Funding A Charitable Remainder Trust With Encumbered Property

Funding A Charitable Remainder Trust With Encumbered Property

Crunching The Numbers
Article posted in Charitable Remainder Trust on 7 July 1999| comments
audience: National Publication | last updated: 15 September 2012
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Summary

Thinking about transferring debt-encumbered property into a charitable remainder trust? In this article, St. Louis attorney Russell Willis examines the landmines and opportunities that exist with what many planners consider one of the most complex of charitable gift transactions.

by Russell A. Willis III

It is often stated that the difficulties in transferring encumbered property to a charitable remainder trust (CRT) are so nearly insurmountable that it should not be attempted. Often, the consequence of this thinking is to dissuade a potential donor from making an otherwise advantageous transfer. This article takes a realistic view of the matter and provides a method of determining mathematically which of several alternative approaches may be preferred.

Basics

It is assumed that the reader has at least a passing familiarity with the income and transfer tax characteristics of CRTs. Briefly, the taxpayer transfers property to a trust in which he/she has retained (or in which he/she has granted to another) a fixed annuity or unitrust1 interest for life, a term of years, or combination thereof, after which the remainder passes to a qualified charity. The taxpayer is allowed an income tax charitable deduction in the year in which the trust is funded, in the amount of the present value of the remainder, determined according to tables published by the Treasury.2

Often, a taxpayer will transfer to the trust property in which his/her basis for purposes of capital gains is considerably lower than the current fair market value (i.e., in which he/she has built-in unrecognized gains). If the trustee later sells the property, there is no immediate income tax consequence because the trust itself is an income tax exempt entity.3 However, the annuity or unitrust distributions will carry taxable income that has accrued to the trust out to the transferor or other "lead" beneficiary4 under a "four tier" system prescribed in Internal Revenue Code (IRC) §664(b)-ordinary income first, then capital gains, "other income" (including, for example, tax-exempt interest) third, and finally corpus. Thus, unless ordinary (first tier) income exceeds the amount of the annuity or unitrust payment, the gain will, over time, be distributed to the lead beneficiary and taxed, somewhat in the manner of an installment sale.

At the transferor's death, if he/she has retained the lead interest, the value of the trust corpus is included in the gross estate under IRC § 2036(a), but there is an offsetting charitable deduction for the remainder to charity.5

Let us suppose, for example, that we have a taxpayer, age 52, who has a property worth $1 million in which the basis for capital gains purposes is $100,000. If the taxpayer were to sell the property, he/she would pay a gains tax of $180,000,6 leaving only $820,000 to reinvest in a more diversified portfolio. If the taxpayer were then able to achieve, for example, a 2% current yield on the portfolio with net 8% growth, the income would rise from $16,400 in the first year to $48,170 in the 15th year.7 All of this would be taxed as ordinary income at rates up to 39.6%, so that over the course of 15 years, if aggregate income from the reinvested proceeds were about $445,504,8 income tax paid on this income would be about $176,420,9 and the net after tax income would be about $269,084. At net 8%, the principal value of the portfolio would have grown over 15 years to $2,408,498.10

Now, let us suppose that instead of selling the property and reinvesting the proceeds, the taxpayer transfers the property to a charitable remainder unitrust paying 5%. According to the tables, the remainder to charity after a 5% unitrust over the life of a transferor aged 52 (assuming an annual payout and a Section 7520 rate of 7.0%) is .30927.11 Thus, if the fair market value of property transferred to the trust were $1 million, the income tax charitable deduction would be $309,270. To the extent the transferor could not use this deduction in the first year under the 30% limitation,12 it could be carried forward up to five years.13 Because the trust would not pay a gains tax on a subsequent sale of the property, the entire $1 million would be available to reinvest.

Assuming net growth in the trust (after payment of the unitrust amount) of 5% per year, distributions would rise from $50,000 in the first year to $98,997 in the 15th year.14 Aggregate distributions over 15 years would be $1,078,928,15 of which (if the trust were invested in low-yield securities so that the gain recognized on sale of the transferred property could be distributed as tier 2 income)16 as much as $900,000 might be taxable at the lower gains rate of 20%. Thus, income tax paid on distributions from the unitrust might be as little as $128,384,17 and the net after tax distributions would be about $950,543.

