest in a personal residence or farm is not subject to any specific limitation on duration in Sec. 170(f)(3)(B)(i), and the Reg. 1.170A-7(b)(3)-(4) specifically mentions retention of an estate for life or term of years. Thus, the transfer can be for a life, lives or a term of years. Since there is no minimum 10% deduction test, such as applies with a charitable remainder trust or charitable gift annuity, there is no specific limit on the number of lives used for the life estate. However, the life estate is most commonly created for one or two lives.
It is also possible to transfer an undivided percentage of the remainder interest. For example, a remainder interest in part of a farm may be transferred to charity. Rev. Rul. 78-303. Alternatively, the remainder interest may be divided and a portion of the remainder transferred to family with the balance transferred to charity. Rev. Rul. 87-37. However, if the charity receives a minority interest in the remainder, it is possible that the minority interest should be subject to a valuation discount.
The ability to transfer part of a remainder interest is beneficial if there is debt on the property. It may be possible to combine a remainder interest gift with a bargain sale. Sec. 1011(a). Alternatively, the charity may purchase a portion of the remainder interest sufficient to pay the debt, and the donor may then give the charity the balance of the remainder interest.
Will Jefferson has resided in his modest home on a four-acre lot for many years. He now is age 80 and his IRA distributions continue to increase. In order to create a charitable deduction to offset his increased taxable income, Will Jefferson is contemplating transferring the remainder in his home to charity. With his IRA and other assets, he has substantial liquidity and will not need the value of the home for living expenses.
Will decides to deed the remainder interest in the home to his favorite charity. Based upon his age, he receives a charitable deduction of $201,930. This deduction is an appreciated-type deduction usable up to 30% of adjusted gross income. Over a period of four or five years, this charitable deduction will save $70,676 in income taxes. The deduction is based on assumed values for the residence of $50,000 and for the land of $250,000. While it is unusual for such a modest residence to be on expensive land, Will has lived on that property for many years and the adjoining city has now developed all around his property, thus increasing substantially the value of the land.
The deed of the remainder interest to charity must not be restricted. When the donor passes away, the charity must receive title to the property. If the charity does not receive an unrestricted right to the property, the deduction could be denied. For example, it is not permissible for the deed to require the charity to sell the property and divide the proceeds with another co-owner. Rev. Rul. 77-305.
It is possible for a donor to make a gift of a remainder interest even though there is a mortgage upon the residence. Unfortunately, there is very little tax guidance on the proper way to handle such a gift. Thus, each donor should proceed only after consulting with qualified counsel.
Absent specific authority, there are some basic tax principles that do provide donors with guidance. First, the charitable deduction calculation should only take the equity portion of the residence into account. It stands to reason that a donor should not enjoy a charitable deduction based upon the debt portion of the property. Indeed, if the donor dies the day after the gift, charity will only receive the value of the property net of the debt. Thus, at the time of the gift, the equity in the property seems an appropriate starting point for measuring the benefit to charity.
Second, with each additional mortgage payment by the donor, it is arguable that a new charitable deduction is allowable equal to the amount of principal reduction. See PLR 9329017. While this is a favorable position, it also involves a good deal of record keeping. In particular, the donor should retain appropriate documentation with respect to the mortgage payments and ongoing principal balance. The donor also needs to calculate a new charitable deduction each year for the remainder value of his or her gift.
Finally, the transfer of property subject to a mortgage may be deemed a bargain sale. Under the bargain sale rules, a donor is treated as having sold the property for the amount of indebtedness. There are two ways to minimize this potential problem. First, a donor may draft a "hold harmless" agreement. Pursuant to this agreement, a donor remains fully liable for the debt and does not hold charity responsible for any amount of the debt. This agreement allows a donor to argue that there is no relief of indebtedness. See Sec. 61. Second, a donor may apply his or her home exclusion to the deemed sale. With a $250,000 or $500,000 home exclusion, many donors can completely avoid any capital gain triggered as a result of the transfer.
An option for a life estate with mortgaged property is a partial sale to charity with the proceeds used to pay off the debt. If donor has property with debt equal to 10% of the value and the remainder interest is 60% of the value, then he or she first may sell part of the remainder to charity and pay off the debt. The donor then deeds the balance of the remainder to charity and qualifies for a charitable deduction on the remainder interest in that value.
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 asset, 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 a 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%. After the trust is funded, 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 solution.
