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Thursday February 2, 2023
Article of the Month
Real Estate Gifts - Debt and Environmental Issues
Bargain Sale Rules for Debt-Encumbered Real Estate
The majority of real estate is encumbered by debt. If contributed real estate is subject to a mortgage, the donor will receive a charitable deduction equal to only the equity portion of the gift. In other words, the donor may not claim a deduction for the debt-encumbered portion of the property.
In addition, the transfer of debt-encumbered property to charity is treated as a "bargain sale." Reg. 1.1011-2(a)(3). Specifically, the relief of indebtedness triggers gain to the extent that the debt exceeds the allocated cost basis. In essence, the contribution is viewed as a sale to charity with the sale price being equal to the mortgage. Finally, the cost basis in the property is prorated between the debt portion and gift portion. See Sec. 1011.
In some instances, a transfer of the mortgaged property will cause the lender to accelerate the entire debt obligation immediately. Therefore, a charity and donor should review the loan documents for this "acceleration" clause prior to any transfer. If the acceleration clause is present, the lender may agree to waive this provision in limited cases.
Debt Financed Income
If the debt is less than five years old and the donor has owned the property for less than five years, there may be acquisition indebtedness. Sec. 514(c)(2)(B). In such a case, the charity will pay income tax when it sells the real estate, since the sale proceeds would be deemed unrelated debt-financed income. Sec. 514(b).
There are two ways for a charity to avoid payment of this unrelated business income tax (UBIT). First, if the donor has owned the property for five years and the debt is five years old, a nonprofit may receive a real estate gift and will have a 10-year period to sell the property. The nonprofit does not assume the mortgage, but may make the monthly payments to defend its position in title.
Second, if the property fails the "5 and 5" test, then the charity may receive the property, pay off the indebtedness and hold the property for at least 12 months. Since the definition of debt-financed income is property on which there has been debt within the 12-month period prior to the sale, the charity should be permitted to sell the debt-free property after the 12-month period with no UBIT. Sec. 514(b).
Example – Mindy Mortgage
Mindy Mortgage purchased a duplex several years ago for $60,000. Her accountant has taken straight-line depreciation and the adjusted basis is now $40,000. The apartment has appreciated in value to $200,000. Debt on the property was created six years ago and there is a $50,000 balance.
Mindy Mortgage offers to give the property to her favorite charity. If the charity accepts the property with an appraised value of $200,000, Mindy will receive a charitable gift receipt for $150,000. This represents the difference between the $200,000 appraised value and the $50,000 mortgage. Since the depreciation was straight line, there is no depreciation recapture. Thus, Mindy's charitable deduction is the full $150,000.
In addition, Mindy would realize $40,000 of income, due to her relief from indebtedness. The $40,000 adjusted basis is prorated between the mortgage and the charitable gift, i.e., $10,000 to the debt. Sec. 1011(b). Therefore, Mindy would realize $40,000 of long-term capital gain ($50,000 - $10,000).
Since the debt is more than five years old and Mindy has owned the property for more than five years, the charity is able to receive the property and sell it without payment of UBIT, so long as the sale is within the next 10 years.
Unitrust Debt Solutions
- Pay Off the Debt: The simplest solution is for the donor to pay the debt off.
- Debt Release: The second strategy is to obtain a release.
- Bridge Loan: The third option is a bridge loan.
- Partial Sale to Charity: A fourth strategy is for the charity to buy part of the property.
- Personal Guarantee: The fifth strategy is for the donor to issue a personal guarantee that the debt will be paid out of retained assets.
There are five strategies for resolving the debt-encumbered property challenge. These are to pay it off, to obtain a release, to use a bridge loan to pay the debt, a partial purchase of assets by the charity or a personal guarantee.
1. Pay Off the Debt
The simplest solution is for the donor to pay off the debt. The debt may be quite small in proportion to the value of the property and the donor may have sufficient liquid assets to make a payment and clear the debt. If the debt is paid off, the property may be transferred into the unitrust after the release from the lender has been recorded at the county registrar of deeds.
Example – Mary Wilson Pays Off a Small Debt
Mary Wilson has property with fair market value of $200,000, cost basis of $50,000 and debt of $10,000. She has owned the property for nearly 20 years and has continued to make payments on the debt. Since Mary has other substantial assets, she is able to pay off the debt. After the release from the lender has been recorded, the property may be transferred into a unitrust. Since this is real property, Mary and her attorney choose to use a FLIP unitrust.
2. Debt Release
The second strategy is to obtain a release. Many properties have been held for a number of years and the debt is a fairly small percentage of the total value. Since most lenders are willing to allow debt to equal 80% of property value, it may be possible to obtain a release on part of the real estate.
