Charitable Gifts of Real Estate: Proceed with Caution

This past weekend I spent some time looking at a client’s proposed transfer of a real estate partnership interest into a Charitable Remainder Annuity Trust (CRAT), year-end tax planning strategy. A contemplated gift to charity at this time of the year often takes on a priority  for income tax minimization purposes. Moreover, a gift to a CRAT makes sense in this period of low interest rates and low inflation [market conditions that also encourage charitable gift annuities and charitable lead annuity trusts (CLATs).] A gift to a CRAT is popular because if an appreciated asset is the subject of the gift to the CRAT, and the CRAT (which is treated as a mini-charity) then sells the real estate interest that it receives, it will not pay any capital gains taxes on the realized gain. Thus, all of the sales proceeds, not just the after-tax net sales proceeds, are available for reinvestment by the CRAT Trustee to be used to support  the donor for the balance of the donor’s life (or the donor’s life and the life of another person.)

Unfortunately, the transfer or real estate to a charity [and a CRAT is a mini-charity] can result in a number of tax problems that can force some subtle changes to the structure of the charitable gift transaction. Some of those tax problems are outlined below:

Follow the Valuation and Substantiation Rules: In order to thwart perceived abuses, Congress has imposed charitable substantiation requirements on the transfer of real estate to a charity. No charitable deduction is allowed for a contribution of real estate worth more than $5,000 to a charity unless the donor obtains a qualified appraisal from a qualified appraiser and that appraisal is attached to Form 8283. To close the information loop to make sure that an inflated value is not reported for the real estate, the charity is also required to report to the IRS if it disposes of the real estate within three years of its receipt, reporting the amount the charity  received on Form 8282. Note that accuracy related penalties can be imposed by the IRS for overstating the value of the charitable tax deduction, and a penalty can even be imposed by the IRS on appraisers for substantial or gross valuation misstatements. Take-away: without proper substantiation and documenting, the charitable deduction will be denied. The IRS will not accept as a qualified appraisal of real estate the Michigan rule of thumb- that FMV = 2 times SEV.

Beware of Minority Interest Discounts: This problem can arise both with lifetime transfers and transfers on death. Assume that I own a shopping mall valued at $5 million. In my Trust I devise 80% of that real estate to my children on my death. I devise the other 20% interest to the local hospital, an IRC tax exempt entity. The IRS says that the transfer of the 20% interest to the hospital on my death is subject to valuation discounts since it is a non-controlling minority interest. So while 20% of $5 million seems to be worth $1.0 million using simple math,  for federal charitable estate tax deduction purposes it is more likely that federal estate tax charitable deduction my estate will claim will only be $750,000 to $800,000 after the minority valuation discount is applied. This result is reinforced in August’s proposed IRC 2704 Regulations that everyone is talking about. The preamble to those proposed Regulations state that when an interest in a closely held business passes to family members and to a charity, the interest passing to the family members will be valued without reference to valuation discounts, while the interest that passes to the charity ‘will be treated separately and subject to discounting.’ Take-away: if a non-controlling interest in real estate is the subject of a gift to charity,  impose appropriate and reasonable valuation discounts on the transferred interest, or be prepared to face an accuracy related penalties that will arise from the over-stated charitable deduction.

Watch Out for a Prearranged Sale: As a generalization, the sale of real estate is privately negotiated. If the donor has entered into a binding sale of the real estate prior to the transfer of the real estate to the charity, like to a CRAT, the donor will not avoid the capital gains on the sale of the real estate by the charity. The donor is personally responsible for the gains under the IRS’ assignment of income doctrine. Equally important, while the donor will be personally responsible to pay the capital gains taxes, the donor cannot force the charity (or CRAT) to distribute the funds needed to pay the capital gains taxes. Obviously, if there is no binding sale agreement prior to the transfer, then there will be no prearranged assignment of income and the donor will not be held responsible to pay the capital gains taxes that result on the charity’s subsequent sale of the appreciated real estate. But the distinction between binding agreement and prearrangement often used interchangeably by the IRS is a bit vague, in that a binding contract may not be signed for the sale of the real estate, but there is an implied understanding who the probable buyer of the real estate will be when the charity later sells the gifted real estate. Revenue Ruling 78-197. Take-away: try to not put any understanding in writing as to the expectation that the transferred real estate interest to the charity will be purchased by a third party, since all that documentation is subject to IRS subpoena powers, and the more documents that exist that suggest that a buyer-in-waiting exists, the more probable the IRS will  assert that there is a prearranged sale of the transferred real estate interest, even in the absence of a binding sale contract.