Roger Realty Commercial Building
Roger Realty owns a $1 million commercial building. At the age of 70, he is ready to retire from the property management business. Therefore, he is contemplating a sale of the building. Because his CPA took straight line depreciation, Roger's cost basis in the building is only $100,000 and he could have a 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. Four weeks later, 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 produce tax savings to offset all of Roger's $270,000 capital gain. 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 fulfill his retirement planning goals.
Safety Recommendations for Split Gifts
Although hundreds of split gifts are completed annually and the IRS has generally not contested the concept of split transfers, 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. To reduce risk, a nonprofit or financial advisor trustee is a better option than a donor as trustee.
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 the right 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. In addition, because the trustee has title to 100% of the asset and a fiduciary duty to distribute the sale proceeds in proportionate shares to the unitrust and revocable trust, the donor may be able to take the undiscounted deduction on the CRT (this strategy has not been tested in Tax Court but is based upon sound reasoning).
4. Limited Partnership
Some conservative attorneys might choose to parallel the fact situation of PLR 9114025 by creating a limited partnership. Although undivided interests held in co-ownership would seem to have very similar self-dealing 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 the charity as trustee of a unitrust. The charity then owns 100% of the asset – part outright and part as trustee of the CRT.
$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. Under this rule, home exclusion can fully apply to the sale portion of the transaction.
Zero Tax Home Sale
Harry and Harriet Homeowner live in a beautiful $1 million home. They purchased the home 30 years ago for $200,000. However, the home is too large for just the two of them. Therefore, Harry and Harriet want to sell their home, downsize to a smaller home, and invest some of the proceeds for retirement. Furthermore, they would appreciate 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 30 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.
Because they retain 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 their $500,000 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 because the tax savings 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 may trigger 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 may 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 even nonrecourse mortgaged property pass the "5 and 5" rule. Simply put, the debt needs to be more than five years old and the property has been owned for more than five years. See 514(c). (For a review of the "5 and 5" rule, see GiftLaw Pro Ch. 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
The customary option for real estate with debt is to find a method to transfer unencumbered assets to the CRT. There are at least five solutions to the debt and CRT problem:
- Pay Off Debt – If a debt is small, the donor may have resources to pay the debt off and then transfer the real estate to the unitrust.
- 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.
- 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.
- 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 then transfer the balance of the real property into a charitable remainder trust. In many cases, the charity CFO is open to purchasing part of the real property if there is a gift portion. The outright gift of part of the asset reduces the risk for the charity.
- 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. The donor gives a personal guarantee that the trust will not be required to pay debt. When the property is sold, the balance of the asset retained by the donor is used to pay the 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 a modestly aggressive strategy and should be taken only after discussions between the donor and his or her professional advisors.
Life Estate in Personal Residence or Farm
A donor may receive a charitable deduction for the transfer of a remainder interest in a personal residence, farm or ranch. Sec. 170(f)(3)(B)(i). The donor deeds the personal residence or farm to a qualified exempt charity and reserves a life estate. The life estate may be a personal right for the donor to use the property, or more commonly a right to the use of the property during the donor's lifetime. The latter option enables the donor to lease the property and receive rental payments during his or her lifetime.
Personal Residence or Farm
A remainder interest may be transferred in any property used by the donor as a personal residence. Personal residence is defined as "any property used by the taxpayer as his personal residence even though it is not used as his principal residence." This may include the taxpayer's vacation or even stock owned by a taxpayer as a tenant-stockholder in a cooperative housing corporation (as those terms are defined in Secs. 216(b)(1) and (2) and if the dwelling which the taxpayer is entitled to occupy as such stockholder is used by him as his personal residence). Reg. 1.170A-7(b)(3).
A remainder interest in a farm also qualifies for a charitable deduction. A farm is property (including the fixtures, buildings, grain bins and other permanent improvements) used by the taxpayer or tenant for the production of crops, fruits, agricultural products or the sustenance of livestock (which includes cattle, hogs, horses, mules, donkeys, sheep, goats, captive fur-bearing animals, chickens, turkeys, pigeons, and other poultry). Reg. 1.170A-7(b)(4). Nearly all property used as a residence or for agricultural purposes will qualify for a life estate gift.
