- Forms, Rates & Tables
- Continuing Professional Education
- Determination Letter
- Email Chief Counsel Advice
- Exempt Organizations Update
- Field Service Advice
- Forms and Instructions
- General Counsel Memoranda
- IRS Announcements
- IRS Fact Sheet
- IRS Forms
- IRS Legal Memoranda
- IRS Notices
- Information Release
- Internal Revenue Code
- Letter Rulings
- Revenue Procedures
- Revenue Rulings
- Technical Advice Memoranda
- Treasury Decisions
- Income Tax
- Transfer Taxes
- Case Studies
- Technical Reports
Contributions of real property represent one of the most complicated yet rewarding opportunities in charitable gift planning. This discussion reviews various types of real property, how it is owned, income tax considerations regarding transfers to charity, factors limiting transfer, and its compatibility with various types of split interest gift planning vehicles.
Real Property Defined
Real property is generally defined as land and the structures that are permanently affixed to it. Examples of real property include:
- raw land
- residential property
- property held for investment such as apartments, office buildings, and shopping centers
- commercial property used in the taxpayer's business such as industrial property, motels and hotels, recreational parks, mobile home and RV parks
- agricultural property used for the production of crops or livestock
Does real property include items of tangible personal property located on the property? Tangible personal property includes "any property, other than land or buildings, that can be seen or touched."1 Buildings, however, must be permanently attached to the land. Accordingly, mobile homes and portable buildings are considered tangible property.
The only specific example found in the regulations regarding the treatment of tangible personal property for charitable contribution purposes involves a gift of a future interest in a chandelier that is attached to a building. If the chandelier is to be severed from the building when the gift becomes complete, it is considered tangible personal property. Conversely, if the chandelier is to remain attached to the building (which is also contributed), it will also be considered real property.2
Real property also includes the natural resources that might accompany the land such as timber, coal, oil and gas, and minerals.
Real Property Ownership
The first step in evaluating gifts of real property involves determining who or what actually owns the property. The ownership of real property falls into three general categories:
- fee simple
- partial interests
- indirect interests
The most common type of individual ownership of real property is fee simple, which means the largest possible estate in real property. The owner of a fee simple interest enjoys all rights in the property during life, including the right to transfer them upon death. These rights include possession, control, enjoyment, and disposition. All other ownership interests consist of partial or indirect interests.
Partial interests occur when a property owner shares ownership of property with another person or entity, or is limited in some way with respect to one of the aforementioned property rights.
Tenancy in Common
Ownership by two or more persons of an undivided fractional interest is called tenancy in common. Owners may possess equal or unequal shares and may, unless contractually prohibited, dispose of their interests individually. Tenants in common are entitled to their prorata share of income from the property and are responsible for their prorata share of expenses.
When a person sells or transfers their interest by gift, the purchaser, or donee, becomes a tenant in common with the remaining owners. When a tenant in common dies, their interest passes according to the terms of their estate plan to whomever he or she designates. If the tenant dies without a will or trust, their interest passes according to state laws of intestate succession.
Joint Tenancy with Right of Survivorship
Joint tenancy with right of survivorship is distinguishable from tenants in common in several ways. First, unlike tenants in common, whereby tenants are permitted to own unequal shares, joint tenants all own equal interests. Second, when one joint tenant dies, the decedent's interest passes in equal shares to the surviving tenants by operation of law. As a result, such transfers are not subject to probate administration in the estate of the decedent tenant.
Likewise, any dispositive provisions in the decedent's will or trust are also disregarded. Accordingly, if jointly owned property is earmarked for a charitable bequest, it should not be held in joint tenancy unless the charitable donee is the joint tenant.
Gift and Estate Tax Considerations Regarding Property Held in Joint Tenancy
A common misconception by laypersons involves the ability of joint tenancy to avoid estate taxation. Even though a decedent tenant's interest avoids probate administration, it remains a component of their gross estate for federal estate tax purposes. Relying on this misconception, some property owners create joint tenancies during life with their children or others. What they have actually accomplished, however, is the completion of a lifetime gift to the donee, which may give rise to federal gift tax.
Tax Basis of Survivor's Interest
Another unique tax consequence applicable to joint tenancy involves the income tax basis of the property in the hands of a survivor tenant. When a joint tenant dies, the decedent's interest receives a stepped-up cost basis; however, the survivor's interest does not. Thus, a sale of appreciated property by the survivor tenant may trigger a taxable gain.
If a joint tenant sells their interest during life, the joint tenancy is severed and the purchaser becomes a tenant in common with the remaining owners.
Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, and Washington are community property states. Likewise, Wisconsin operates under a system of marital property that is similar to community property.
Community property laws vary by state; however, in general, income earned and property acquired during marriage are shared equally by both spouses, even if one spouse earns all the income. As in other states, property owned before marriage plus gifts and inheritances may generally remain as separate property provided they are maintained with separate assets and not otherwise commingled with community assets.
Unlike property held in joint tenancy and tenants by the entirety, community property does not pass by operation of law to the surviving spouse; rather, it passes according to the terms of the decedent spouse's will, trust, or by the laws of intestacy.
Also, unlike joint tenancy, which upon the death of a joint tenant provides a stepped-up cost basis for the decedent spouse's interest only, community property receives a stepped-up cost basis as to the entire property. Accordingly, if a surviving spouse subsequently sells the property, they will realize gain applicable only to post-death appreciation.
Tenancy by the Entirety
When a married couple take title to property together, many states consider each of them to be owners of the entire property. Such interests are referred to as tenants by the entirety. As such, neither can dispose of their interest individually. And like joint tenancy, when one tenant dies, their interest passes automatically to the surviving tenant by operation of law. When divorce severs the tenancy, the parties become tenants in common. Tenants by the entirety title are not recognized in community property states.
The concept of dividing property horizontally dates back to ancient Rome, yet was first recognized in this country with The Housing Act of 196 Most states subsequently enacted horizontal property acts that recognize and legally protect condominium ownership.
Under condominium co-ownership, each unit owner possesses an exclusive right to use, occupy, mortgage, and dispose of his or her specific unit, plus the undivided fractional interest in the areas and fixtures that comprise common areas. The same rules applicable to fee ownership apply to the ownership of specific units and co-owned common areas. Title to a condominium is evidenced by a deed and can be held in any of the forms referenced in this section.
Another common form of partial property ownership consists of short or long-term leaseholds of land or structures. When evaluating leasehold interests, it is important to distinguish if the donor owns the property and is the lessor (landlord) or is the lessee (tenant).
In Ltr. Rul. 9014033, the Service approved a transaction whereby a lessee proposed to transfer her interest in a ground lease and a three-story building located on the property and also subject to the ground lease to a charitable remainder unitrust that had a measuring term of ten years. The lessee paid annual rent to the lessor (landlord) and subleased the structure to a third party for an amount that exceeded the amount she paid the lessor. The value of the leasehold interest transferred to the trust was based on the difference between what she paid under the lease and what she received under the sublease. The Service approved the arrangement, holding the transaction would not cause the trust to have unrelated business income or constitute a prohibited act of self-dealing.
It is important to note that the sublease constituted the donor's entire interest in the property. The transfer of a lease by a lessor who also owns the underlying property would most likely constitute a nonqualified gift of a partial interest.3
Life Estates and Remainders
Previous examples represent forms of concurrent ownership of real property. Life estate and remainder interests provide for consecutive ownership. In a life estate agreement, the fee interest is divided among two or more persons. The life tenant is given the right as to possession, control, and enjoyment of the property for a period stated in the deed. This period is frequently measured by the life of the tenant; however, the estate can also be measured by a term of years or by a combination of life and a term of years. After conclusion of the measuring term, the property is transferred to the remainder beneficiary, who then holds the fee interest.
A comprehensive discussion of the charitable Life Estate Agreements is found in the Gift Vehicle Review section of the Reading Room.
Indirect interests exist when an individual does not actually hold title to property itself, but owns an interest in a legal entity that in fact holds title to the property.
Partnerships are structured as a general partnership or limited partnership. In a general partnership, all partners are personally liable for the debts of the partnership. Likewise, most general partners participate in management decisions.
Conversely, the liability of a limited partner is limited to their investment. In this respect, limited partners are similar to corporate shareholders. Also, limited partners have no voice in the day-to-day management decisions of the partnership.