Avoid Unrelated Business Income Excise Tax (UBIT) Exposure: While charities generally are not subject to income tax, an exception applies if the charitable entity has income that is subject to the UBIT. Income is subject to UBIT if it originates from a trade or business that is regularly carried on and the activity is not substantially related to the charitable entity’s tax exempt purposes. Most passive income, like rental income from real estate, is not subject to UBIT. However, even passive rental income is subject to UBIT to the extent that it is derived from debt financed real property. Back to my earlier example: assume that I own a $5.0 million shopping mall against which there is a $1.0 million mortgage that I took out to purchase the mall. I now transfer title to that real estate to a CRAT that I create. Part of the rent generated by the real estate, while clearly passive in nature, is nonetheless treated as UBIT to the CRAT since a mortgage was obtained to generate that passive income. Why is this a problem? A 100% excise tax is imposed on that UBIT income reported by the CRAT. Take-away: remove any encumbering mortgages from real estate before the real estate is transferred to the charity to avoid the UBIT 100% excise tax.

Avoid Excess Business Holdings Excise Tax Entities: Assume that my real estate interest is wrapped inside an LLC, owned by my children and me, and I want to transfer my LLC units to a CRAT. In addition to the self-dealing rules described below, there are the excess business holding rules that result in the imposition of an excise tax on the CRAT. Excess business holdings exist if the CRAT and its disqualified persons (my children) own more than 20% of the voting interest in the business entity, like the LLC. Thus if the LLC membership units are transferred by me to a CRAT, and my children retain their voting interests in the family owned LLC,  the CRAT will have excess business holdings if it and the other disqualified persons (my children) own more than 20% of the LLC’s voting interests. The CRAT must dispose of the excess business holdings within 5 years to avoid this excise tax. While the obvious ‘simple solution’ is for the CRAT Trustee to sell those excess business holdings back to me, or to my children, that will not be possible because that disposition ‘back’ would constitute the prohibited act of self-dealing. Take-away: Family owned business entities often are not good subjects for contribution to a CRAT if other family members continue to own their interests in the same family business entity.

Remove Mortgages Before Transferring Real Property: As noted, there is a good reason to get rid of mortgages that encumber real estate before it is transferred to a charity, due to the UBIT problem. But there is another problem. If the donor transfers mortgaged property to the charity the donor is considered to have recognized taxable income on some portion, or all, of the outstanding mortgage. IRC 1011(b) This results even if the mortgage is non-recourse to the grantor, and even if the donor continues to pay the mortgage after the donor’s charitable transfer. Things get even more complicated if the transfer of the mortgaged property is to a CRAT. If the mortgage is assumed by the CRAT Trustee was placed on the real estate within 10 years of the transfer to the CRAT, the CRAT is treated as a grantor Trust for income tax reporting purposes. Restating the problem, a qualified CRAT can never be a grantor Trust; the donor would lose the income and gift tax charitable deductions that motivated the gift to the CRAT in the first place, and the CRAT would lose its tax exempt status, all of which means that if the CRAT trustee later sells the appreciated real estate, the donor pays the capital gains taxes. Take-away: The same as above, the donor needs to remove the mortgage from the real estate before the encumbered real estate is transferred to the charity.

Avoid the Self-Dealing Prohibitions: With a transfer of real estate to a CRAT we then run into the IRS’ potential self-dealing rules. IRC 4941. The basic principle is that financial transactions between a CRAT and a disqualified person are prohibited, whether or not the transaction benefits the charity. For example assume that I transfer my shopping mall to a CRAT, but I intend to continue to rent one of the units in the shopping mall to conduct my business. The CRAT will be deemed to have conferred a direct benefit on me, the donor, which results in an excise tax imposed for self-dealing, regardless of whether the rent that I will pay will be fair market rent or not. Nor can I avoid this problem by waiting until after the transfer of the shopping mall to the CRAT and only then do I enter into a lease, post-transfer, with the Trustee of the CRAT. Take-away: in order to avoid all self-dealing risks and excise taxes, I must move out of the shopping mall or cease all business relations with the real property before I make the charitable contribution to the CRAT, and after the transaction as well. See IRC 4941(d)(2).

Beware of Prior Accelerated Depreciation: Generally it is typical for a building that is held for investment to be depreciated for tax purposes over time. Most depreciation is done using the straight-line method. But some buildings are depreciated using an accelerated depreciation schedule. Any charitable deduction will be reduced when accelerated depreciation has been taken. The amount of the charitable income tax deduction is reduced by the amount of the accelerated depreciation taken exceeds what would have been permitted to be taken by the donor under a straight-line method of depreciation. Take-away: When calculating the possible amount of the charitable income tax deduction available to the donor, you need to first identify if the subject real estate has been subject to accelerated depreciation deductions.

Charitable giving is an important opportunity for our clients to consider, especially in a period of low interest rates. But an abundance of caution is required when real estate is the subject of our client’s philanthropy, and especially so if the preferred charitable vehicle to implement that planning is a charitable remainder trust. Let me know if you have questions.