Duration
The qualified transfer of a remainder interest in a personal residence or farm is not subject to any specific limitation on duration in Sec. 170(f)(3)(B)(i), and the Reg. 1.170A-7(b)(3)-(4) specifically mentions retention of an estate for life or term of years. Thus, the transfer can be for a life, lives or a term of years. Since there is no minimum 10% deduction test, such as applies with a charitable remainder trust or charitable gift annuity, there is no specific limit on the number of lives used for the life estate. However, the life estate is most commonly created for one or two lives.
Undivided Interests in Life Estates
It is also possible to transfer an undivided percentage of the remainder interest. For example, a remainder interest in part of a farm may be transferred to charity. Rev. Rul. 78-303. Alternatively, the remainder interest may be divided and a portion of the remainder transferred to family with the balance transferred to charity. Rev. Rul. 87-37. However, if the charity receives a minority interest in the remainder, it is possible that the minority interest should be subject to a valuation discount.
The ability to transfer part of a remainder interest is beneficial if there is debt on the property. It may be possible to combine a remainder interest gift with a bargain sale. Sec. 1011(a). Alternatively, the charity may purchase a portion of the remainder interest sufficient to pay the debt, and the donor may then give the charity the balance of the remainder interest.
Life Estate on Home for Will Jefferson
Will Jefferson has resided in his modest home on a four-acre lot for many years. He now is age 80 and his IRA distributions continue to increase. In order to create a charitable deduction to offset his increased taxable income, Will Jefferson is contemplating transferring the remainder in his home to charity. With his IRA and other assets, he has substantial liquidity and will not need the value of the home for living expenses.
Will decides to deed the remainder interest in the home to his favorite charity. Based upon his age, he receives a charitable deduction of $201,930. This deduction is an appreciated-type deduction usable up to 30% of adjusted gross income. Over a period of four or five years, this charitable deduction will save $70,676 in income taxes. The deduction is based on assumed values for the residence of $50,000 and for the land of $250,000. While it is unusual for such a modest residence to be on expensive land, Will has lived on that property for many years and the adjoining city has now developed all around his property, thus increasing substantially the value of the land.
Restrictions In the Life Estate Deed
The deed of the remainder interest to charity must not be restricted. When the donor passes away, the charity must receive title to the property. If the charity does not receive an unrestricted right to the property, the deduction could be denied. For example, it is not permissible for the deed to require the charity to sell the property and divide the proceeds with another co-owner. Rev. Rul. 77-305.
Mortgage on Personal Residence or Farm
It is possible for a donor to make a gift of a remainder interest even though there is a mortgage upon the residence. Unfortunately, there is very little tax guidance on the proper way to handle such a gift. Thus, each donor should proceed only after consulting with qualified counsel.
Absent specific authority, there are some basic tax principles that do provide donors with guidance. First, the charitable deduction calculation should only take the equity portion of the residence into account. It stands to reason that a donor should not enjoy a charitable deduction based upon the debt portion of the property. Indeed, if the donor dies the day after the gift, charity will only receive the value of the property net of the debt. Thus, at the time of the gift, the equity in the property seems an appropriate starting point for measuring the benefit to charity.
Second, with each additional mortgage payment by the donor, it is arguable that a new charitable deduction is allowable equal to the amount of principal reduction. See PLR 9329017. While this is a favorable position, it also involves a good deal of record keeping. In particular, the donor should retain appropriate documentation with respect to the mortgage payments and ongoing principal balance. The donor also needs to calculate a new charitable deduction each year for the remainder value of his or her gift.
Finally, the transfer of property subject to a mortgage may be deemed a bargain sale. Under the bargain sale rules, a donor is treated as having sold the property for the amount of indebtedness. There are two ways to minimize this potential problem. First, a donor may draft a "hold harmless" agreement. Pursuant to this agreement, a donor remains fully liable for the debt and does not hold charity responsible for any amount of the debt. This agreement allows a donor to argue that there is no relief of indebtedness. See Sec. 61. Second, a donor may apply his or her home exclusion to the deemed sale. With a $250,000 or $500,000 home exclusion, many donors can completely avoid any capital gain triggered as a result of the transfer.
An option for a life estate with mortgaged property is a partial sale to charity with the proceeds used to pay off the debt. If donor has property with debt equal to 10% of the value and the remainder interest is 60% of the value, then he or she first may sell part of the remainder to charity and pay off the debt. The donor then deeds the balance of the remainder to charity and qualifies for a charitable deduction on the remainder interest in that value.
Published April 1, 2022