For income tax purposes, partnerships are considered pass-through entities. This means that items of income and expense, gain and loss, and indebtedness are considered owned by each partner according to their percentage interest in or share of the partnership.
When evaluating gifts of property owned by a partnership, it is important to note the partnership owns the property and the partner owns a partnership interest. A careful reading of the partnership agreement will determine if and under what conditions a partnership interest can be transferred to charity.
Because partners are considered the owners of the partnership's income for income tax purposes, planners must take care to determine if the partnership generates any unrelated business income. As will be discussed, the presence of such income can, depending on the type of charitable donee, produce adverse tax consequences.
Likewise, because partners are considered the owners of partnership indebtedness, the transfer of a partnership interest in which the underlying assets are debt encumbered will be considered a bargain sale. For a comprehensive discussion of the income tax consequences of bargain sales, see Gift Vehicle Review - Bargain Sales.
As an alternative to transferring a partnership interest, it may be preferable to distribute the property to be contributed from the partnership to the partners. The donor/partner then transfers their tenants in common interest in the underlying property. Unlike a transfer of property from a corporation to a shareholder, a distribution of real property by a partnership may be able to be accomplished without a taxable event to the distributee.
Real property is frequently owned by a corporation in which a donor owns corporate stock. From a tax planning perspective, the transfer of corporate owned real property is the most complicated because of the presence of two taxpaying entities and two levels of tax -- the corporation and the shareholder. It is therefore important to determine who the donor should be.
When property is owned by a corporation that qualifies as a C-corporation for income tax purposes, gain or loss on sale is taxable initially at the corporate level. Whether or not the stock of the corporation is owned by a tax-exempt charitable organization or charitable remainder trust is irrelevant. A complete discussion of the issues surrounding corporate owned assets is found in Gift Asset Review - Privately Held Business Interests.
For income tax purposes, however, a corporation may qualify as an S Corporation. Such status is favorable, because in most instances the corporate level of tax is eliminated. For a comprehensive discussion of issues surrounding S-corporations, see Charitable Gifts of Subchapter S Stock: How to Solve the Practical Legal Problems by Christopher R. Hoyt.
Cooperative Housing Corporations
A "co-op" is a form of indirect ownership whereby property (typically multi-tenant residential) is acquired by a cooperative housing corporation. In many cases, the corporation finances 70 to 80 percent of the purchase price and obtains the balance through the sale of equity shares. Tenant-shareholders may also obtain conventional mortgage financing to acquire their shares.
A tenant-shareholder can be any entity (such as a corporation, trust, estate, partnership, or association) as well as an individual. In effect, each tenant-shareholder holds a proprietary lease that is subject to liens, debts, and obligations incurred by the corporation. Tenant-shareholders pay rent in an amount necessary to cover maintenance, debt service, property taxes, insurance, and to fund capital improvements. Generally, shareholders can deduct their share of the real estate taxes the corporation pays or incurs on the property. Likewise, shareholders are permitted to deduct their allocated share of mortgage interest payments. Shares in a cooperative housing corporation are subject to the same capital gain sale rules as principal residences. Accordingly, a tenant-shareholder can exclude $250,000 of capital gain on sale ($500,000 for a married couple filing jointly) provided certain ownership and occupancy time requirements are satisfied.
If the property is held for investment purposes, the shareholder may claim allocable depreciation. When selling the shares, the shareholder can also take advantage of the exchange rules of IRC §1031 to defer gain.
In most states, shares in a cooperative are considered real property; however, in others, they are considered intangible personal property.
Limited Liability Companies
A Limited Liability Company (LLC) is an entity formed under state law by filing articles of organization as an LL Unlike a general partnership, none of the members of an LLC are personally liable for the LLC's debts. An LLC may be classified as a partnership or corporation for federal income tax purposes. If an LLC is taxed as a partnership, there is a pass-through of the tax character of the distributive share to the member. There is also a pass-through of the characterization of the distribution for purposes of determining whether it is unrelated business income. Likewise, debt encumbered property held by an LLC will cause imposition of the bargain sale rules.
Revocable Living Trusts
The most common type of trust used in estate planning is the revocable living trust. Living trusts are intended to protect an estate owner's assets from the delay, publicity, court supervision, and expense of probate administration. In states with streamlined and decedent-friendly probate statutes and procedures, living trusts are virtually non-existent. Title to trust property is held by the trustee. In order to ensure proper tax treatment, it is generally preferable to transfer title to real property from the trust back to the trustors as individuals, after which, the individuals transfer the property to charity.
Many living trusts call for the division of the trust upon the death of the first spouse. This division is intended to segregate the estate for estate tax purposes to ensure that both spouse's unified gift and estate tax credit is utilized. These trusts are commonly referred to a "credit shelter" and "A/B" trusts. Some trusts take an additional step to create yet a third trust to preserve the right of decedent spouse regarding the ultimate disposition of their share of their estate. These trusts are commonly referred to as "qualified terminable interest property" or "QTIP" trusts and are particularly common when spouses have children from prior marriages for whom they intend to provide an inheritance from their separate assets.
Real Estate Investment Trusts
A real estate investment trust (REIT) is a publicly traded company that specializes in acquiring various types of investment real property or mortgages. Because they are publicly traded, REITs are easily valued and are considered liquid. REITs also offer investors diversification and professional management.
From an income tax perspective, REITs operate much like mutual funds. The majority of income and gains are passed through to shareholders. However, some REITs may produce unrelated business income. Accordingly, transfers of REIT shares to a charitable remainder trust may cause the trust to lose its tax-exempt status. A thorough review of the REIT prospectus to ensure compatibility with the intended gift form is, therefore, recommended.
Evidence of Title
Ownership of real property is evidenced by a written deed and is controlled by local law. Deeds vary with respect to content and form depending on the title interest to be conveyed and the purposes to be served. The types of deeds commonly observed in charitable gift planning include --
- full covenant and warranty deeds,
- grant deeds,
- quitclaim deeds, and
- executor's deeds.
Full Covenant and Warranty Deed
As its name implies, a full covenant and warranty deed provides the greatest amount of protection to the grantee (i.e., buyer or donee). The purpose of this type of deed is to create a continuing future obligation on the grantor to guarantee the covenants contained in the deed. These covenants generally include:
- seizin - a guarantee the seller is the owner of, has possession of, and has the right to sell the property.
- quiet enjoyment - a guarantee the grantee will not be disturbed in the possession of the property.
- encumbrance - a guarantee the property is not subject to any encumbrances other than stated in the deed.
- further assurance - the procurement and delivery of any instrument (other than the deed) to make the title good.
- warranty forever - an absolute guarantee by the grantor to the grantee of title and possession of the property.
Even though a warranty deed provides a grantor with assurances of good title, it does not guarantee the grantee will have marketable title. Subsequent to the transfer, a third party may arise to make a claim to rights in the property. Although such claims may not violate any deed covenants or otherwise be sufficient to cause the grantee to relinquish possession, they may nevertheless cloud the title.
In some states, grant deeds are used in the place of warranty deeds. A grant deed first warrants the property has not been conveyed to another person. It further warrants the property is free of any encumbrances (other than those specifically referenced on the deed) made by the grantor or any person claiming under him including liens, taxes, and assessments. A grant deed also describes any rights-of-way or other easements and building restrictions. Unlike a warranty deed, however, a grant deed does not warrant good title.
Quit Claim Deed
A quit claim deed does not warrant possession to or any right of title to the property; rather, it simply conveys whatever rights the grantor possesses at the time of transfer. For this reason, quit claim deeds offer grantees the least amount of security.
Quit claim deeds are commonly used by divorcing couples; one spouse signs all rights in the couple's real estate over to the other. This can be especially useful if it isn't clear how much of an interest, if any, that one spouse has in property that is held in the other spouse's name. For charitable contribution purposes, however, quit claim deeds are the least desirable.
Executor's deeds are used to convey title from the estate of a decedent. It contains only a covenant against acts of the grantor and, like a quit claim deed, makes no warrantees with respect to possession or good title.
