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Gifts of Real Estate
Studies show that over 30 percent of the assets of wealthy individuals are comprised of real property. In this edition of Gift Planner's Digest, Dr. Bruce Bigelow reviews the many opportunities that exist for charitable gifts of real estate, and how planned giving professionals and professional advisors can work together to complete them.
by Bruce E. Bigelow, Ph.D.
Bruce Bigelow currently serves as the vice president for development and college relations at Hood College (Frederick, MD). He is a former member of the Board of Directors of NCPG, past chair of the International Outreach Committee, and is a former Conference Chair. He is a founding member and past President of the Chesapeake Planned Giving Council in Baltimore and is a member of both the Planned Giving Council of Greater Washington, DC and the CANARAS Group. He has written extensively in the field of planned giving. Dr. Bigelow received his BA from the College of Wooster and both an MA and Ph.D. from the University of Chicago.
As one travels throughout the world, there are few assets more evident to the casual observer than real estate. The physical landscape of houses and farms, factories and fields, golf courses and woodlands passes us constantly, whether we travel the familiar paths from house to work or we move in unexplored territory over roadways new to us. No wonder charities would, and should, consider gifts of real estate as a major part of their set of possible contributions. No wonder donors would consider using real estate as a primary vehicle for making contributions.
Two attributes of real estate make real property especially attractive as the focus of charitable gifts. First, the inherent value in real estate far exceeds that of any other single asset, both in the aggregate, and in many instances, in individual portfolios. While the value of any specific piece of real estate may, of course, vary greatly from other pieces that bear a superficial resemblance to it--location, accessibility, land contour, zoning, and so many other factors influencing value--and while the value of that same specific piece of real property might itself vary over time, as market conditions, zoning, utility restrictions, legal requirements, and demand might dictate, real estate is a most valuable commodity. Of the 10, 12, or 14 trillion dollars that economists estimate will pass from one generation to the next in the years before 2025, approximately 35% to 40% is in real estate, outstripping both publicly traded and closely held stock portfolios, the massive holdings of Bill Gates and Warren Buffet notwithstanding.
For many individuals the ratios are similar. In a recent article on personal wealth in the United States (data drawn from Federal estate tax returns) it is noted that approximately 30% of the assets of individuals who have a net worth between $1 and $10 million were in real estate. For estates under $1 million, the percentage rises considerably to between 45% and 50% of value. These percentages peak, especially for individuals between 50 and 65, to between 30% and 40% in real estate assets.
The second significant attribute of real estate is its abundance. Real estate is everywhere, and its owners are legion. Even people with relatively small estates own real estate, and wealthy people often own multiple real estate holdings. While its desirability may fluctuate wildly, it is little wonder that gifts of real estate are part of the discussion of almost all major or planned gifts. And it is no wonder that gift planning professionals, even at small offices, should seek to develop knowledge of, and expertise in, real estate transfers in order to fulfill their mission.
Forms Of Real Estate
Real estate comes in a variety of forms. Before considering some of the ways that charity might structure gifts of real estate to maximize value, both for the donor and for the donee, it is beneficial to consider some of the opportunities and limitations inherent in each of the major types of real estate.
Personal residences are by far the most numerous, even if they are not the most valuable types of real estate. Many people of relatively modest means own a personal residence. In fact, for a significant number of donors, a personal residence is the only piece of real estate they will ever own. Buying and selling personal residences--and the marketing and transfer process involved in such transactions--is often the only model with which our donors are familiar. That model often affects what can and ought to be done with gifts of real estate, even when its character may be quite different from that of a personal residence.
Notwithstanding the relative commonality, familiarity, and the potential as gifts from a wide spectrum of donors, personal residences carry an inherent limitation. By its very nature, a personal residence is where people live, and often where people want to continue to live. Even in cases where the occupants of a personal residence want to move, they cannot do so without having previously secured another place to live. Personal residences cannot, like most other real estate assets, be separated from the process of daily living, and any gift of a personal residence must be made solely in the context of that process.
This fact also offers special opportunities. Many people, for example, have lived in a home for many years and may be both unfamiliar with, and somewhat intimidated by the prospect of trying to sell their house to move to a retirement community. The uncertainties of the marketplace, the image of strangers peering into the private spaces of their lives, and the details of trying to coordinate the timing of the sale with the availability of the unit in the retirement community may all appear daunting to some. By being sensitive to these issues, by taking on the responsibility for marketing the property, and by remaining flexible in its own timing, a charity can often create gifts that carry as much psychological comfort as financial and tax benefit for the donors.
Our vacation preferences, those places we elect to spend our leisure time, may radically alter over the years. Sometimes, people find just the right spot where they return year after year that may, in fact, become a second, or even eventually, a first home. Other times, the place that seemed so appealing at one stage of life, in another takes on limitations that may hinder, or at least distract, from a desire to explore other vacation destinations. In still other instances, vacation homes may be used rarely, sitting empty for much of the year, and producing no tangible benefit for the owner in the unoccupied weeks and months.
