Wednesday September 20, 2017
Case of the Week
Exit Strategies for Real Estate Investors, Part 6
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.
There was one downside to the idea of selling, however. Karl held the property only four months, which meant the gain from the sale would be short-term capital gain. In other words, the applicable tax rate would be 43.4%, not 23.8%. Karl cringed at the thought of paying much of his gain to the government. At the same time, Karl knew the hot real estate market would not last forever and could change directions in the next year. So, although Karl wanted the 23.8% tax rate, Karl did not want to risk holding the property another eight months.
Question:Karl wanted a zero tax sale exit strategy. In other words, he wanted to sell and pay no tax. Can Karl sell the building, bypass the tax on the sale of the property and receive cash?
Solution:Based upon Karl's situation and goals, a "Sale and FLIP CRUT" would be an excellent option. Prior to any binding sale agreement, Karl could transfer an undivided interest in his property into the FLIP CRUT. In this case, the potential buyer merely expressed an interest in the property. Because there was no legally binding agreement between Karl and the buyer, there was no prearranged sale problem.
Once the undivided interest in the property was transferred into the FLIP CRUT, the trust would list and sell the property. It would be advisable for the trust to handle the sale of Karl's portion as well. (See GiftLaw Pro 4.7.5 for a full discussion on this issue.)
The trust would owe no taxes on the portion of the property it sold because the trust would be exempt from income taxes. Accordingly, the FLIP CRUT would meet Karl's first goal – avoiding an immediate large tax bite. However, Karl would have taxable income from the sale of his portion of the property. Thus, the goal was to use the FLIP CRUT charitable deduction to offset any taxable income from his sale of the property.
The key questions for Karl was what percentage to transfer to the FLIP CRUT and what percentage to retain. Pursuant to IRC Sec. 170(e), Karl would receive a charitable income tax deduction based upon the cost basis in the property, not its fair market value. Section 170(e) does not allow a donor to claim a charitable income tax deduction for a property's non-long term gain element. In this case, all of the gain on the property would be short term capital gain, so Sec. 170(e) would apply. The reduced deduction would ultimately affect the zero tax calculation.
Based upon these considerations, Karl decided to transfer 45% of his property into the FLIP CRUT and retain 55% of the property. Upon the sale of the property for $2 million, the trust received $900,000 ($2,000,000 x 45%) and Karl received $1,100,000 ($2,000,000 x 55%). Karl's deduction was $420,587 and saved him about $223,098. The deduction was subject to the 50% AGI limitation since it was a basis deduction. But, given Karl's enormous AGI for this year, the limitation would not pose a problem.
Karl owed $146,475 as a result of the sale of his portion of the property. However, Karl's tax savings from his charitable deduction fully offset his tax liability, resulting in a zero tax sale. Exactly what he wanted! The zero tax sale plan clearly met all of Karl's objectives. In the end, Karl walked away with $1,100,000, a $900,000 FLIP CRUT and no tax payment to the government. He thought, "Not bad for only four months' work!"
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