The transfer of title is a complicated procedure that, in different areas of the country, is coordinated by an attorney or an escrow company. The items that must be attended to between the signing of the sales contract and the closing generally include:
- a title search
- title insurance
- property survey
- potential environmental hazards
- physical inspection of property and financial records
- RESPA disclosures
- removal and acceptance of encumbrances
A title search is intended to determine whether there are any defects, liens, or other restrictions against a property's title, and is performed by an attorney, conveyancer, abstract company, or title company. Any defects that are uncovered during a title search, such as unpaid taxes, delinquent mortgage payments, or judgments against the seller/donor, are disclosed in the title report.
Have debt reconveyances been recorded? Do any covenants or other agreements made by the trustor prevent the transfer and sale of the property? Has the property been declared a wetland or adversely zoned? Is the property in compliance with building codes and free of any material defects that would result in a delay of sale? Are there any easements on the land that might affect its future use or sale?
No form of title search is infallible. For this reason, title insurance is commonly used to guarantee the grantee's title is "marketable," and otherwise protect the grantee from loss or damage as a result of any title defects.
The title insurance policy describes the property in detail and states what limitations, if any, there are to the grantee's ownership. Furthermore, a title insurance policy may guarantee the property to be free of undisclosed liens, confusion in the rights of ownership, and other clouds on the title.
Although a title report reveals conditions shown in public recording offices, it does not reveal if the property has been encroached upon. Although not required, for additional protection, a purchaser may desire to have the property surveyed. A survey is a drawing prepared by a surveyor or civil engineer that shows the precise legal boundaries of a property, along with the location of improvements, easements, rights of way, encroachments, and other physical features.
The third step in the buyer/trustee/donee's due diligence process is a physical inspection of the property. When income-producing property is involved, a confirmation of the identity of the occupants, space occupied, rents, leases, and security deposits should be secured. The purpose of this process is to ensure that no occupant has any claim of ownership or encumbrance on the premises.
Included with the inspection process is a review for any environmental hazards. According to the Comprehensive Environmental Response, Compensation and Liability Act of 1980 (CERCLA), an owner of property within the boundaries of a "Superfund" site may be held liable for the costs of cleaning up the site. State law may also apply.
As originally drafted, the liability was joint and several. Thus, a charitable organization or fiduciary accepting property could be subject to liability for the entire cost of cleanup even though they played no role in contaminating it. The remediation expense frequently exceeded the value of the contributed property.
In 1996, Congress enacted the Asset Conservation, Lender Liability, and Deposit Insurance Protection Act. The Act amended the fiduciary liability rules under CERCLA to limit liability to the property itself and to protect fiduciaries against personal liability. However, the safe harbor rule does not limit the liability of a fiduciary whose negligence causes or contributes to a release or threatened release.
When even a remote possibility of an environmental hazard exists, a potential donee or trustee should require an environmental audit prior to accepting the property. A Phase 1 review researches prior owners and uses of the property. If the findings are suspect, a Phase 2 review includes physical inspection and core sampling. Such actions may also qualify the donee of real estate for the innocent landowner exception to strict liability under the environmental laws.
The Real Estate Settlement Procedures Act of 1974, as amended provides buyer/borrowers a good faith estimate of closing costs upon the issuance of a written loan commitment. Because most charitable contributions do not involve the issuance of new indebtedness on the part of the donee, RESPA disclosure is usually inapplicable.
Acceptance and Removal of Encumbrances
One of the most important pre-closing issues is whether or not the property will be transferred with any indebtedness. The consequences of transferring debt-encumbered property to charity are discussed later in this text. If the encumbrances are to be removed prior to transfer it is important that such removal is evidenced by a reconveyance that has been recorded.
Income Tax Considerations
Charitable transfers of real property present special issues for purposes of determining the amount of the donor's income tax charitable deduction. The following discussion assumes the reader is familiar with the percentage limitation and reduction rules imposed under IRC 170. These rules can be reviewed in detail in Tax Review, Section II. Determining the Donor's Allowable Charitable Income Tax Deduction. There are, however, several additional issues that apply specifically to gifts of real property.
Ordinary Income Property
The majority of real property gifts consist of property that has been held long-term by the donor. In such cases, the donor can deduct the fair market value of the property subject to the 30 percent annual deduction limitation. If, however, the property would produce any ordinary income if sold by the donor on the date of contribution, the amount of the deduction must be reduced by the ordinary income amount.
Ordinary income can occur in several situations:
- The property may have been held less than one year by the donor, in which case all gain is ordinary income.
- The property may be held by the donor as a real estate dealer.
- The property may be subject to depreciation recapture.
Property Held as Investor or Dealer
A natural starting point when evaluating a potential gift of real property is to determine if the donor holds the property for investment purposes or is considered a dealer in real estate.
Property owners are investors if they hold property for personal use, the production of income, and capital appreciation. Property held by a donor as an investor is considered a capital asset and, therefore, is subject to the percentage limitation and reduction rules applicable to capital gain property.
In general, if the property has been held by the donor long-term, the donor's deduction is based on the fair market value of the property transferred. The deduction can be used to the extent of 30 percent of the donor's contribution base with a five-year carry forward of any excess deduction.
If the property has been held short-term, the deduction is limited to the lesser of the property's fair market value or the donor's cost basis. This deduction can be used to the extent of 50 percent of the donor's contribution base with a five year carry forward of any excess deduction. Other reduction rules, discussed below, may reduce the amount of the donor's deduction.
Property owners are not investors but are dealers if they hold and develop property as inventory for sale to customers. Inventory is not considered a capital asset but, rather, property held by a taxpayer primarily for sale to customers in the ordinary course of a trade or business.4
Dealer status typically arises when a property owner improves property prior to sale. Such improvements include subdivision, development of infrastructure, and construction of buildings or other improvements. However, not all subdivision activity gives rise to dealer status.
Property held by a taxpayer as a dealer is considered ordinary income property subject to the percentage limitation and reduction rules. The donor's charitable deduction is based on the lesser of the property's fair market value and the cost of goods sold (ordinary income property).5 The resulting amount is deductible to the extent of 50 percent of the donor's contribution base.
Dealer status can also arise when a property owner is engaged in the frequent purchase and sale of real property. It is important to confirm the status of the donor as investor or dealer prior to completing a gift transaction. Dealer status is based upon all of the facts and circumstances surrounding the acquisition and use of the property.
Subject to exceptions discussed later, a donor does not generally realize any gain or loss on the transfer of property to charity. If property that is sold by the donor on the date of contribution would produce depreciation recapture under IRC §1250, the donor does not realize the recaptured amount. However, the fair market value of the property must be reduced by the amount that would have been recaptured for purposes of determining the donor's allowable income tax charitable deduction.6
Property with Retained Mineral Rights
Can a donor transfer property to charity (or to a split-interest planned giving vehicle) while retaining the right to minerals in place? Yes, but they will forfeit their charitable contribution deduction. Rev. Rul. 76-331 holds that retaining such a right is comparable to the contribution of stock with retained voting rights.7 Therefore, the transfer was deemed a nonqualified gift of a partial interest.
Some nonqualifying transfers may bear more risk than others. For example, a transfer of property to a charitable remainder trust that does not produce a charitable contribution income tax deduction may cause the trust to be treated as a grantor trust.8
If the donor intends on claiming an income tax charitable contribution deduction exceeding $5,000, a qualified appraisal will need to be performed by an independent qualified appraiser. The appraisal is required to be performed no earlier than 60 days prior to the transfer, and no later than the date on which the donor files the federal income tax return on which they claim the deduction. The appraisal will not only establish a valuation for charitable deduction purposes, but also will help the donee or trustee set a sales price. Accordingly, the appraisal is usually performed close to the transfer date.
Determining Fair Market Value
IRS Publication 561 helps donors, trustees, and appraisers determine the value of property (other than cash) that is given to qualified charitable organizations. In making and supporting the valuation of property, all factors affecting value are relevant and must be considered. These include:
- the selling price of the property
- sales of comparable properties
- replacement cost
- opinions of experts
With respect to real property, several factors affect the determination of fair market value: zoning and use; the condition of property, structures, and surrounding area; and the presence of easements which may affect the use of or access to the property.
When a fractional interest in an indivisible asset, such as real property, is contributed to charity, the valuation must reflect the minority or majority interest, and the lack of transferability and marketability that accompanies a partial interest, even though it might be the donor's entire interest.