The transfer to the charitable remainder unitrust would, in this scenario, result in a net improvement in cash flow to the transferor of about $681,458. At net 5%, the principal value of the trust would have grown over 15 years to $1,979,931,18 but the remainder of the unitrust would pass at the transferor's death to a charity, rather than to the transferor's legatees. For this reason, a portion of the increased cash flow from the unitrust is often used to fund premiums on a policy of insurance on the life of the transferor that is held in an irrevocable "asset replacement" trust outside the grantor's gross estate.

The "Bargain Sale" Rule

Now, let us suppose that the property transferred to the unitrust is encumbered by a mortgage of $200,000. Under IRC §1011(b), the transfer would be treated as a "bargain sale;"19 that is, the transferor would be treated as having received the present value of the interest in the unitrust, or $690,730,20 plus 30.927% of the debt (i.e., that portion of the debt that is allocated to the remainder), or $61,854, in exchange for an asset in which the taxpayer's basis was prorated to $69,073.21 Thus, the taxpayer would report a taxable gain of $683,511.22

In addition, that portion of the transferor's basis that was allocated to the remainder, $30,927, would reduce the income tax charitable deduction to $278,343. Although the transferor would pay a gains tax of $136,702, the unitrust would still have the full $1 million to invest, but the IRS has taken the position that the debt must be taken into account in calculating the amount of the unitrust payment.23 Thus, distributions over 15 years would aggregate $863,142,24 of which as much as $247,41625 would be taxable as capital gain at 20%, leaving $615,726 to be taxed as ordinary income at 39.6%, so that the net after tax distributions would be about $569,831.26

Subtracting the gains tax paid on the initial transfer to the unitrust, and adding back the tax benefit realized from the charitable deduction,27 the transferor is left with about $411,045 net cash flow28 (disregarding the lost opportunity to reinvest the amount paid in gains tax at the outset).29

Had the taxpayer instead sold the property, discharging the mortgage, and incurred the gain, the aggregate income over 15 years on the reinvested proceeds (at 2% current yield with 8% growth) would have been $336,844.47,30 and her net after tax at 39.6% would have been $203,450.50.31 The transfer of encumbered property to a charitable remainder unitrust results, in this instance, in a net improvement in cash flow to the transferor of about $207,590.

Other Difficulties32

In PLR 9015049, the Service asserted that because the unitrust might make payments from income on a mortgage on which the transferor remained liable, it was a "grantor trust" under IRC §677(a), and therefore disqualified as a CRT.33 While this ruling seems unnecessary in view of the "bargain sale" rule, it does not appear that the IRS intends to reverse its position. A number of solutions have been proposed to this problem-the simplest being to have the transferor pay off the mortgage or to ask the lender to release the mortgage and substitute other collateral before transferring the property to the trust.

Another alternative would be to include language in the trust instrument expressly protecting the trustee from liability on the mortgage and precluding the trustee from making direct payments on the debt. In PLR 9533014, although the Service declined to rule on the qualification of a charitable remainder unitrust to which the grantor proposed to transfer his interest in a partnership that owned property subject to non-recourse debt, it did rule that because the transferor had agreed to indemnify the trustee from and to hold it harmless against any liabilities, the trust would not violate Reg. 1.664-3(a)(4), which forbids the payment of any amount to, or for the benefit of, any person other than a qualified charity.

Another strategy would be to fund the remainder trust with an option to purchase the property at a nominal price, which the trustee would then sell to a third party for an amount equal to the difference between fair market value and the exercise price. This device has met with some resistance from the IRS. In PLR 9240017, the Service, citing Rev. Rul. 82-197,34 in which it had been held that the gift of an option to a charity does not generate an income tax deduction until the year in which the option is exercised, applied that reasoning to the case of a charitable remainder unitrust.