Vacation homes, consequently, offer key potential gift opportunities. Whether as an outright gift, a gift into some life income arrangement, or a gift of an undivided partial interest entitling the charity to use the property for a specific period of time during the year, vacation homes can often turn a financial or logistical liability into a tax savings, and a cash flow stream of far greater benefit to the donor, and produce a gift to the charity at the same time.
Commercial properties--office buildings, factories, industrial parks, condominiums, mobile home parks, and the like--are often the most valuable type of real estate. They tend, as a rule, to be large (relative to personal residences), and carry a market value well into seven or eight figures.
They are also complex. Environmental concerns may loom. The market for such properties is relatively narrow, and creative sales financing may become a key element to a successful gift transaction. For this reason, a team of experts in legal and marketing issues becomes even more critical when working with potential gifts of commercial real estate.
Commercial property also carries a significant benefit beyond its intrinsic value. By definition it produces income. It is an investment and does not, therefore, require a sale, as is the case of most other types of real estate, in order to produce a cash flow to fund a life income plan, or even to fulfill the fiduciary responsibilities of a charity's board of directors or trustees. Sometimes, in fact, holding on to the property makes more financial sense than trying to sell it. In that case, one entire aspect of most real estate gift transactions becomes unnecessary.
Working with commercial pieces of real estate requires far more business analysis than working with any other type of real estate. Careful review of financials, the history of management, and the business risks associated with owning and potentially operating or managing commercial real estate are key elements of a gift transaction. However, these complexities notwithstanding, if all of the pieces fall into place, a gift of commercial real estate can be a tremendous boon for both the charity and the donor.
Much of the real property in the United States is yet undeveloped. Some of it will remain undeveloped in perpetuity or at least in the foreseeable future. One of the key questions, therefore, about raw land focuses on its development potential, which differentiates the two most important types of land for gift purposes.
Farmland: The United States initially developed as an agricultural country. As settlers moved westward, they gradually planted fields and erected fences in order to grow the crops that have nourished and sustained not only America, but also many other parts of the world for generations. More recently, farms have been consolidated, and as the value of farmland has grown, many traditional farming families find themselves turning to other pursuits. Traditional farmland, because of zoning restrictions and market opportunity, often has no immediate development potential. However, its attractiveness as farmland remains high. In many ways, farmland is an easy asset with which to deal, because its value is not dependent upon a future change in its status. Although the market for farms is more narrowly defined than that for personal residences, it remains a fairly straightforward buyer-seller relationship.
Commercially Developable Property: Commercially developable, but currently unoccupied raw land offers both the most challenging, and the most lucrative real estate gift possibility. The process of turning raw land into developed property, and of realizing the inherent value (often two, three, or four times the value prior to development) in such property, is long and complex. Gift possibilities may occur at almost any stage in the process, from the fields of corn and soybeans to finished lots ready for sale or lease. Each of these stages represents challenges, both to charities and to donors. One of the key issues involved in using commercially developable property as a charitable gift is the difficulty charities have of realizing its inherent benefit without falling prey to the stigma of becoming a "dealer" in real estate or falling afoul of the self dealing private foundation rules in the case of a charitable trust. Later, we will explore various options charities might use to participate in the potential value of developable property while remaining free from the limitations that outright development could impose.
One other issue about which charities and donors should be aware is the impact of "development" on the general environment of an area. Zoning usually determines which tracts of land will change status over time, but sometimes the decision about how, when, and in what manner development takes place remains in the hands of the owner of property. Charities are, or should be, good corporate citizens of whatever community they influence.
Consideration of how actions may influence communities is part of the responsibility of such citizens. It may not be a strictly financial issue, but may have considerable affect on how the charity is viewed by the community in the future.
Resources Needed For A Good Real Estate Program
While each potential real estate gift is unique in itself and contains its own challenges and opportunities, a solid real estate program, whether resting with a charitable organization, or with real estate or legal professionals, is built on a common set of foundation structures.
Well Designed Policies
Because almost everyone has a story of a real estate deal gone bad that happened either to them or to someone they know, it is critical at the beginning to set the boundaries and parameters within which a program will operate. Clearly articulating the steps needed to analyze and evaluate a potential gift of real estate, and the terms under which such a gift might occur help both to avoid potential pitfalls and allay the concerns that boards of directors or trustees might naturally feel about such gifts. If everyone involved understands that a potential gift of real estate must pass certain tests, and must undergo a series of evaluations before being considered as a gift, programs will carry with them a solid foundation and operate within limits of comfort for those who carry the fiduciary responsibility for the charity.
Similarly, professionals, whether directly in the real estate field or in the legal, financial planning, or accounting fields, will know clearly which pieces of real estate might make potential gifts, and which might fall outside the limits of reasonable gift possibilities.
Policies may take many forms and should be structured according to the sensibilities and understandings of the particular organization for which they are written. As a guide, Exhibit A is a set of policies for Hood College, which form the underpinning of a successful and multivaried real estate gift program.