It is also important to note that for charitable income tax deduction purposes, the fair market value of real property is determined net of any indebtedness secured by the property. The transfer of debt encumbered property to charity is also considered a bargain sale, which may give rise to the realization of gain by the donor. This and other issues involving property subject to indebtedness are discussed later in this text.
Transfers to Split-Interest Gift Vehicles
The transfer of real property to various types of split-interest gift vehicles presents unique planning challenges. Is the property compatible with the intended vehicle? Will the property be held or sold? Does the property need to produce income and, if so, what happens if it fails to do so?
Transfers of Real Property in Exchange for a Charitable Gift Annuity
It is important to note that not every charitable organization offers charitable gift annuities. Furthermore, because the obligation to make annuity payments pursuant to a charitable gift annuity agreement is a general obligation of the issuing charity, the obligation to make payments under an immediate payment gift annuity commences immediately regardless of whether the charitable organization has sold the contributed property. For this reason, many organizations do not accept real property in exchange for charitable gift annuities or state law restricts a charity from accepting it in return for a gift annuity. If they do, their decision is based on a thorough examination of the subject property and a possible reduction of the annuity rate or discount of purchase price used to determine the annuity payments. Such discounts compensate the charitable organization for liquidity risk.
For further reading, see Charitable Gift Annuities.
Transfers of Real Property to a Pooled Income Fund
As with charitable gift annuities, not every charitable organization offers pooled income funds. If they do, they may or may not, as policy, accept transfers of real property into their fund. The reason is possible dilution. When a pooled income fund accepts a transfer, the fund issues units to the donor in much the same way as a mutual fund. The named income recipient of the units begins receiving his or her prorata share of total fund income regardless of whether or not the contributed property has produced any income or has been sold. If the fund is unable to sell the contributed property for a protracted amount of time, and the property produces no income, all other fund participants' income will be reduced.
If the charitable organization does accept property into its pooled income fund, it will usually be based on the fact the property produces income, can be readily sold, or the charitable organization is prepared to purchase the property or use it in connection with its mission.
Colleges and Universities have lead the way in the use of pooled income funds created for the purpose of owning real property that is used by the organization in connection with its charitable purposes. Under this type of arrangement, a charitable organization establishes a pooled income fund to which donors make contributions of cash or other property, the fund liquidates the contributed property and uses the proceeds to construct new facilities or purchase property from the charitable organization. The organization in some cases leases land to the fund at a nominal cost for this purpose. In order to facilitate the construction process, the charitable organization may also lend money to the fund, or secure independent construction and long-term financing.
Although not specifically required, the fund most often uses the property in connection with its tax-exempt purposes (e.g., dormitories) with the rental income (net of debt-service, operating expenses, and funded depreciation) distributed to fund beneficiaries according to their units of participation. As was previously discussed, the fund may pass depreciation deductions (to the extent they exceed the required depreciation reserve) and tax credits (in their entirety) through to income beneficiaries.
For further reading, see Pooled Income Funds.
Transfers of Real Property to Charitable Remainder Trusts
Real property may or may not be suitable for transfer to a charitable remainder trust and if so, is certainly more appropriately transferred to certain types of charitable remainder trusts.
As previously discussed, the transfer of debt-encumbered property to a charitable remainder trust exposes the trust and trustor to significant income tax risks. If the property is free-and-clear, however, the question then becomes what type of trust is best?
Annuity Trust or Unitrust?
The principle issue that drives the selection of trust type is the property's ability to generate income from rents or the sale of the property itself. This issue is best described by example.
A trustor is considering the transfer of a 30-unit apartment complex to a charitable remainder trust. The property is free-and-clear of indebtedness. The trustor, who is conservative, desires the assurance of a steady income stream that is available through a charitable remainder annuity trust. The property is transferred to such a trust bearing an 8 percent annuity rate. Following the transfer, the property is placed on the market and a buyer is found; however, while in escrow the city inspector finds asbestos pealing off all of the acoustic ceilings and orders the problem to be remedied prior to sale. In the meantime, the renters move out and all rental income ceases.
What options are available to the annuity trust? Can the trust borrow the money necessary to make the repairs? A loan may be considered acquisition indebtedness and cause the trust to have unrelated business income. Could the trustor make an additional contribution to the trust? No, additional contributions to charitable remainder annuity trusts are not permitted. Meanwhile the requirement of the trust to make annuity payments continues. Can the annuity trust distribute undivided interests in the property as annuity payments to its income beneficiaries?
Although this may seem to be an extreme example, art does imitate life. Because of the annuity trust's inability to receive additional contributions or borrow funds to solve unforeseen problems, the selection of an annuity trust format places trustors and income recipients at the greatest risk among all forms of charitable remainder trusts. Therefore, the conservative trustor, who selected the annuity trust form based on the assurance of income, could be in for an unpleasant surprise.
The charitable remainder unitrust can accept additional contributions, which generally makes them the vehicle of choice when considering a transfer of real property. The next decision is the payout format, of which there are four types: 1) standard; 2) net income; 3) net income with makeup option; and 4) the newly recognized "flip" unitrust. Which of these is most compatible with real property? Unless the trustor desires the ability to defer income distributions, the authors prefer either the standard or flip formats over either the net income or net income with makeup formats. Why? The flip and standard unitrusts can be invested on a "total return" basis to satisfy the long-term investment objectives of the income recipients and charitable remaindermen.
For an extensive discussion of this issue, see Technical Reports - Charitable Remainder Trusts.
Charitable remainder trusts are subject to certain private foundation excise taxes, including prohibitions against acts of self-dealing between the trustee and a disqualified person.
Acts of self-dealing generally include a sale, exchange or lease, loan or other credit (except a loan that bears no interest), furnishing goods, services or use of trust property, or payment of compensation, income or use of assets, between a private foundation (charitable remainder trust) and a disqualified person.9
Of particular concern with real property is the use of property by a disqualified person. Disqualified persons include, but are not limited to, the trustor and members of the trustor's family or entities controlled by them. If the property is occupied or used by a disqualified person, they should vacate the property and terminate its use prior to transfer to the trust.
For further reading, see the discussion of self-dealing located in the Technical Reports - Charitable Remainder Trusts.
Unrelated Business Income
If a charitable remainder trust has any unrelated business taxable income (UBTI) in its taxable year, the trust is subject to a 100 percent excise tax on such income.10
This can be particularly punitive if contributed property is subject to an acquisition indebtedness. Since a charitable remainder trust takes on the cost basis and holding period of assets transferred to it, gain from the sale of property subject to an acquisition indebtedness can cause the entire gain to be confiscated via the excise tax.
Unrelated business taxable income is defined as "the gross income derived by an exempt organization from any unrelated trade or business regularly carried on by it, less the deductions directly connected with the carrying out of such trade or business, both computed with certain modifications." Among the modifications permitted is a specific deduction of $1,000.11
With respect to real property, the regulations specifically exempt, from the definition of unrelated business income, all rents from real property, if not debt-financed, and all rents from personal property, leased with real property, if such rents are an incidental amount and are not debt financed.12
The phrase "rents from real property" is a term of art and must be carefully analyzed for qualification as an exception to UBTI. The regulations, however, draw a distinction between rents and the provision of services for the convenience of the occupant. Section 512(b)-1(c)(5) of the regulations provides that payments for the use or occupancy of rooms and other space where services are also rendered to the occupant, such as for the use or occupancy of rooms or other quarters in hotels, boarding houses, or apartment houses furnishing hotel services, or in tourist camps or tourist homes, motor courts or motels, or for the use or occupancy of space in parking lots, warehouses, or storage garages, do not constitute rent from real property. Generally, services are considered rendered to the occupant if they are primarily for his convenience and are other than those usually or customarily rendered in connection with the rental of rooms or other space for occupancy only. The supplying of maid service, for example, constitutes such service; whereas the furnishing of heat and light, the cleaning of public entrances, exits, stairways and lobbies, and the collection of trash are not considered as services rendered to the occupant.13
Payments for the use or occupancy of entire private residences or living quarters in duplex or multiple housing units or offices in an office building are generally treated as rent from real property.