This ruling was then withdrawn by PLR 9417005. In withdrawing the ruling, the IRS stated that "no inference should be made" from the fact of the withdrawal, but some commentators nonetheless inferred that the Service was considering a ruling that, because an option is not itself an interest in property, the use of an option to fund a remainder trust might somehow disqualify the trust as an exempt entity. And, in 1995, the Service in fact issued such a ruling. PLR 9501004 takes the position that the gift of an option destroys the qualified status of the trust. The reasoning is that because a gratuitous option is not enforceable under applicable state law, the transfer to the trust is not a completed gift, and therefore "the trust cannot be a charitable remainder trust in every respect and cannot function exclusively as a charitable remainder trust from its inception," which are requirements under Regulations 1.664-1(a)(2) and 1.664-1(a)(4). Therefore, because the grantor had reserved a 9% unitrust interest, he had a retained interest for purposes of IRC §677(a) and he would be taxed on the gain realized when the trust sold the option to a third party. Although the ruling is not well reasoned, one should hesitate to fund a remainder trust with a gratuitous option in light of the IRS's obvious distaste for the device.

Yet another alternative would be to structure the transaction so that: 1) the transferor gives an undivided fractional interest in the property, equivalent to her unencumbered equity, to the trust, retaining the balance; 2) the trustee does not assume the indebtedness; 3) the transferor agrees to remain liable for and to hold the trustee harmless from liability on the debt; and 4) the transferor gives the trustee authority to market the entire property, including the retained interest.

The transferor will (ostensibly) have made a gift of the equity to the trust, and because he/she will not have been relieved of liability on the mortgage, the "bargain sale" rules arguably should not apply.35 Similarly, because the trustee will not have accepted any liability on the debt, the acquisition indebtedness rules should not apply, and because the transferor will have given the trustee authority to market the entire property, the self-dealing rules should not apply. Thus, if the fair market value of the property is $1 million, the taxpayer has a basis of $100,000, and there is a mortgage of $200,000, the taxpayer would transfer an undivided 80% interest in the property to the unitrust, reserving a 20% interest for the taxpayer. The income tax charitable deduction would be $247,416.36

Upon a subsequent sale of the property and discharge of the note, the transferor would report a gain of $180,000, on which he/she would pay gains tax of $36,000.37 The trust would have $800,000 to invest, and assuming net growth in the trust (after payment of the unitrust amount) of 5% per year, distributions would rise from $40,000 in the first year to $79,197 in the 15th year.38 Aggregate distributions over 15 years would be $863,142.20,39 of which as much as $720,000 could be characterized as gain. Thus, income tax paid on distributions from the unitrust might be as little as $200,684,40 and the net after tax distributions would be about $662,457.89. At net 5%, the principal value of the trust would have grown over 15 years to $1,583,944.70.41 Subtracting the gains tax paid on the initial transfer to the unitrust, and adding back the tax benefit realized from the charitable deduction,42 the transferor is left with about $724,435 net cash flow43 (disregarding the lost opportunity to reinvest the amount paid in gains tax at the outset).44 These numbers are a substantial improvement over the "bargain sale," but there is, at best, a mixed likelihood that the IRS would respect the purported severance of the "encumbered" from the "unencumbered" fractional interests in the property. Certainly the lender would not.

Partial Sale

Finally, the transferor might sell a fractional interest to the charity and transfer the remaining fractional interest to a unitrust, discharging the note in part from the proceeds and in part from the tax savings generated by the charitable deduction.45 Thus, if the transferor sold an undivided 11.114819% interest in the property to the charity for $111,148.19, he/she would recognize gain of $100,033.37,46 on which the gains tax would be $20,006.67,47 leaving her $91,141.52 in net, after-tax proceeds. The remaining 88.88519% could then be transferred to a 5% unitrust, where it would generate an income tax deduction of $274,895,48 resulting in tax savings (at 39.6%) of $108,859. This, together with the net proceeds of the sale, would be exactly sufficient to discharge the note. A 5% unitrust would pay $44,443 in the first year, and assuming net growth of 5%, the unitrust payments would rise to $87,99349 over 15 years. The aggregate distributions would be about $959,007.50 Of this, as much as $799,96751 could be taxed as capital gain, so that the income tax paid on the aggregate distributions might be as little as $222,973,52 leaving the transferor with net, after-tax distributions of $736,034. This result is actually better than the numbers produced in the previous scenario, and the partial sale does not entail as substantial a risk that the IRS will disregard the form of the transaction. The risk it does present, which may make the device unworkable in many situations, is that the charity must commit its own money to the purchase of an undivided fractional interest in property that it may not later be able to sell at the predicted price.

