A Charitable Giving Exit Strategy for Real Estate Investors and Business Owners
Clients are often hesitant to consider making charitable gifts of illiquid assets because of a perceived complexity surrounding such gifts. Gifts of real estate and closely held business interests can seem daunting for both taxpayers and charities. For taxpayers who are looking for an income stream, a charitable income tax deduction, and an upfront bypass of capital gains taxes, a FLIP Charitable Remainder Unitrust (FLIP CRUT) offers a solution.
Charitable remainder unitrusts are referred to as a split-interest vehicles. This is because the trust first pays an income stream to the donor and then upon the termination of the trust the remainder interest passes to charity. Charitable remainder unitrusts are often described as a “win-win” strategy for both the taxpayer and charities. A special type of charitable remainder unitrust is the FLIP CRUT, also referred to as a “combination of methods” unitrust. Typically, the FLIP CRUT first operates as a net income only unitrust which pays income beneficiaries the lesser of the net income or the stated unitrust percentage set forth in the trust document. Given the current low interest rate environment we are facing, initially, the trust will most likely only pay the net income to the unitrust income beneficiaries. After a stated “triggering event” occurs, which can be defined in the trust document as the sale of certain real estate or other illiquid assets, the trust will convert to a standard unitrust on January 1st of the following calendar year. The valuation date for the trust is typically December 31st of each year. With a standard unitrust, the unitrust payout percentage is multiplied by the trust value to arrive at the annual unitrust amount. Charitable remainder unitrusts must make unitrust payouts or they will be disqualified. The “combination of methods” unitrust allows taxpayers to use illiquid assets to fund a charitable remainder unitrust without having to distribute fractional interests of the illiquid asset prior to the sale of the asset. The FLIP CRUT solves a liquidity issue for taxpayers and charities.
Unitrust income distributions are taxed first as ordinary income, then capital gain, then tax-free income, and finally return of corpus. This distribution method is often described as the “Four Tier” accounting structure. Although it appears complex, the basic concept is simple. The distribution to the recipient requires payment of the tax at the highest possible rate. Thus, all ordinary income earned by the trust must be distributed before any capital gain is paid out. Since the goal for most charitable remainder unitrusts is to distribute capital gain, the trust investments may be carefully selected to attempt to minimize the production of ordinary income and maximize recognized capital gain. The Trustee of the CRUT may wish to discuss this investment strategy with the trust’s investment manager. Investing for growth and attempting to create gain involves inherent risk, which should be carefully weighed before considering such a strategy. However, the lower capital gains tax rates provide greater tax efficiency for the unitrust income beneficiaries.
A unitrust payout percentage must not be less than 5 percent or more than 50 percent of the net fair market value of the trust assets, pursuant to federal law. Additionally, there is a 10 percent Minimum Remainder Interest (MRI) rule, which states that the charitable deduction generated from the gift to the trust must be 10 percent or greater of the net fair market value of such property as of the date such property is contributed to the trust. This same 10 percent MRI rule applies for all additional contributions to the charitable remainder trust. A lower unitrust payout percentage will produce a larger charitable income tax deduction. The charitable income tax deduction may be utilized the year in which the gift is made plus an additional five years for the carryover of any excess. Contributions of appreciated assets to public charities held long term are deductible up to 30 percent of the taxpayer’s contribution base unless the taxpayer elects to limit the deduction to his or her basis.
A donor may own real estate that he or she has depreciated, e.g., rental property. As a result, there may be depreciation recapture issues. If a donor has taken accelerated depreciation, depreciation recapture requires the donor to realize ordinary income upon sale of the depreciated property in an amount equal to the excess of accelerated depreciation over straight-line depreciation. In the event depreciation recapture applies to a donor, any gift of the depreciated property will be subject to the income tax reduction rules. Basically, the initial fair market value charitable deduction will be reduced by the ordinary income component of the real estate.
The value of the illiquid asset contributed to the trust, whether it is real estate, a business interest, or even tangible personal property, will be determined by obtaining a “qualified appraisal.” The regulations for “qualified appraisals” are strict and must be satisfied. Otherwise, the donor’s charitable income tax deduction may be jeopardized.
If you have any questions about funding a charitable remainder trust with appreciated interests in real estate or a closely held business, please contact the authors.