Case of the Week

Case:

Karl was a man with the golden touch. Throughout his life, it seemed every investment idea that he touched turned to gold. Karl’s passion was real estate and he was very successful in his investments.

Karl continued to buy and sell real estate at the age of 85. His latest venture led him to 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 another great buy.

There was one downside, however, to the idea of selling. Karl held the property for 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 40.8%, not 23.8%. Karl cringed at the thought of paying much of his gain to the government. At the same time, Karl knew the 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.

Karl decided to implement a “FLIP CRUT and partial sale” exit strategy (See Part 6). In other words, he wanted to sell and pay no tax. However, there still was one point of concern.

Karl’s advisors noted that once the undivided interest in the property was transferred into the FLIP CRUT, the FLIP CRUT should list and sell the entire property. In short, it would be advisable for the trustee to handle the sale of Karl’s portion as well.

Question:

Karl wondered why this step was important and whether it was necessary.

Solution:

Although hundreds of split gifts are completed annually and the IRS to date has not contested the concept of split transfers on any of these transactions, it is prudent to evaluate options that increase the safety of prospective transactions. While no strategy short of a private letter ruling for a specific transfer promises 100% safety, several actions may increase safety levels for a split gift. Here are some safety recommendations for split-interest gifts:

1. No Personal Use

   The FLIP CRUT trustee must ensure that Karl does not use the trust property for any personal or private matter.

2. Independent Trustee

   Split gifts and self-trustees can end up being an overly aggressive strategy. In PLR 9114025, the IRS repeatedly emphasized that the "independent trustee acts independently" in order to avoid price manipulation that could increase value received by donors upon the sale of their retained interest. Self-trustees who have authority to sell trust assets as trustee and retain assets as owner obviously could manipulate sale terms in a prohibited manner. Independent trusteeship is essential to minimize such potential problems.

3. Revocable Trust and Unitrust

   An easy method for reducing self-dealing risk is to transfer an undivided interest into a unitrust with an independent trustee and the remaining interest into a revocable trust with that same independent trustee. Donors have rights to income from the unitrust and revocable trust and rights to revoke and recover principal from the revocable trust. However, an independent trustee has both legal title and fiduciary responsibility for both trusts. Given the trustee's ability to control sale terms for both trusts, there is a reduced likelihood of a self-dealing violation.

4. Limited Partnership

   Some conservative attorneys might choose to parallel the fact situation of PLR 9114025 by creating a limited partnership as was done in that ruling. Although undivided interests held in co-ownership would seem to have very similar characteristics to a limited partnership with respect to self-dealing issues, a partnership does indeed fit the specific fact pattern of that ruling.

5. Partial Sale to Charity

   Finally, one completely avoids the self-dealing issue by selling the partial interest to a public charity prior to funding the unitrust. After sale of part, the donor transfers the balance of the real property to a unitrust.

   To answer Karl’s questions, there is no requirement that a safety step be used. However, considering the size of the transaction and the benefits at stake, incorporating one or more of the safety steps may prove fruitful should the IRS come calling.