Support Of The CEO And The Board
No matter how valuable a potential real estate gift might be or how much benefit a charity might derive from such a gift, if the chief executive officer or key members of the governing board are uncomfortable with gifts of real estate, or with particular forms of such gifts, a program is bound to flounder. It is important, therefore, that CEOs and perhaps board members are familiar with both the challenges and the opportunities associated with real estate gifts. Periodic training sessions for board committees often fulfill this function. Likewise, regular review sessions with the CEO will insure that the nuances and details of real estate gift transactions surprise no one when they arise.
Reliable Legal Counsel
Real estate law is, like most specialties in the legal profession, a subject that requires significant training and experience. Because real estate law is often governed by local jurisdictions that impose zoning and utility restrictions, accessibility requirements, and the like, it is critical to have legal council available who is familiar in detail with the climate of the specific jurisdiction within which the real estate is located.
Actually, most real estate transactions require two sets of legal expertise. The first has to do with the transfer itself and any local peculiarities related to that transfer. Local council is essential as a key part of any such transaction. In addition, many gift transactions involving real estate also require legal council familiar with the charitable and tax implications of the transfer. Real estate gifts come in all shapes and sizes with many complexities. Many of these are potential "deal killers" or carry with them implications not readily apparent to the untrained eye that can undermine the tax benefits of the gift or even, in some cases, the charitable benefit of the gift. Most of these pitfalls can be avoided through the scrutiny of competent tax council prior to any signed agreements. In the case of valuable and complex real estate transactions, the costs of legal council's involvement early in the process are well worth the benefit. In fact, involvement of, and scrutiny by, both tax council and real estate transfer council should be specific elements of the real estate policies referred to above.
Other than instances in which real estate is located immediately adjacent to a charity's base of operations and may be used, therefore, in direct conjunction with the charity's work, or where a commercial piece of property produces cash benefits such that the charity elects to retain ownership, the inherent value in real estate can be realized only through a market sale. Accordingly, it is critical that an individual, or a firm familiar with the market conditions in the specific locale of the real estate, or with the larger market related to a specialized type of real estate, (e.g., mobile home parks or specialized commercial properties) be a vital partner in this process. Such individuals not only provide a check on any appraised value for the property, they also can secure what is, in the long run, even more important: a qualified and ready buyer. Quite often, charities can work with real estate professionals and market experts prior to a gift transfer in order to survey the potential buyers and even negotiate with a possible buyer, always keeping in mind that a charity cannot act merely as the agent of the donor in such transactions. It is critical, therefore, that if any conversations occur with a potential buyer it occurs between the charity and the buyer, or between a real estate professional acting as the charity's agent and the buyer. Professionals should take scrupulous care to avoid any assigned obligation to sell the property to a specific party prior to the actual gift transfer to the charity, or to a charitable foundation, or trust.
Real estate professionals can often bring charitable gift possibilities to the attention of both the donor and the charity. Real estate agents are most familiar with the conditions of their own market and have direct contact with potential buyers. They also are aware of what properties might be most marketable, particularly in the field of commercial property or raw land, and they may be most aware of the tax consequences of a sale for the donor, which may be of such magnitude as to keep an otherwise solid financial transaction from being completed. The partnership between real estate professionals, willing buyers, willing sellers, and charitable organizations can be a partnership beneficial to everyone involved.
Central Concerns About Real Estate
Although there are many specific issues that may arise with a potential gift of any given piece of real estate, there are three primary concerns that form the fundamental basis of a real estate gift analysis.
The potential liabilities for charities (as well as for current owners) of environmental hazards make environmental analysis of any piece of real estate essential. Even in the case of personal residences, both charities and professionals should ask environmental questions regarding possible old buried oil storage tanks and the like. And in the case of commercial property or farmland, these questions should loom even larger.
One of the critical policies of any real estate program should be to have a level one environmental analysis done for each piece of property, with the charity reserving the right to go to a level two analysis, if it believes any potential hazards are not serious but needs a more detailed analysis to make sure. Again, any costs associated with these environmental analyses are far less than the risks involved in ignoring these issues.
The real estate market is fickle. No one, even the most knowledgeable local professional, can truly predict when a piece of property will sell, for how much, or the terms of such a sale transaction. Those who desire absolute guarantees should stay out of the real estate marketplace.
However, these uncertainties notwithstanding, everyone involved in the transaction--charities, professionals, and donors--should have as clear an understanding of the market as possible. The closer one can come to a specific possible buyer under delineated terms, the more secure the transaction will become, and the less natural uncertainties will come into play. For that reason, most good real estate transactions spend more time in analyzing, evaluating, and negotiating within the marketplace prior to the gift than in any other aspect of the transaction. Without these efforts, donors remain uncertain of their tax benefits or, in the case of a life income arrangement, of the cash flow that will devolve to them; charities remain uncertain of both the time and cash benefits inherent in the gift; and professionals remain uncompensated, with commissions still off in the indefinite future.