UBTI also includes income from the sale of goods. For example, suppose a donor is considering the transfer of a mobile home park. Is there a convenience store located on the property? Are there coin operated food dispensers or laundry facilities on the property? Are there centrally metered utilities for which the owner bills tenants at a profit? All of these examples may produce unrelated business income to the trust. In addition, the sale of "dealer" property will generate UBTI.
For further reading, see the discussion of unrelated business income located in Technical Reports - Charitable Remainder Trusts.
Charitable remainder trusts can invest in depreciable property. Depreciation deductions are generally apportioned between income recipient and trustee on the basis of trust income allocable to each, unless the governing instrument (or local law) requires or permits the trustee to maintain a reserve for depreciation. In the latter case, the deduction is allocated to the trustee to the extent of the depreciation reserve with any excess being apportioned between income recipient and trustee according to trust income allocable to each.14
The Service has ruled that a depreciation reserve is not required for a standard unitrust (and presumably an annuity trust), whereas one is required for a net income unitrust.15
Transfers of Real Property to Charitable Lead Trusts
The design of charitable lead trusts in use today is based on two main themes:
- whether the trust income is considered owned by the grantor and therefore produces an income tax charitable deduction, and
- whether the remainder interest reverts to the grantor or is distributed to third parties such as members of the grantor's family.
There are four basic types of charitable lead trusts arising out of these themes:
- Qualified reversionary grantor trust
- Qualified nonreversionary grantor trust
- Qualified nonreversionary nongrantor trust, and
- Nonqualified reversionary nongrantor trust
These trusts are described in detail in Technical Reports - Charitable Lead Trusts.
Unlike charitable remainder trusts, which are conditionally exempt from income tax and, therefore, can sell appreciated property without incurring taxable gain, charitable lead trusts and their grantors do not enjoy tax-exempt status. For this reason, real property is not generally transferred with the intention of an immediate sale; rather, it is usually transferred with the intent of being held for the duration of the trust and subsequent transfer to the noncharitable remainderman. For this reason, the most suitable type of real property for transfer to a charitable lead trust is property that produces, and can reasonably be expected to continue to produce, income which the trust will distribute in satisfaction of the annuity or unitrust amount.
The remainderman can be the grantor, in which case the trust would be considered a reversionary trust, or to persons other than the grantor, in which case the trust would be considered nonreversionary.
The selection of grantor or nongrantor format depends on the income tax structure of the grantor and the subject property.
Grantor Charitable Lead Trusts
A grantor charitable lead trust is a trust for which the grantor is considered, for income tax purposes, to be the owner of all trust income. The grantor is permitted an income tax charitable deduction for the present value of the charitable income payments when the trust is created. Grantors are taxed on the income produced by the trust as if the trust does not exist and can claim deductions and tax credits associated with such income. No additional deduction is available for the annual amounts distributed by the trust to charity, however.
If real property is to be transferred to a grantor charitable lead trust, it must be transferred with the understanding that income produced by the property, net of deductions allowed in connection with the property, will be taxable to grantor even though the entire amount may be paid to charity in satisfaction of the annuity or unitrust amount. Further, if the property is sold during the trust term, any gain resulting from the sale will be taxable to the grantor. This may not be an issue if the property is not highly appreciated or the grantor possesses capital loss or passive loss deductions to offset any realized gain. However, if an income tax is generated, the obligation to pay the tax is that of the grantor and not the trust.
Nongrantor Lead Trusts
As its name suggests, a nongrantor lead trust does not qualify under grantor trust rules; accordingly, the grantor does not receive a charitable income tax deduction; however, none of the income produced by the trust is taxable to the grantor. Nongrantor charitable lead trusts are taxed as complex trusts.16
Nongrantor lead trusts are permitted deductions for amounts distributed to charity and amounts normally deductible in connection with real property ownership. If the property is sold, any gain arising from the sale is taxable to the trust itself. These features make the income tax consequences of real property transfers to nongrantor lead trusts a far more predictable proposition than for grantor trusts.
Unrelated Business Income
The presence of unrelated business income in charitable lead trusts does not carry the same ominous tax consequences that apply to charitable remainder trusts. With respect to charitable remainder trusts, the presence of even one dollar of unrelated business taxable income causes it to lose its tax-exempt status for such tax year and be taxed as a complex trust. Conversely, nongrantor charitable lead trusts are taxable as complex trusts from inception; therefore, the tax consequences of unrelated business taxable income are not so problematic.
With respect to nongrantor charitable lead trusts, amounts distributed to charity that otherwise qualify for deduction under IRC §642(c) are not deductible to the extent that such amounts are allocable to unrelated business income (as described in IRC §512) realized by the trust during the taxable year.17
Unrelated business income typically arises from certain business activities, leases, mineral exploration carried on by the trust, and possibly including income produced by debt-financed property. Unrelated business income can also arise indirectly from the ownership by the trust of pass-through entities such as partnerships over which the trustee may have no control over operations and the resulting tax character of income produced by the enterprise.
Although the deduction for distributions of UBI is disallowed under IRC §681, section 512(b)(11) provides partial mitigation. Specifically, this section permits the trust to deduct payments of UBI actually made to charity subject to the percentage limitation rules applicable to individual taxpayers. Accordingly, if the distributions consist of cash payable to a public charity as described in IRC §170(b)(1)(A), the trust can deduct distributions of UBI to the extent of 50 percent of the trust's contribution base.18 If the payments are made to a private non-operating foundation, the percentage limitation is 30 percent.
Planning for Liquidity
One of the greatest risks associated with the transfer of real property to a charitable lead trust is the lack of cash with which to make payments to charity or otherwise manage and operate the property. Those who own real property are all too familiar with the term "unforeseen expense."
One solution would be for the grantor to make an additional contribution to the trust. Are such contributions permissible? With respect to charitable remainder trusts, additional contributions to unitrusts are expressly permitted. Conversely, additional contributions to charitable remainder annuity trusts are specifically prohibited.19
In the case of charitable lead trusts, however, there are no restrictions that prohibit additional contributions to either an annuity trust or unitrust. There are several important distinctions, however:
Additional Contributions to Annuity Trusts
In order for a transfer to a charitable lead annuity trust to qualify for income, gift, or estate tax deduction purposes, the annuity amount must be "determinable with certainty" at the time the trust is created.20
The increased annuity amount arising from an additional contribution violates this rule. Therefore, any additional contributions will not produce any additional income, gift, or estate tax deductions. This failure will not disqualify the deduction produced by the initial contribution, however.
Additional Contributions to Unitrusts
Because payments from a charitable lead unitrust do not have to be determinable with certainty at the time the trust is created, additional contributions will qualify for income, gift, and estate tax deduction purposes. The Service has ruled privately that a charitable lead unitrust that contained a provision that expressly provided for additional contributions was qualified, and that additional contributions would qualify for gift tax purposes.21
Interest-Free Loan from Disqualified Person to Trust Permissible
As an alternative to an additional contribution, can the grantor make a loan to the trust? The lending of money by a disqualified person to a private foundation is not a prohibited act of self-dealing as long as the loan is without interest or other charge and the proceeds are used exclusively for purposes described in IRC §501(c)(3). Furthermore, the imputed interest rules of IRC §7872 do not apply. A loan may cause the trust to have acquisition indebtedness, however.
Gifts of Remainder Interest in Personal Residence or Farm
A gift of a remainder interest in a personal residence or farm is described generally as a transaction in which an individual irrevocably transfers title to a personal residence or farm to a charitable organization with a retained right to the use of the property for a term that is specified in the gift agreement. At the conclusion of the measuring term, all rights in the property are transferred to the charitable remainderman.
A comprehensive discussion of this vehicle (including transfers of debt-encumbered property) is found in Technical Reports - Life Estate Agreements.
Property Management and Maintenance
Who will maintain the property during the period in which the donee or trust holds it? Suppose an individual transfers real property to a charitable remainder trust. Can the trustor manage the property? Can the trustor receive compensation for providing management services without such compensation being considered an act of self-dealing? The answer to both questions is yes, provided compensation reflects market rates.22
Property Tax Considerations
Will transferring the title to real property to charity or to a split-interest planned giving vehicle trigger a revaluation for property tax purposes? The answer depends on the county in which the property is situated. Refer to local law.
Transfers of Real Property Subject to Indebtedness
If the property is subject to an indebtedness, is it compatible with the type of gift or gift vehicle being contemplated?