Increasing The Debt Load

In the specific example considered here, the benefits of the partial sale disappear as the debt on the property approaches $820,000 (i.e., as the net sale proceeds remaining after discharge of the debt approaches the amount of the gains tax to be paid). On the other hand, the "bargain sale" (i.e., the transfer of the encumbered property to a unitrust, with the grantor agreeing to indemnify the trustee against any liability on the debt) continues to yield a net advantage over the straight sale even as the debt load approaches 100%. Obviously, these figures are sensitive to the rate of return assumptions employed. (If we assume that an investment strategy is employed outside the unitrust that will combine a current yield of 5% with net 5% growth, despite the ongoing capital gains recognition problems this would entail, we will get rather different results.) But they are largely unaffected by changes in the table factor determining the present value of the charitable remainder (i.e., by the term of the lead interest), as this number-whatever it may be-occurs on both sides of the equation.

Conclusion

With careful attention to the legal difficulties attending the transfer of encumbered property to a CRT, and with diligent crunching of the numbers, it will often be possible to structure the transaction so as to yield a net after-tax cash flow advantage over the "straight sale," even when the debt load is significant.

Footnotes


  1. A unitrust pays to the holder of the life or term interest a fixed percentage of the fair market value of the trust corpus, determined annually. The dollar amount of the unitrust payment will fluctuate with the value of the trust corpus.back

  2. These tables are collected in Publications 1457 (the "Alpha" volume), KF 6571.A615, and 1458 (the "Beta" volume), KF 6571.A616, both issued in August 1989.back

  3. IRC §664(c).back

  4. For convenience, the life or term annuity or unitrust interest, whether retained by the transferor or granted to another, will be referred to generically as the "lead" interest.back

  5. If there are unexpired lead interests at the transferor's death (as, for example, for the remaining life of a spouse or child, or for an unexpired term of years), the charitable deduction will not fully offset the inclusion of the trust in the transferor's estate. An unexpired lead interest to a spouse will, however, be subject to a marital deduction under IRC §2056(b)(8).back

  6.  

       1,000.00      fair market value
        (100.00)     basis
         900.00      gain
         x 0.20      tax rate
         180.00      capital gains tax
    
    back
  7.  

        820.00       net proceeds
        x 0.02       yield
         16.40       income year 1
        x 1.0814     growth factor (approx. 2.9371929)
        48.169963    income year 15
    
    back
  8. 16.40 x (1.080 + 1.081 + 1.082 + 1.083 + ... 1.0814) = 445.50398k aggregate income over 15 years.back

  9.  

       445.50398    aggregate income over 15 years
        x .396      tax rate
       176.41957    total income tax paid
    
    back
  10.  

       820.00       initial balance
       x 1.0814     growth factor
     2,408.4981     principal balance after 15 years
    
    back
  11. Table U(1) under Reg. §1.664-4(e)(5).back

  12. Because one of the objectives of contributing appreciated property to the remainder trust is to defer gain, the transferor would ordinarily forego the election under IRC § 170(b)(1)(C)(iii) to avail the taxpayer of the higher ceiling (50% of adjusted gross income) by reducing the value of the contribution to his/her basis.back

  13. IRC §170(d)(2)(A).back

  14.  