Value, like beauty in the old saying, is in the eye of the beholder. And rarely is it more subjective than in many instances of real estate. Traditionally, the fair market value of a piece of real estate (or any item, for that matter) is what a willing buyer would pay to a willing seller for that item under completely noncoercive conditions. This sounds wonderful, but both willing buyers and willing sellers are rarely free from pressures that have little to do with the intrinsic value of the real estate itself. Likewise, what one willing buyer might be able or willing to pay might be quite different from what another willing buyer might put on the table. Consequently, determining fair market value is, at best, a professional estimate.
As in so many instances in which professional judgment is a key factor, two or three or more heads are often better--or at least more credible--than one. That is why professional appraisers will use at least three, and perhaps more, comparable properties to estimate the value, and why it is sometimes prudent for charitable organizations and donors alike to secure more than one professional opinion of value prior to any transfer of ownership through a gift transaction. By securing more than one appraisal or professional opinion, all of the parties involved can be assured that the fair market value estimation is either well within a defined range of consensus, or understand that market conditions in that locale for that piece of property may be quite volatile, and that a gift transaction will need to take that volatility into account.
Sometimes, where there are significant disparities among different professional opinions of value, an average or mean, can serve as a reasonable compromise for determining the value of the property for gift purposes.
No matter how careful professional opinions or appraisals might be, or even how many consensuses one derives from a set of appraisals, nothing undergirds value more definitively than an actual sale. Consequently, real estate gift transactions often work best, for both the donor and the donee, when the potential donee organization is able to work with real estate professionals prior to the gift to determine possible buyers.
So long as the negotiations are conducted between the donee organization and the potential buyer, and so long as the real estate professional acts as the agent for the donee organization and not for the donor, these conversations can move very close to a sales agreement. Specific prices and terms can be negotiated, all in the hypothetical and under the condition that the gift does indeed occur. In fact, donee organizations often find it helpful and reassuring to be able to put these terms into a memo of understanding with potential buyers prior to the gift having been made. The key is that the donee organization must not feel coerced or be legally bound to sell to a specific buyer under certain conditions because of the prior negotiations of the donor. There is a significant difference, however, between the legal structures of a step transaction and a donee organization's prudent and logical exploration of the marketplace.
For all of these reasons, often the key to a successful real estate transaction is the real estate professional, especially where a trust or an annuity is concerned and, therefore, a payout obligation from the donee organization is involved. By providing both market understanding, marketing expertise, and by helping the donee organization find potential buyers for the property, the real estate professional can, and often must, close the key loop in the transaction. Partnership between the donee organization and the real estate professional is a critical element of success of many real estate gift transactions.
A hidden valuation issue that may be the most critical, but often is never addressed, is the potential increase in value to a piece of property from development. Turning a property from a "wholesale" asset to a "retail" asset may be a complex process, but potentially can increase the value of that property by factors of two, three, four, or even more.
Traditionally, charities have left that potential on the table, leaving the upside increases to developers. Two major concerns have dictated this approach to the development potential of key pieces of real estate.
First, it is a complex process. Taking a piece of property from its "raw land" status to the point where the enhanced value of a developed tract can be realized frequently requires significant zoning changes, access permissions, utility construction and hookups, adequate public facilities compliance, forestation issues, environmental and waste water disposal assurances, and a whole host of other, often very localized requirements and processes. All of this takes time, and usually money, both of which are in limited supply, even for relatively wealthy charitable organizations. Likewise, political naivetxc3© and unfamiliarity with the specific processes of securing requisite permissions, and constructing the necessary infrastructure of a development project, can often produce both delays and expenses with which charities are unprepared to contend, and produce frustration and impatience on the part of charitable boards. All of these prospects often cause charities simply to forego the process entirely, thereby eliminating any prospect of participating in the enhanced value of the property over time.
The second major barrier to a charity taking on the development role is a tax and legal one. Without careful planning and detailed monitoring of legal arrangements, a charity can become what tax professionals call "dealers" in real estate. Since "dealing" in real estate is usually not the tax exempt purpose of the charity, these activities may become subject to unrelated business income tax and, therefore, significantly reduce the net financial benefit of the transaction to the charity. In some cases, if the project is large enough, and the charity's other activities are more limited, moving through a development process into an unrelated business can threaten, or at least throw into question, the charity's tax exempt status. While this is an unusual circumstance, it is clearly serious enough that small charities, in particular, should examine the prospect very carefully before entering into a real estate development project. Developing real estate carries with it special dangers when the property is the funding mechanism for a charitable trust. Unitrusts and annuity trusts are subject to a series of restrictions found under the private foundation rules of the IRS Code.
Most important among these is the impact of unrelated business income within the trust. If a trust earns a dollar of unrelated business taxable income during the year, its tax exempt status is lost for the year in which the unrelated business income occurred. That loss of status can have disastrous affects on the finances of the trust and on the tax benefit for the donor. Clearly it is a circumstance to be avoided at all costs. Even in cases in which the charity's development activities are marginal and a good case can be made for the charity's retaining the tax exempt character of its income, the risk of invalidating the trust as a charitable entity for that year is rarely worth the benefit. If there is any question, a Private Letter Ruling will allay concerns and is worth securing.