For example, with a large parcel of real property, a quarter section, half section or larger portion of the property may be released from the debt, allowing the balance of the property to secure the indebtedness. Alternatively, there may be multiple apartments or commercial buildings that are subject to the same debt obligation. One or more could be released and the remaining properties would secure the debt.
Example – John and Mary Obtain a Release
John and Mary Smith have three buildings. The buildings each have a cost basis of $200,000 and fair market value of $1 million. There is a total of $600,000 in debt on the three buildings.
Since the debt is fairly modest in comparison to value of the buildings, John and Mary approach Cooperative Lender. Cooperative Lender is willing to release Buildings A and B and allow the $600,000 in debt to be secured by the value of Building C. After the release from Cooperative Lender has been recorded, John and Mary transfer Buildings A and B into a FLIP unitrust. They then sell all three buildings. The $1 million cash received from Building C is more than sufficient to pay the $600,000 debt. John and Mary receive income from the $2 million in the unitrust that was funded with Buildings A and B. The charitable income tax deduction on the FLIP unitrust also offsets the capital gains tax payable on the sale of Building C.
3. Bridge Loan
The third option is a bridge loan. If the donor owns other real estate assets, then it may be possible to obtain a loan on other property. The loan proceeds may then be used to pay off the debt on the property to be transferred to the unitrust. After the debt has been paid and the release recorded, the unencumbered property may then be transferred into the unitrust.
In some cases, the charity has made the bridge loan to the donor. This is permissible, so long as the terms are commercially reasonable. The loan must bear a reasonable rate of interest and the real estate securing the debt must be sufficient in value that it could be sold to pay the debt.
Example – Bill and Helen Use a Bridge Loan
Bill and Helen Wilson own three apartment buildings. Each apartment building has a value of $1 million, cost basis of $200,000 and debt of $200,000. They also own land parcel XYZ, with value of $1 million. Bill and Helen borrow $600,000 on parcel XYZ and pay off Buildings A, B and C. They then transfer Building A and Building B into a FLIP unitrust. Bill, Helen and the trustee sell Buildings A, B and C. With the $1 million cash received from Building C, they repay the bridge loan and parcel XYZ is again free and clear of debt.
4. Partial Sale to Charity
A fourth strategy is for the charity to buy part of the property. If there are divisible units, such as a large farm or ranch or multiple apartment buildings or commercial buildings, then it may be preferable for the charity to purchase an identified property. However, in some circumstances, the charity may also purchase an undivided interest in a specific property.
Normally, the chief financial officer (CFO) of the charity will be reluctant to purchase real estate as an endowment investment. However, if a portion of the value is a gift to the charity and the balance is a purchase, then the transaction frequently may be accomplished. If the donor will give 10% or 15% of the property outright to the charity, the charity will then purchase the other 85% or 90%. Because the gift lowers the risk of holding real estate, this plan is usually acceptable to the CFO. The value of the outright gift reduces the potential market risk and defrays the sales cost for the charity.
Example – Nonprofit CFO Receives 10% Gift and Buys 90% of Building
Sam and Susan Jones have apartment buildings A, B and C. Each building has a fair market value of $1 million, cost basis of $200,000 and debt of $200,000. Charity WXYZ is interested in creating a unitrust with WXYZ as trustee and remainder recipient. Sam and Susan transfer an undivided 10% of Building C as a gift to charity and also sell 90% of Building C to charity for $900,000. After paying the $200,000 debt obligation on Building C, $400,000 of the remaining $700,000 is used to pay off the indebtedness on Buildings A and B. After the release has been recorded, Buildings A and B are transferred into a FLIP unitrust with the charity as trustee. The charity then sells all three properties. When the charity has received proceeds at closing, the charitable trust receives $2 million and the charity receives $1 million for selling its interest in Building C. Charity is now the remainder recipient in a CRT and also received a current gift of $100,000.
5. Personal Guarantee
The fifth strategy is for the donor to issue a personal guarantee that the debt will be paid out of retained assets. This strategy has not been formally approved by Treasury, but has been used by individuals and advisors who are willing to undertake modest risk.
If the donor owns a substantial asset with moderate debt, it is possible to transfer an undivided percentage of that asset into a charitable trust and to retain the balance of the asset. Upon sale of the property, the donor has issued a personal guarantee that the debt will be satisfied out of the portion retained by the donor.
This plan works acceptably if the property may be sold within a reasonable period of time. After the sale, the trust receives its portion and the donor pays the debt from his or her portion of the retained asset. Once the debt has been paid and the trust has received its full value, the transaction is unlikely to be questioned by the IRS. If the property is readily saleable, this personal guarantee strategy can be contemplated.