        1,000.00       net proceeds
          x 0.05       unitrust payout
           50.00       distribution year 1
          x 1.0514      net growth factor (approx. 1.9799309)
           98.996545   distribution year 15
    
    back
  15. 50.00 x (1.050 + 1.051 + 1.052 + 1.053 + ... 1.0514) = 1,078.9277k aggregate distributions over 15 years.back

  16. Note, however, that if the proceeds are reinvested in tax-exempt bonds pursuant to a pre-arrangement, the transferor will be taxed on the gain as though he/she had sold the property and transferred the proceeds to the trust. Rev. Rul. 60-370, 1960-2 C.B. 203.back

  17.  

       1,078.9277   aggregate distributions over 15 years
        (900.00)    capital gains
         178.9277   ordinary income
        (309.27)    charitable deduction
        (130.3423)  net taxable income
          x .396    tax rate
         (51.61555) tax benefit
         180.00     gains tax on 900.00
         128.38445  total income tax paid
    
    back
  18.  

       1,000.00    initial balance
         x 1.0514  net growth factor
       1,979.9309  principal balance after 15 years
    


    This figure is considerably lower than the remaining principal balance in the first scenario because the transferor has been receiving a 5% rather than a 2% payout. back
  19. According to Reg. §1.1011-2(a)(3), "[i]f property is transferred subject to an indebtedness, the amount of the indebtedness must be treated as an amount realized for purposes of determining whether there is a sale or exchange to which section 1011(b) and this section apply, even though the transferee does not agree to assume or pay the indebtedness." The justification for this regulation is unclear.back

  20.  

       1,000.00      fair market value
        (309.27)     value of remainder
         690.73      value of retained interest
    
    back
  21.  

         100.00      basis
      /1,000.00      fair market value
           0.10      Ratio of basis to value
       x 690.73      present value of retained interest
          69.073     pro-rated basis in retained interest
    
    back
  22.  

         690.73      retained interest
          61.854     debt allocated to remainder
         752.584     amount deemed received in "bargain sale"
         (69.073)    pro-rated basis in retained interest
         683.511     reportable gain
    
    back
  23. See PLR 9533014, infra n.33.back

  24. 40.00 x (1.050 + 1.051 + 1.052 + 1.053 + ... 1.0514) = 863.1422k aggregate distributions over 15 years. This figure would, of course, increase if the debt were reduced or discharged during the term.back

  25.  

       1,000.00      gross sale proceeds
        (752.584)    basis in hands of unitrust (see supra n. 22)
         247.416     gain
    
    back
  26.  

         863.1422    aggregate distributions
        (243.82757)  tax at 39.6% on 615.7262
         (49.4832)   tax at 20% on 247.416
         569.83143   aggregate after tax distributions
    
    back
  27.  

         278.343     charitable deduction
          x .396     tax rate
         110.223828  tax benefit
    
    back
  28.  

         569.83143   aggregate after tax distributions
        (136.7022)   gains tax paid
         433.12923
         110.223828  tax benefit
         543.35305   net cash flow
    
    back
  29. 136.7022 gains tax paid times .05 rate of return times 1.9799309 growth factor times .604, i.e., 1 minus .396, after tax factor equals 8.1739591.back

  30.  

         820.00      net proceeds after gains tax
        (200.00)     discharge of note
         620.00
         x 0.02      yield
          12.40      income year 1
          12.40 x (1.080 = 1.081 + 1.082 + 1.083 + ... 1.0814)
            = 336.84447k aggregate income over 15 years.
    
    back
  31.  

         336.84447   aggregate income over 15 years
          x .396     tax rate
         133.39041   total income tax paid
    
    back
  32. Apart from the difficulties discussed in the text, if the transferor has held the property less than five years, or if the mortgage has been in place less than five years, the trust will be treated as having unrelated business income under IRC §514 and will not be exempt from income taxation (thereby destroying the income-shifting advantages of the trust). This problem cannot be avoided by having the lender release the transferor from liability on the debt because the mortgage would be "acquisition indebtedness" in the hands of the trust. Note, however, that the transferor would still be allowed the income tax charitable deduction for the transfer of the trust remainder. Further, a transfer of mortgaged property to the trust other than at its creation would be self-dealing under IRC §4941.back

  33. The ruling may be limited to recourse debt, although this is not clear. In PLR 9402026, the Service ruled that the funding of a charitable lead annuity trust with the grantor's limited partnership interest in a partnership that owned property subject to non-recourse debt would not cause trust income to be taxable to the grantor, where the governing instrument required that all income not used to pay the annuity amount was to be added to principal and forbade the trustee (during the annuity term) to distribute income or principal to anyone other than a qualified charitable organization. The remainder was to be distributed to the grantor's grandchildren. See PLR 9533014, discussed in the text.back

  34. 1982-2 C.B. 72.back

  35. Reg. §1.1011-2(a)(3), see supra n. 19.back

  36.  