Charitable trusts are also subject to the prohibitions against self dealing. That is, they cannot carry on any meaningful business interaction with individuals who are materially part of the trust transaction, such as the donor, the donor's immediate family, representatives of the charity, or professionals who were key players in the transaction. For example, this means that a donor cannot live on property donated to a charitable trust, even if he or she agrees to pay fair market rent. These practical considerations often present serious roadblocks to the successful completion of a charitable gift.
Overcoming Barriers And Realizing Value
While each real estate gift is unique and while real estate gifts sometimes present significant challenges to donors, professional advisors, and charities alike, the size and potential benefit to everyone concerned often makes meeting these challenges well worth the effort. With some careful planning, what might otherwise have appeared to be an insurmountable obstacle, can be eliminated and might well enhance the value of the gift for charitable purposes, or even for the donor or the donor's family as well. Following are several suggestions for accomplishing these purposes. Professional advisors should always remember, however, that each of these suggestions must be applied to the specific circumstances of any particular gift, and those new circumstances may require still further creative thought.
Installment Bargain Sales
Installment bargain sales are an attractive alternative to the more widely used charitable trusts or gift annuities. As the name suggests, installment bargain sales are a combination of traditional bargain sale arrangements and an installment payment schedule. They are, from a technical standpoint, the purchase by the charity of an asset for less than its fair market value, with payments made over a period of time.
Installment bargain sales can look very much like charitable trust transactions from the donor's perspective. They can result in a stream of income much as a trust would, with a charitable deduction in the same ball park as the trust, and, as with charitable gift annuities, the avoidance of part of the capital gains tax, with the remainder of the capital gains spread over the term of the payments. Like charitable gift annuity payments, installment bargain sales can result in regular payments to the donor, a portion of which will be taxed at favorable capital gains rates as opposed to the more onerous ordinary income rates. The income to the donor may result in less tax than would be the case with a traditional charitable trust.
Installment bargain sales also contain a great deal of flexibility, and therein lies their primary attraction to both charities and donors. Because they are bilateral agreements, there is no third party entity (that is, no charitable trust) and, therefore, no requirement to follow the restrictions of the normal private foundation rules. This has two prime advantages for all of the parties involved in the transaction. First, there is no prohibition against self dealing and, therefore, an opportunity to allow the donor to live on a piece of property for a period of time after the transaction is complete so long as a fair market rent is assessed. This opportunity is often a key element to the successful completion of a real estate gift if the donor wishes to move into a retirement community but is uncertain of the timing or availability of the new home. The second benefit is that unrelated business income tax does not disqualify or seriously undermine the charitable character of the transaction. Although it still may be desirable to avoid unrelated business tax for purely financial reasons, there are no legal restrictions to unrelated business activity, and no negative consequences of generation of UBIT beyond the financial considerations themselves.
Installment bargain sales contain additional flexibility as well. They can be put together much as any sales transaction, using a wide variety of terms. The four examples in Exhibit B (MS Excel) illustrate four ways of assembling the details of an installment bargain sale.
Example A is the most traditional way, and illustrates an installment bargain sale that produces a steady and constant stream of income to the donor for a fixed number of years. This transaction behaves almost exactly like a charitable remainder annuity trust, or a charitable gift annuity, if the annuity were for a fixed period of time. In this example, the donor is receiving an income payment equal to 6% of the initial fair market value of the property. This transaction extends 20 years and will generate an income tax deduction of $93,941, more than the charitable deduction of $78,758, which an annuity trust making the same income payment would generate. As one can see from the example, the income payment will be broken into three categories of income: An interest payment that will be taxed at ordinary income rates; a capital gains component, taxed at capital gains rates; and a principal payment that is tax free to the donor.
Example B illustrates a variable payment schedule: The initial payment is a larger amount with smaller payments in subsequent years. This is only one of a very broad number of such scheduling possibilities, but illustrates the wide variation in terms that may be incorporated into an installment bargain sale transaction.
Example C illustrates an installment bargain sale in which the payments are postponed for a three-year period, with interest accruing during that period of time and then paid out in the first several years after the payments begin. This allows the charity sufficient time to market and sell the property without income obligation, while preserving the ultimate benefit to the donor as well. The deferral can be for as long as the charity and the donor decide with no negative consequences to the transaction.
Finally, Example D illustrates an installment bargain sale transaction that derives from the charitable deduction instead of from the income payment to the donor. In this case, the donor and the charity start with a desire to generate a charitable deduction of X dollars. The payment schedule then flows from that variable. Again, this simply illustrates the wide flexibility of installment bargain sales and the possibilities of structuring these transactions to meet the specific desires and needs of the donors and their charitable partners.