When debt encumbered property is transferred to charity by outright gift, the entire amount of the indebtedness is considered an amount realized by the donor for purposes of the bargain sale rules. The amount of the realized gain is calculated as if the donor had received cash in the amount of the indebtedness. A complete discussion of the income tax consequences to donors and charities of bargain sales can be found in Gift Vehicle Review.
Bargain Installment Sales
If property is sold to charity for less than its fair market value in exchange for an installment note, can the gain attributable to the bargain sale be reported using the installment method? Properly structured, the answer is yes. In Rev. Rul. 79-326, a taxpayer made a bargain sale of real property to an educational organization. At the time of the transfer the property was subject to an existing mortgage. The organization made a cash down payment, executed a new mortgage to the seller, and assumed the existing mortgage. The Service ruled that the transaction would qualify for bargain sale treatment. Further, for purposes of determining the taxation of the mortgage payments to the taxpayer, the amount of the assumed mortgage in excess of the taxpayer's basis allocated to the amount realized in connection with the bargain sale, is included for the purpose of determining the taxation of payments received by the taxpayer in the year of sale and the total contract price. 23
In a request for private ruling, a taxpayer proposed to contribute a one-half interest in real property to a charitable remainder unitrust and concurrently sell the remaining one-half interest to the charitable remainderman of the trust. The Service ruled that the transfer to the charitable remainder trust would qualify for charitable deduction purposes and the portion sold would qualify as a bargain sale. Based on the facts submitted and the installment sale rules that existed at the time of the ruling, the Service concluded that the seller could report gain realized from the sale of the land as the installment payments were received.24
Taxpayers must be aware that if a sale of property, exclusive of a bargain to charity, would not qualify for installment sale reporting, neither will a bargain installment sale of such property to charity. Furthermore, if the sales contract does not carry a sufficient amount of interest, as described in IRC §483, a portion of the sales price may be recharacterized as unstated interest, thereby reducing both the amount of charitable contribution deduction and the amount of gain that may otherwise qualify for reporting as long-term capital gain. Lastly, issues have been raised regarding the possible application of the debt-financed property rules to such a charitable bargain installment sale.
Transfers of Debt Encumbered Property to Charitable Remainder Trusts
The transfer of debt-encumbered property to a charitable remainder trust raises more questions than any other issue. If there was ever a need for the Service to provide clear guidance via a Revenue Ruling, this is it. In the absence of such authority, however, two letter rulings can be used as guides to the issues.
In Ltr. Rul. 9533014, an individual owned a 70 percent interest in a partnership. The sole asset of the partnership was an apartment building that was subject to nonrecourse mortgage debt. The debt was incurred in 1970 and refinanced (with no increase in the amount of original debt) in 199 All income from the partnership qualified as rents from real property, excluded from treatment as unrelated business income.25 None of the partners had any personal liability with respect to the partnership debt. Each partner would, however, remain liable for any future cash calls by the partnership.
The taxpayer proposed to transfer between 50 percent and 100 percent of his partnership interest to a charitable remainder unitrust, after which, he would indemnify and hold the trust harmless from and against all expenses, losses, payments, or obligations that might arise from the partnership.
The taxpayer also provided management services, through a wholly owned company, on behalf of the property for a fee equal to 2 percent of gross revenues. The donor agreed to waive any management fees due from the trust.
The taxpayer proposed the following:
- The proposed gift will not violate the regulations regarding restrictions on investments.
- The gift will not violate the prohibition against other payments from a charitable remainder trust.
- The transfer will not constitute a prohibited act of self-dealing.
- The trust's distributive share of income or sale from the partnership will not be unrelated debt-financed income for a period of ten years following the date of the gift.
- Upon completion of the gift, continued payment of reasonable management fees by the partnership to the donor's management company (less the trust's portion of the fees) will not constitute self-dealing.
Restrictions on Investments
The regulations provide that a trust is not a charitable remainder trust if it includes a provision that restricts the trustee from investing the trust assets in a manner which could result in the annual realization of a reasonable amount of income or gain from the sale or disposition of assets.26 The Service found no provision that violated the rule.
Prohibitions against "Other" Payments
The regulations provide in part that, (a) no amount other than the unitrust amount may be paid to or for the use of any person other than an organization described in section 170(c); (b) an amount is not paid to or for the use of any person other than an organization described in section 170(c) if the amount is transferred for full and adequate consideration; and (c) the trust may not be subject to a power to invade, alter, amend, or revoke for the beneficial use of a person other than an organization described in section 170(c).27
Although it is not specifically stated in the ruling, it is implied that the partnership (as compared to the trustor or trustee) will make the payments on the indebtedness and that the partners will remain personally responsible for any cash calls. The Service concluded that, because the taxpayer agreed to remain solely liable for any obligation arising under the partnership for which the trust would otherwise be liable, the proposed gift would not violate the prohibition against other payments.
The Code provides that a transfer of real or personal property by a disqualified person to a private foundation shall be treated as a sale or exchange if (a) the property is subject to a mortgage or similar lien which the private foundation assumes, or (b) it is subject to a mortgage or similar lien which a disqualified person placed on the property within the 10-year period ending on the date of transfer (to the trust).28
A charitable remainder trust is treated as a private foundation for purposes of the rules against self-dealing.29 As a substantial contributor and creator of the trust, the donor is a disqualified person with respect to the trust.30 The regulations provide, however, that the donor's status as a substantial contributor is disregarded in determining whether the transfer to the charitable remainder trust is self-dealing, because the donor's stature as a substantial contributor arises only as a result of the transfer.31 In this case, the donor's status as a disqualified person arises not as a result of making the gift but, rather, out of the donor's decision to serve as trustee.
According to the Service, the threshold question was whether the partnership interest was transferred subject to the mortgage. Without deciding that question, the Service found that the transfer was not treatable as a sale or exchange; that the charitable remainder trust would not assume the mortgage; and that no disqualified person placed the mortgage on the property within 10-years of the gift. In making the latter decision, the Service disregarded the refinancing because it did not increase the amount of the outstanding debt.32
If the trustee of a charitable remainder trust accepts property subject to an indebtedness or places indebtedness on the property after its contribution to the trust, the trust will have acquisition indebtedness. Therefore, income from the property and gain upon sale will be included within the computation of unrelated business taxable income.
When a charitable remainder trust acquires mortgaged property by gift, the debt secured by the mortgage will not be treated as acquisition indebtedness during the 10 years following the date of acquisition as long as:
- the mortgage was placed on the property more than five years prior to the gift, and
- the property was held by the donor for more than five years prior to the gift.
However, this exception is inapplicable if the trust assumes any part of the debt secured by the mortgage.33 The trust must, therefore, take property subject to the indebtedness in order for the exception to apply.
It is important to distinguish the agreements between the original obligor on the note (original borrower) and a transferee who assumes the debt, and any rights that a lender may have against a borrower.
A transferee may acquire property by taking it subject to an existing indebtedness, in which case such transferee has no obligation either to the lender or to the transferor (original borrower). Alternatively, the transferee may assume the indebtedness by contractually agreeing to pay the obligation and relieving the transferor of any responsibility or risk. Note, however, that unless the lender consents to this and releases the original borrower from liability, such assumption is merely an agreement between transferor and transferee.
Some obligations are deemed recourse debts and others are classified as nonrecourse debts. In the case of recourse indebtedness, the borrower remains personally liable for any amount by which the debt remains unpaid after foreclosure and sale of the property. In the case of nonrecourse indebtedness, a lender's ability to recover the loan amount is limited to the property itself. Laws vary by state. In California, for example, deficiency judgments against borrowers (i.e., personal liability) are prohibited under a purchase money deed of trust or mortgage for a personal residence or four-unit or less structure in which the borrower resides. Commercial properties may be subject to recourse debts, however.
In Ltr. Rul. 9533014, the Service ruled that under Rev. Rul. 74-197, a charitable remainder trust's interest in a partnership than incurs acquisition indebtedness is debt-financed property. Therefore, a portion of the trust's share of the net income derived by the partnership from the rental or sale of property is UBTI, unless an exception applies.34 In this case, it did. Because the mortgage was placed on the property more than five years prior to the gift, and the property was held by the trustor for more than five years prior to the gift, the debt secured by the mortgage will not be treated as acquisition indebtedness during the 10-years following the date of the gift.