         800.00      value of transferred interest
          x .30927   remainder factor
         247.416     value of charitable remainder
    
    back
  37.  

         200.00      sale proceeds to transferor
         (20.00)     basis in retained interest
         180.00      gain
          x .20      tax rate
          36.00      gains tax
    


    In view of this result, the transferor may want to hold back a somewhat larger undivided fractional interest calculated so that the additional proceeds are sufficient to pay the tax. The multivariable algebra required to calculate this amount, though reasonably straightforward, is beyond the scope of this paper. The method is similar to that illustrated at infra n. 45. back
  38.  

         800.00      net proceeds
         x 0.05      unitrust payout
          40.00      distribution year 1
         x 1.0514    net growth factor
          79.197236  distribution year 15
    
    back
  39. 40.00 x (1.050 + 1.051 + 1.052 + 1.053 + ... 1.0514) = 863.1422k aggregate distributions over 15 years.back

  40.  

         720.00      gain component
          x .20      tax rate
         144.00      tax on gain component
    
         143.1422    ordinary income component
          x .396  tax rate
          56.684311   tax on ordinary income component
    
         144.00
          56.684311
         200.68431    aggregate tax
    
    back
  41.  

         800.00       initial balance
         x 1.0514     net growth factor
       1,583.9447     principal balance after 15 years
    
    back
  42.  

         247.416      charitable deduction
          x .396      tax rate
          97.976736   tax benefit
    
    back
  43.  

         662.45789    aggregate after tax distributions
         (36.00)      gains tax paid
         626.45789
          97.976736   tax benefit
         724.43462    net cash flow
    
    back
  44. 36.00 gains tax paid times .05 rate of return times 1.9799309 growth factor times .604, i.e., 1 minus .396, after tax factor equals 2.1525808.back

  45. If the proceeds of the sale of a partial interest to the charity were s, then the gain component of that sale would be .9s and the gains tax would be .2(.9s), or .18s. The net after tax sale proceeds would thus be .82s.

    The transfer to the unitrust would be (1,000k - s), and the present value of the remainder to the charity would be .30927(1,000k - s), or 309.27k - .30927s. The income tax benefit at 39.6% would be .396(309.27k - .30927s), or 122.4709k - .1224709s.

    If we want the net after tax sale proceeds plus the tax benefit to exactly discharge the note, then the equation is:

    .82s + 122.4709k - .1224709s = 200k

    This simplifies to:

    .6975291s = 77.5291k

    Then,

    s = 111.14819kback

  46.  

         111.14819      sale proceeds
         (11.114819)    pro-rated basis
         100.03337      gain
    
    back
  47.  

         100.03337      gain
          x .20         tax rate
          20.006674     tax
    
    back
  48.  

         888.8519       transfer to unitrust
          x .30927      remainder factor per Table U(1)
         274.89522      charitable deduction
    
    back
  49.  

          44.442595     income year 1
         x 1.0514       growth factor
          87.993267     income year 15
    
    back
  50. 44.442595 x (1.050 + 1.051 + 1.052 + ... 1.0514) = 959.00698k aggregate distributions over 15 years.back

  51.  

         888.8519       transfer to unitrust
         (88.88519)     pro-rated basis
         799.96671      gain component
    
    back
  52.  

         799.96671      gain component
          x .20         tax rate
         159.99334      tax on gain component
    
         159.04027      ordinary income component
          x .396        tax rate
          62.979946     tax on ordinary income component
    
         159.99334
          62.979946
         222.97328      aggregate tax
    
    back

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