In summary, installment bargain sales allow any reasonable payment schedule over whatever time frame makes sense without some of the restrictions of other kinds of charitable gifts. They are, of course, an obligation of the charity, and charities should enter into these transactions only with that knowledge. In other words, the points made earlier about market conditions and value become more critical in installment bargain sale transactions. Once the contract is completed, like any other contractual arrangement, the charity is then obligated to follow its terms and needs to be as sure as possible about its position before entering into the arrangement.
Charitable Gift Annuities
Like installment bargain sales, charitable gift annuities are bilateral contractual agreements between the charity and the donor. And, like installment bargain sales, annuities are not subject to the private foundation rules against self dealing or unrelated business activities. Because charitable gift annuities have been in existence for many decades (in fact they are the oldest official planned gift), they are familiar instruments for many financial planners and legal advisors. Also, because they are relatively simple to understand and draft, they appeal to donors who are sometimes immobilized by the overt complexity of charitable trust documents.
Gift annuities may be written with a deferral clause that will allow charities sufficient time to market and sell a piece of property as well as augment the charitable deduction for the donor. However, charitable gift annuities must be written for the life of the donor, or of the donor and spouse, and cannot carry with them a term certain without generating potential taxable income for the charity. In that sense, they are less flexible than installment bargain sales as a way of handling some of the particular desires of certain donors.
States vary a great deal in their regulation of charitable gift annuities and, although the National Association of Insurance Commissioners is moving rapidly toward more uniform regulations than have previously been the case, some states nonetheless remain quite stringent in their rules governing gift annuities. In particular, some states (New York being the most important of these) prohibit the use of real estate as a funding vehicle for charitable gift annuities entirely. For New York residents, and for many others, installment bargain sales may provide a much more reasonable alternative to the charitable gift annuity as a way of structuring a life income gift while still protecting the interests of the charity.
Partnerships With Professionals
Charities and donors alike have often been frustrated in the course of negotiating charitable gift transactions by those situations in which the potential value of a piece of real estate is significantly greater than its fair market value under current conditions. In many of these cases, realization of that potential--often three, four, or more times greater than might initially be the case--comes only as a function of a great deal of planning and effort to secure permits and zoning, build roads or other access ways, establish utility connections, respond to environmental or water and forestation requirements, and generally prepare the property for "retail" sales to end users. This is true whether the end users are residents, commercial, or industrial clients.
As noted above, these efforts are usually costly, at least in the short term, requiring time and energy from staff, necessitating expertise in often complex negotiation and the increased value of the property notwithstanding, may cause a tax to be imposed on the net profits of the project. Even with these complexities and financial implications, some charities have nonetheless decided to undertake such development, and to form deliberately structured for-profit subsidiaries to manage and to oversee these projects. Some of these for-profit activities have been quite successful, and in a few celebrated cases, have even transformed the financial terrain on which the charity operates. Other charities have made the decision that the potential increase in value is insufficient to warrant the expenditure of time and money. Sometimes the complexity and apparent (although not always real) risk of failure simply frightens charitable boards away before even beginning the task. If charities and their for-profit advisors could find ways of immunizing the charitable entity from the UBIT virus, while passing responsibility for handling the complex details of a real estate development to other professionals whose job it is to manage these complexities, both charities and donors could benefit in significantly more ways than has historically been the case. Land with development potential may be donated at various points along the spectrum of development. One end is the completely undeveloped land situated geographically in such a way that commercial or residential development is likely to move in its direction in the foreseeable future. It may be land already zoned for such development or potentially zoned in that way, such that the potential is really a function of time, market opportunity, and infrastructure development.
It is also possible for a gift to occur using property that has already been rezoned, permitted, or even prepared by the current owner for development. That is, sewer and water lines, access roads, other utility connections, and requisite local permits may already have been secured. Lots, or pads, may have been surveyed and ready for sale to the end users. Or, the property may be somewhere between these extremes, with some of the work to take the property from a "wholesale" to "retail" condition completed, but with more to be done before the full market potential can be realized.
The key issue for charities, particularly with respect to unrelated business income tax, is to avoid falling into the trap of becoming a "dealer" in real estate. That is, the charity must refrain from active marketing and sales of pieces of real estate, of "being in the business" of real estate development and sale. Rental income from real estate is treated by the tax code as passive income and, therefore, not subject to unrelated business income tax, and leasing of property, as opposed to sales, may help to avoid some of these pitfalls. Likewise, so long as a charity goes about what is termed "orderly liquidation" of property, it will not be treated as a dealer for tax purposes. Orderly liquidation does not mean fire sale or even necessarily rapid liquidation. However, it does mean that the charity is limited in the amount of change it can actively make to the character of the property and to the closeness it can come to what a commercial dealer in such property would undertake. The line here is somewhat fuzzy, and charities should secure competent legal advice any time there is a question of whether a particular kind of activity may approach too close to that line, or pose a risk of imposing dealer status on the charity.
There are several ways in which charities might partner with real estate professionals to avoid coming too close to that line. Let me suggest two variations on these methods.