Bargain Sale and Related Issues
In the present ruling, the Service noted other consequences of the transaction. These included the application of the bargain sale rules, determination of the charitable contribution deduction, and determination of the unitrust amount.
If property subject to indebtedness is transferred to charity, the donor is treated as having been relieved of the indebtedness under the bargain sale rules of IRC §1011(b). In such case, the amount of indebtedness is treated as an amount realized by the donor, even though the transferee does not agree to assume or pay the indebtedness.35
Applying this rule to the charitable remainder trust, the Service concluded that the adjusted basis in contributed property subject to nonrecourse indebtedness is allocated to the indebtedness in the same ratio the basis bears to the entire property. The trustor recognizes the gain attributable to the indebtedness.36
If any portion of the gain would have been treated as ordinary income under section 751 of the Code (because of unrealized receivables or substantially appreciated inventory items), such gain must also be apportioned to the amount recognized.37
In determining whether a charitable contribution deduction is allowable, the Service stated that if section 751 applies, the amount of the charitable contribution deduction might be reduced under section 170(e)(5). Finally, although the liability was nonrecourse, the fair market value of the property must be reduced by the liability in determining the annual unitrust amount.
The Service then made an interesting qualifying statement. It said, "Otherwise, we express no opinion as to the tax consequences of the above-described transaction under the cited provisions of the Code or under any other provisions of the Code. Specifically, no opinion is expressed or implied concerning whether the trust qualifies as a charitable remainder trust under the Code." The Service then offered to provide the taxpayer with additional information relating to the issues under sections 170, 664, 751, and 1011 of the Code. Had the taxpayer asked all of the relevant questions? Is this really a positive ruling?
Grantor Trust Rules
The grantor trust rules of sections 671 through 677 of the Code contain provisions that tax the income of a trust to the grantor or another person even though he or she may not be a beneficiary. Sections 673 through 677 define the circumstances under which income is taxed to a grantor. These circumstances are in general as follows:
- The grantor has retained a reversionary interest in the trust, within specified time limits (section 673).
- The grantor or a nonadverse party has certain powers over the beneficial interests under the trust (section 674).
- Certain administrative powers over the trust exist under which the grantor can, or does, benefit (section 675).
- The grantor or a nonadverse party has the power to revoke the trust or return the trust to the grantor (section 676).
- The grantor or a nonadverse party has the power to distribute income to or for the benefit of the grantor or the grantor's spouse (section 677).
Regulation §671-1(d) provides that, the provisions of Subpart E (the grantor trust rules) are not applicable with respect to a pooled income fund as defined in paragraph (5) of section 642(c) and the regulations thereunder, a charitable remainder annuity trust as defined in paragraph (1) section 664(d), or a charitable remainder unitrust as described in paragraph (2) of section 664(d). At first glance, one might conclude that all charitable remainder trusts are exempt from the grantor trust rules. This is not the case, however, if the trust contains any provision that would otherwise cause the grantor to be treated as the owner of the trust. The regulations describe several additional situations that will cause the grantor to realize income. They include:
- an assignment of future income, whether or not the assignment is in trust.
- the rules applicable to family partnerships, even though the partnership may be held in trust.
- the right of a grantor to deductions for payments to a trust under a transfer and leaseback arrangement.
- the income of a trust when it is used to discharge a legal obligation of a grantor.
The following discussion illustrates the application of the fourth situation to the contribution of debt-encumbered property to a charitable remainder trust.
In Ltr. Rul. 9015049, a taxpayer proposed to fund a charitable remainder unitrust with income-producing real property that was encumbered by a mortgage liability for which the taxpayer was to remain personally liable following transfer. Further, the trust would make the mortgage payments.
The Service ruled that under such circumstances the trust would be subject to Reg. §677(a)-1(d) which provides that a trustor is, in general, treated as the owner of a portion of a trust whose income is, or in the discretion of the trustor or a non-adverse party or both, may be applied in discharge of a legal obligation of the trustor. Accordingly, the taxpayer will be treated as owner of the entire trust under IRC §67 Therefore, the trust is not a charitable remainder trust under IRC §66 The IRS did rule beyond this issue.
It is interesting to note that in Ltr. Rul. 9533014 there is no mention of application of the grantor trust rules to the transaction. Perhaps the differentiating fact (and explanation of the Service's silence) between the rulings is the presence of nonrecourse (as opposed to recourse) financing.38
Might the Service argue that the trustor's intent to serve as the trustee for a hard-to-value asset (i.e., a partnership interest) might implicate the grantor trust rules?
Possible Solutions to Debt-Encumbrance Problems
Retire Debt Prior to Transfer
Although paying off the debt is the cleanest alternative, many people cannot afford this option. As an alternative, it may be possible, depending on the lender, to re-hypothecate the debt to other property in the trustor's portfolio.
Short-Term Swing Loan
Suppose Mr. Brown owns a commercial building worth $1,000,000 with an adjusted basis of $200,000. In addition the property is encumbered by a $200,000 mortgage that is one year old. Brown would like to sell the property via a charitable remainder trust. However, transferring the property subject to a fresh loan will cause the trust to have acquisition indebtedness. In addition, Brown owns a $500,000 bungalow that is free-and-clear.
Step 1. As an alternative, Brown will borrow $200,000, secured by his bungalow.
Step 2. Brown pays off the loan on the building (and records the reconveyance).
Step 3. Brown transfers an undivided fractional interest of 80percent of the building to a charitable remainder unitrust.
Step 4. Brown and the trustee each sell their respective interests to a third party buyer.
Step 5. Brown uses his $200,000 of sales proceeds to pay off the loan against his bungalow.
To summarize, Brown will incur a capital gain of $180,000 on the sale of his retained interest ($200,000 - $20,000 allocable basis). However, the gain can be partially offset by the charitable contribution deduction.
Caution: IRS has suggested that a transfer of an undivided fractional interest in property to a charitable remainder trust with a retained interest by the trustor (a disqualified person) may constitute a prohibited act of self-dealing.39
Charity Purchases a Fractional Interest in Property Equal to Debt and Joins in Sale
In the previous example, the charitable remainderman might have participated as the lender. Such transactions are usually structured at arm's length with an independent trustee. As an alternative, the trustor can avoid a potential self-dealing problem by having the charity purchase an undivided fractional interest in the property from the trustor in an amount equal to or greater than the indebtedness. The sale proceeds are used to retire the indebtedness, and then the free-and-clear remaining interest is transferred to the charitable remainder trust. The trustor and charity then join in the sale of their respective interests.
Because the seller is transferring his entire interest in the property, no self-dealing issue should be raised. Gain recognized on the taxable sale to the charity can be mitigated by the charitable contribution deduction generated upon transfer of the retained interest to the trust.
Trustor Holds Trustee Harmless for Debt Obligation
The issues of bargain sale, unrelated debt-financed income, and grantor trust implications all assume the trustor is relieved of the mortgage obligation. Several legal commentators have speculated that, if the trustor indemnifies the trustee against liability for the debt, there is no such relief of indebtedness.
However, because the lender would most likely not reduce its security by releasing any portion of the property transferred to the trust, the trustor would retain an undivided fractional interest in the property. When the property is ultimately sold, the trustor will have the proceeds necessary to retire the debt.
Comment: Again, the potential self-dealing problem may discourage use of this technique. The problem is, proceeds paid on the sale of the property owned by the trust will not relieve the trustor of the personal liability unless the trustor pays off the debt outside the trust.
Transfers of Debt Encumbered Property in Exchange for a Charitable Gift Annuity
Whereas the transfer of debt-encumbered property to a charitable remainder trust presents significant tax risks, a charitable gift annuity may be an ideal recipient of debt-encumbered property. Because a charitable gift annuity does not utilize a trust, the transfer of debt-encumbered property does not run afoul of the grantor trust rules.
When debt encumbered property is transferred in exchange for a gift annuity, the amount of debt plus the investment in the contract is considered an amount realized by the donor for purposes of application of the bargain sale rules. A complete discussion of these rules is found in Charitable Gift Annuities.
