Wednesday July 26, 2017
Case of the Week
Exit Strategies for Real Estate Investors, Part 5
Case:Karl Hendricks was a man with the golden touch. Throughout his life, it seemed every investment idea that he touched turned to gold. By far, Karl was most successful with real estate investments. It was definitely his passion.
Amazingly, Karl continued to buy and sell real estate at the age of 85. For instance, about three months ago, Karl discovered a great investment property. It was a "fixer-upper" commercial building in a great area. While other nearby buildings sold for over $2 million, the seller needed to sell quickly and was asking just $1 million.
The condition of the building turned many buyers away. It was being sold "as-is," but Karl was not deterred. He could see great potential with the building and knew it would not take much to get it to market condition. Therefore, Karl swooped in, bought the building for $1 million and instantly hired contractors to refurbish the place.
After three months of hard work refurbishing the building, the place looked like new! In the end, Karl invested $250,000 in the building, bringing his total investment in the property to $1.25 million. One month after the completion of the work, Karl was contacted informally by a company that expressed an interest in the building – a $2 million interest! This was no surprise to Karl. He knew the building was a great buy.
After Karl learned about the benefits of a FLIP CRUT, he eagerly wanted to move forward. (See Parts 1 and 2 for a full discussion of this decision.) It looked like the perfect solution.
Question:However, there was still one issue unresolved. There was a $100,000 debt on the property that Karl incurred at the time of purchase. The debt was a major obstacle to the successful completion of the FLIP CRUT plan. What solutions are available to remove the debt?
Solution:Karl has at least five solutions to the debt and FLIP CRUT problem.
1. Payoff - If possible, Karl may have the resources to pay the debt and then transfer the real estate to the FLIP CRUT.
2. Release - If there is a parcel of land that may be divided under zoning rules or there are multiple deeds to the parcel, it may be possible to obtain a release on some of the property, leaving the debt on the balance. The released property may then be transferred to the FLIP CRUT.
3. Bridge Loan - Karl may borrow funds on other property, pay the debt on the existing property and transfer an undivided interest into the trust. When the property is sold, the undivided portion retained by Karl is used to pay the bridge loan.
4. Charity Purchase - The charitable organization may be willing to purchase part of the real property from Karl. Following this purchase, Karl has funds to pay off the debt and transfer the balance of the real property into the trust.
5. Personal Guarantee - While the Service has not approved this method, some counsels have suggested it is possible to transfer an undivided percentage of encumbered property into a CRT. When the property is sold, the balance of the asset is used to pay the debt. The donor gives a personal guarantee that the trust will not be required to pay debt. So long as the transaction works as contemplated, the theory is that the issue is moot after the sale and debt repayment. This is an aggressive strategy that is not without risk.
Donors generally should proceed through these five potential steps in order. The technical and practical challenges increase with the latter methods. Given his choices, Karl quickly elects option 1 – payoff the debt. With the simple removal of the $100,000 debt, the UBIT and grantor trust status issues disappear. Furthermore, the future sale of the real estate will return the $100,000 "pay off amount" back to Karl. Karl is happy once again knowing that his FLIP CRUT plan is back on track.
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