First, a charity might partner with a real estate professional who would undertake the job of moving a property from current condition to sale readiness and then the ultimate sale of the property. This partnership would occur in two steps. First, the charity would actually sell the property to the real estate developer. The sales contract is usually structured in such a way that the purchase price is a set percentage of the estimated final market value of the property. The difference between the purchase price and the estimated developed value of the property is the amount that would go to the real estate professional. This is calculated from potential commission costs, sales and marketing costs, and development costs, all of which would be borne by the real estate professional, not by the charity. In this way the charity is able to realize its net benefit, to be paid subsequent to the final sale of the property, without falling into the trap of being a real estate developer itself. A specific example might illustrate how this would work. Let us say that a piece of property is already zoned for residential development. The property has a current fair market value of $400,000 with a donor's cost basis of $250,000, and permits have been secured to divide the property into 10 lots that have a potential retail value of $100,000 each. There is no further work that has been done on the property. Before the property can be sold to potential home owners, an access road must be constructed, a series of trees must be planted to meet forestation requirements, sewer and water lines must be installed, electric and telephone lines must be laid, and a storm water management pond must be constructed. All of these improvements will cost $200,000. If the charity were to undertake this development and to retain the services of a real estate professional to sell the final product, they would pay a rough commission of 5%, or, in our illustration, $50,000. In other words, if the charity were to undertake this development and pay all of the costs itself, it would stand to realize a net value of $750,000--$350,000 more than the "wholesale" gift value of the property. If the charity were to carry forward with this plan, $500,000 ($750,000 less the carry over basis of $250,000) would be taxable as unrelated business income, thus reducing the net profit by roughly 40%, and the final net to the charity to $550,000.
As an alternative, the charity may sell the property to a real estate professional for $725,000. The real estate professional will undertake to pay for and supervise all of the infrastructure development and preparation for market, the marketing and sales transactions themselves, and the ultimate transfer to end users. The real estate professional will then be able to recoup his or her expenses, and earn a significant profit in the process, not as a commission in this case, but as direct profit from the transaction.
The bottom line is that the charity is able to realize $125,000 more from this transaction than it would in the first, taxable circumstance, with no direct responsibility and no expenditure of time or energy on the part of the charity itself. This is a far simpler transaction, a more profitable transaction for the charity, and a partnership in which each side is able to bring its own special expertise to the table for the benefit of everyone involved.
This is particularly important in the case of a charitable trust. Charitable trusts, as we have noted before, must avoid unrelated business income tax in order to retain their charitable character. If the piece of real estate cited above were to go into a charitable trust, particularly if the trust is set up as an income only unitrust, and especially if the trust documents and state law allowed the trustee to treat post gift appreciation as fiduciary income, the donor, in addition to the charity, would benefit significantly from the increased value of the trust as a function of this transaction. In this way, the trustee is able to act for the benefit of both the charity and the income beneficiary and indeed, the U.S. government. The Internal Revenue Service ultimately would benefit as well through the increased income (and the tax it is able to levy thereon) from the trust over its lifetime.
Sometimes charities may find themselves with a special opportunity with real estate whose initial fair market value and development potential is far greater than even the illustration cited above. In that case, it may be that a single real estate professional is unable to undertake the complicated process of development that might be called for with such a property. The charity may elect to go into a formal partnership with a professional development company. So long as the partnership itself conducts the orderly liquidation through wholesale liquidation of large components of the property, the partnership can move ahead without running into unrelated business tax problems. However, if the partnership goes through a process of development, and then markets and sells smaller pieces of the property to end users, it may well be that the charity will need to work with its for-profit partner through a second partnership in which the charity has no direct interest. This second partnership would act in much the same way as the real estate professional did in the illustration above. The first partnership (charity has an active part) would sell pieces of the property to the second partnership for a fixed percentage of the estimated future potential value. The difference again between the sale price and the market value would be equal to the costs of marketing and selling the property, borne by the real estate developer who would be the sole party involved in the second partnership. This transaction has been supported by Private Letter Ruling 9704010 and again will serve to benefit charities and, in the case of charitable trusts, beneficiaries as well.
Partnerships with real estate professionals, either individuals or corporations, can be complicated and require significant care to establish. However, the difference between the wholesale and retail values of some pieces of real estate can be so significant that these efforts are well worth the time and attention. It is, after all, what the charity finally realizes from a piece of real estate that ultimately counts. Likewise, the benefits to an income beneficiary are usually a function of the amount of cash realized by a charitable trust from a sale of real property, rather than the estimated or appraised value at the time of the gift itself. The appraisal will determine the charitable income tax deduction, of course, but may be far removed from the ultimate source of the income that will flow to the beneficiaries over time.
Real estate is a gift worth pursuing. Real property comes in many different forms with both highly lucrative potential and significant and onerous potential liabilities as well. Charities, real estate professionals, legal, and financial experts all must come to understand the intricacies of real estate gifts in order to separate those worth pursuing and those best left alone. The potential good that can be done for the missions of charities, as well as for the benefit of donors, requires careful attention, significant technical knowledge of the questions and issues surrounding real estate, and recognition of the high visibility that real estate often generates. When all of these skills are brought together, the benefits can truly be outstanding for everyone involved.