Example – Will and Clara Promise to Pay the Debt
Will and Clara Green own an apartment building with value of $1 million and the cost basis of $100,000. They have taken straight-line depreciation and would have no ordinary income recapture if the property were sold. There is debt on the property of $200,000.
Will and Clara visit with their attorney and decide to fund a FLIP unitrust with an undivided 60% interest in the property. They determine that they will retain an undivided 40%. With their 40% interest, they will be able to fulfill their personal guarantee to pay the full $200,000 debt at closing. In order to minimize any risk that there would be problems with prearranged sale or potential indirect self-dealing, the attorney serves as the initial trustee of the FLIP unitrust and also receives title to the 40% held for Will and Clara in a revocable trust.
The unitrust is funded and Will and Clara issue a personal guarantee that the $200,000 in debt will be paid from the balance of the property. The attorney as trustee then lists the property for sale and sells in approximately two months. At closing, the $200,000 debt is paid from the $400,000 share of Will and Clara. They also benefit from the 6% unitrust funded with $600,000. They bypass $540,000 of gain on that trust and receive an income tax deduction of $252,372. The trust will pay an estimated $745,071 over their projected 18.4 years of life expectancy. After two lives, the charity will receive $765,313.
Since cash was received, there will be a gain of $360,000. In addition, they will pay $200,000 to cover the debt. After paying the debt, the charitable deduction offsets the tax payable on the portion sold. Will and Clara have $200,000 cash plus income for two lives from the $600,000 unitrust.
Environmental Issues When Accepting Gifts of Real Estate
"It is a great property, but there is a minor toxic waste problem."
Potential Donor to Favorite Charity
In a typical gift of real estate to charity, charity must take title to the property. Although charity will sell the property as soon as possible, it will now be listed in the chain of title. Therefore, any environmental problems arising from the property could subject the charity to potential liability.
With the potential unlimited liability associated with federal and state environmental laws, a charity must carefully review any gifts of real estate prior to acceptance. In particular, if the real estate is commercial or industrial in nature, a charity will want to take additional safety steps before accepting the contribution.
Such steps may include obtaining an environmental impact survey (EIS). Depending on the level of testing desired, an EIS might be Phase 1, Phase 2 or Phase 3. With each higher phase, a charity is provided with more assurances regarding the likelihood of an environmental problem. However, with each higher phase, the cost increases significantly. A charity can request that a donor pay the costs associated with an EIS, but in some cases, a charity will pay for the EIS if it feels the cost can be offset by the donor's gift. Thus, a charity and a donor have to balance the cost and liability issues carefully.
In some instances, a charity should simply refuse a gift of real estate if the environmental risks outweigh the financial benefits. This also applies to gifts of real estate in exchange for a charitable gift annuity. Since the charity becomes the owner of the real estate pursuant to a CGA, the same outright gift precautions apply to a potential CGA funded with real estate.
Charity as CRT Trustee
In many cases, a donor wants to fund a CRT with real estate. This is an excellent use of CRTs. However, in situations where the charity serves as trustee, it is important to review real estate gift acceptance policies, especially as they relate to environmental issues.
There are two courses of action the charity may take. First, the charity can request that the donor serve as trustee of the CRT until the property is sold. Once the property is sold, the charity may take over as successor trustee. This is an excellent and inexpensive solution. It keeps the charity (as trustee) from ever appearing in the property's chain of title. Therefore, charity should not have liability for any environmental problems.
Second, the charity can follow the usual safety steps for accepting gifts of property. For instance, the charity can request an EIS before accepting the property as trustee. After the safety steps are completed, the real estate may be transferred to the CRT with the charity serving as trustee. The downsides of this course of action are the associated costs, time and potential liability risk.
The LLC Option
Instead of taking title to the real estate directly, a charity may establish a single-member LLC to hold the real estate and reduce its environmental liability. The charity would not be the manager of the LLC, but would have the power to appoint and remove managers. Charity would appoint the donor to be manager of the LLC. However, he or she would be required to serve without compensation.
After creation of the LLC, the donor would transfer the real estate to the LLC. The donor, as sole manager of the LLC, would then sell the property. Once the property is sold, the donor would no longer need to serve as the LLC manager. Afterwards, the LLC would distribute the sales proceeds to the charity. But more important, the charity would never be in the chain of title with respect to the real estate.
This LLC option is based upon the ruling in PLR 200150027. However, letter rulings may not be used as a precedent. In addition, the IRS did not directly rule on the deductibility of the donor's contribution.
Debt and Environmental Liability with Real Estate Gifts
Real estate is an excellent gift – a donor who gives real estate instead of cash is likely to make a much larger gift. If there is substantial equity, then the debt solutions will nearly always be successful. With potential environmental issues, the donor-as-trustee or EIS solutions may facilitate a wonderful major gift.