Transfers of Debt Encumbered Property to a Pooled Income Fund
As with charitable remainder trusts, the regulations are not clear with respect to the income tax consequences of contributions of debt-encumbered property. Unlike a charitable remainder trust which in the event it accepts debt-encumbered property risks being treated as a grantor trust thereby forfeiting its tax-exempt status, pooled income funds have no tax-exempt status to forfeit. Furthermore, the special exemption from tax for long-term capital gains permanently set aside for charity enables a pooled income fund to accept debt-encumbered property, sell it, and pay no tax on long-term capital gains.
That's the good news. On the downside, when debt-encumbered property is transferred to a pooled income fund, the entire amount of the indebtedness is an amount realized by the donor for purposes of computing gain under the bargain sale rules of IRC §1011(b). In essence, the transaction is treated as though the charity has handed the donor cash in the amount of the indebtedness. If the property is appreciated, gain attributable to the debt is realized by the donor in the same ratio the donor would have realized gain had the entire property been sold on the date of transfer.
Another potential problem involves the possible application of the self-dealing rules discussed infra. Finally, the transfer of debt-encumbered property might trigger a "due on sale" clause that accelerates that repayment of indebtedness or possibly UBTI. Provided the pooled income fund had liquidity with which to retire the indebtedness, this would cause dilution of the income earning capacity of the fund. As an alternative, if the charitable organization believes the property is readily marketable, it might consider purchasing the property from the fund immediately after transfer and selling it in due course. As mentioned previously, the organization should weigh the potential investment risk and expense against the net benefit of the gift.
Transfers of Debt Encumbered Property to Charitable Lead Trusts
Unlike charitable remainder trusts, for which the presence of debt-encumbered property can cause disqualification, the ownership of debt-encumbered property by charitable lead trusts may cause the trust to have unrelated business income.
If a charitable lead trust has any debt-financed property, the income from such property is considered unrelated debt-financed income subject to unrelated business income tax rules as described above. Debt-financed property includes property that had "acquisition indebtedness" at anytime during the tax year or within 12-months of disposition of the property. In this context, the term "income" is not limited to recurring income but applies as well to gains from the disposition of property.40
The term "acquisition indebtedness" generally means the outstanding amount of principal indebtedness incurred prior, during, or after acquiring or improving the property.41
Further, where property is acquired subject to indebtedness, the indebtedness is considered as an indebtedness of the organization incurred in acquiring the property even though the organization does not assume or agree to pay such indebtedness.42
Where a charitable lead trust acquires mortgaged property by gift, the debt secured by the mortgage will not be treated as acquisition indebtedness during the ten years following the date of acquisition as long as the mortgage was placed on the property more than five years prior to the gift, and the property was held by the trustor for more than five years prior to the gift. This exception is inapplicable, however, if the trust assumes any part of the debt secured by the mortgage.43
The Service has ruled privately that a transfer of real property subject to a nonrecourse indebtedness, that was placed on the property more than 10-years prior, was not considered property subject to acquisition indebtedness, did not constitute an act of self-dealing, was not a jeopardizing investment, and was not an excess business holding.44
In the same ruling, the Service held that in addition to the deduction of standard expenses normally associated with real property ownership, such as depreciation, amortization of leasehold, commissions, management fees, accounting and legal fees, the trust could also deduct the interest paid on the mortgage. Furthermore, interest and amortization of principal on the loan would not be considered payments for a private purpose.
This ruling suggests that a charitable lead trust may be able to own debt-encumbered property and make payments on the loan without having unrelated business income, provided the loan is nonrecourse and meets the previously mentioned holding period requirements.
Other Related Concerns
Although the five-and-five exception seemingly clears the way for funding a charitable lead trust with debt-encumbered property, there is at least one other consideration. A prohibited act of self-dealing will occur if property is transferred to a charitable lead trust that is subject to a mortgage or similar lien which a disqualified person placed on the property within the 10-year period ending on the date of the transfer. This rule increases the five-and-five year rule to ten years.
As previously mentioned, the lending of money by a disqualified person to a private foundation is not a prohibited act of self-dealing as long as the loan is without interest or other charge and the proceeds are used exclusively for purposes described in IRC §501(c)(3). Furthermore, the imputed interest rules of IRC §7872 do not apply.45 A loan may cause the trust to have acquisition indebtedness, however.
Application of Bargain Sale Rules
Does the transfer of debt-encumbered property to a charitable lead trust cause the grantor to realize gain under the bargain sale rules? IRC §1011(b) provides that if a deduction is allowable under section 170 (relating to charitable contributions) by reason of a sale, then the adjusted basis for determining the gain from such sale shall be that portion of the adjusted basis which bears the same ratio to the adjusted basis as the amount realized bears to the fair market value of the property.
Although the regulations provide that a transfer of debt-encumbered property to charity in exchange for a charitable gift annuity requires the donor to treat the indebtedness as an amount realized for purposes of the bargain sale rules, no guidance is given regarding a contribution of an income interest such as occurs with a charitable lead trust.46
In the case of a transfer to a nongrantor charitable lead trust, no deduction is allowable under IRC §170. We conclude, therefore, that the bargain sale rules should not apply to such transfers. With respect to transfers to grantor lead trusts for which a deduction under IRC §170 is produced, such transfers would, if based solely on these criteria, seem to trigger the bargain sale rule. Gifts of an income interest are, however, distinguishable from both outright gifts and gifts of a remainder interest.
When debt-encumbered property is transferred by outright gift to charity, the donor is relieved of the obligation. Such relief is considered income. The same theory holds true with a gift of a remainder interest to charity. Although there is an intervening income interest, the debt is ultimately transferred to charity.
In the case of a grantor lead trust, the grantor is treated as owner of the income interest. Furthermore, the trust corpus (remainder interest) and, therefore, the indebtedness is never transferred to charity. Provided the trust takes the property "subject to" and does not "assume" the indebtedness, it would seem plausible that the transfer would not be considered a bargain sale. The IRS has not, however, issued any public or private rulings on this issue.
Selling Contributed Property
Unless the contributed property will be put to use by the charitable donee or held for the production of income, real property is best transferred to charity or to a charitable trust with the intent of an immediate sale. If, however, the only means of disposition available to the owner is to give the property away, it is probably not a suitable candidate for a charitable gift. The majority of real property is contributed to charity based on the presumption it will subsequently be sold by the donee.
Binding Obligation to Sell
Gain on the sale of an appreciated asset is not considered attributable to the donor so long as the asset is given away before sale. However, this rule is inapplicable if the donor retains direct or indirect control over the asset or there is an express or implied prearranged obligation on the part of the donee to sell the property. In such case, the donor may be taxed on the subsequent sale on one of three theories.47
Most practitioners agree that, in the case of real property, the obligation to sell arises upon the opening of a sale escrow or execution of a sale contract. For further reading, see How Far Is Too Far? The Prearranged Sale And The Palmer / Blake Conundrum in Gift Planner's Digest.
Property Subject to a Purchase Option
The IRS has ruled privately that, in the case of property transferred to a charitable remainder unitrust subject to a lease with a purchase option at fair market value, the exercise of such option would not defeat the interest of charity. The effect of the transaction would be to substitute one interest for another of equal value.
The Service also noted that, the lease and option to purchase are factors to be considered in arriving at the fair market value of the property (for purposes of determining the charitable contribution deduction and establishing the annuity or unitrust amount).48
Publication 526 (3-98) -- Charitable Contributionsback
IRC §§170(f)(3)(A); 2055(e)(2); 2522(c)(2)
Reg. §512-1(b)(4) Example 5back
IRC §651(a); Reg. §651(a)-4
Contribution base is defined as adjusted gross income without regard to NOL carryback into the contribution year.back
Reg. §§170A-6(c)(2)(i); 20.2055-2(e)(2)(vi)(a); 22522(c)-3(c)(2)(vi)(a).back
IRC §§507(d)(2)(A); 4946(a)(1) and 4946(b)back
IRC §1011(b); Reg. §1011-2(a)(3)back
Presumably, the recapture rules of IRC §§1245 and 1250 would also apply.back
It may also be distinguishable that the 1990 ruling that was issued by the Pass-Throughs and Special Industries Branch of the Internal Revenue Service while the 1995 ruling was issued by the Exempt Organizations Technical Branch. Differences of opinion or interpretation are not the exclusive domain of the private sector.back
Ltr. Rul. 7808067back