Policies For Accepting Gifts Of Real Property
The following policies shall govern the acquisition by the College of gifts of real property. The Board of Trustees of the College reserves the right to make exceptions to these policies.
- A gift transaction shall be consistent with the mission of Hood College and will not damage the institution's image or reputation.
- Neither the acceptance nor subsequent sale of the gift parcel of real property shall produce a substantial administrative burden on either the staff or administrators of the College.
- Neither the acceptance nor the subsequent sale of the gift parcel of real property shall create a taxable event for the College nor shall such acceptance or subsequent sale in any way impede the nonprofit status of the College.
- The College shall require the donor, at the donor's expense, to secure an independent appraisal of the subject gift parcel by an MAI appraiser who has regularly engaged in the business of real estate appraisals within the jurisdiction where the property is located. The College, in its sole discretion, may elect to accept the valuation resulting from the donor's appraisal, or may secure its own appraisal of the property.
- The College, as it deems necessary and in its sole discretion, may require the donor to submit reports on the gift parcel, including but not limited to, hazardous waste audits, Phase I Environmental Studies, surveys, a title search, zoning restrictions, dominant and servient tenements, access to public utilities, and engineering inspections.
- The College may require a Level Two environmental audit. The College will not accept property with significant Level Two environmental concerns.
- The College shall obtain as much information as possible regarding the market conditions for the property's subsequent sale.
- A member of the College staff shall physically inspect the parcel of real estate to be given to the College before the College accepts the proposed gift.
- The College shall secure title insurance in the full amount of the value of the gift parcel of real estate.
- The College shall acquire property insurance to cover casualty losses to any improvements on the real estate and, if such improvements are located in a HUD designated flood area, obtain flood insurance, if available.
- Prior to accepting a gift of real estate, the Development Office and Vice President for Finance and Administration shall conduct an analysis of the anticipated cash flow in the proposed transaction. This analysis shall determine the maximum exposure the College may incur and the level or risk that is associated with the receipt, ownership, and eventual sale of the property.
- The College shall not accept outright gifts of real property with a present fair market value of less than $25,000 or gifts into trust with a value less than $100,000.
- The College shall not accept an intervivos gift of real estate that is encumbered by debt unless either: a) the donor enters into a written agreement with the College to retain responsibility for the debt; or b) the real estate i) produces income sufficient to pay the debt obligation under the terms of the debt instrument, ii) the remaining life of the debt is less than ten (10) years, and iii) the debt is not greater than twenty-five percent (25%) of the fair market value of the subject real estate.
- If the real estate is to be given subject to an agreement for lifetime annuities or trust payments, such an agreement shall not be written with a beneficiary(ies) younger than sixty (60) years of age unless payments are to be deferred until the beneficiary(ies) reach such age. In cases involving a younger beneficiary, all efforts shall be made to limit the payout to a fixed term of twenty (20) years or less.
- Unitrusts with an income-only limitation on payout or in which a FLIP clause allows deferral of payments until a sale occurs are preferred to annuities or annuity trusts.
- Prior to the acceptance of any parcel of real estate in exchange for which a lifetime annuity or trust agreement is to be given, such annuity or trust agreement first shall be approved by the Investment Committee of the Board of Trustees. In cases that the value of the real estate exceeds $300,000, or the proposed transaction could result in negative cash flow to the College, the proposal shall be submitted to the full Board of Trustees for final approval before the real estate is accepted, or any annuity or trust agreement is executed by the College.
- All transactions shall be structured in a manner that will provide the College with the maximum flexibility for the subsequent disposal of the real estate.
- In accordance with the policies set forth herein, the College may accept the remainder interest in property where the donor retains a life estate for one or more lives in the gift real estate, subject to the conditions that: a) the life tenant shall be responsible for maintenance, utilities, real estate taxes, and all appropriate insurance; b) that the life tenant shall not commit waste; c) that the life tenant shall not permit liens to be placed on the property or in any way obligate the College to the life tenant's creditors; and d) that the remainder interest in the property shall ultimately pass debt free to the College.
- Subject to the policies set forth herein and to the right to disclaim any devise, the College may accept testamentary gifts of real estate.
- Legal title to all real property conveyed to the College shall be held in the name of the College or shall be conveyed to a trust of which the College is the ultimate remainder beneficiary.
- The College shall assume no responsibility for providing financial, investment, or legal advice to donors but shall encourage all prospective donors to seek independent financial, investment, and legal advice prior to entering into any transaction with the College.
- The College will not pay a commission on the occasion of a gift of real estate to the College. Reasonable commissions may be paid only upon the subsequent sale of the property.
- The College shall structure annuity and trust agreements such that it shall not be obligated to make a payment to income beneficiaries until the real property is sold unless the property is income producing, or there is sufficient cash in the trust to cover the payment.
Adopted this _____ day of _______________, ____ by the Board of Trustees.