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 buildings nearby 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 work to get it into market condition. 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 as he knew the building was a great buy.

There was one downside to the idea of selling, however. 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 could change directions in the next year. Although Karl wanted the 23.8% tax rate, he did not want to risk holding the property another eight months.

Question:

Can Karl sell the building and bypass the tax on the sale of the property? Karl wants to reinvest the full sale proceeds in an income-producing investment. Is this possible?

Solution:

Based upon Karl’s situation and goals, a FLIP CRUT would be an excellent option. Prior to any binding sale agreement, Karl could transfer his property to a FLIP CRUT. In this case, the potential buyer has merely expressed an interest in the property. Because there is no legally binding agreement between Karl and any buyer, there would be no prearranged sale problem.

Once the property is transferred to a FLIP CRUT, the trustee would list and sell the property. Even if the property sold for $2 million, the trust would owe no taxes on the sale because the trust is exempt from income taxes.  Therefore, a FLIP CRUT would meet Karl’s first goal – avoiding an immediate 40.8% bite out of his short-term capital gain.

Next, the trust would reinvest the full sales proceeds of $2 million (minus selling costs). Pursuant to Karl’s goals, the trust would likely invest for income. It could invest in bonds, dividend paying stocks or even rental property.  This would meet Karl’s second goal.

So far, Karl is very pleased with the FLIP CRUT option. It looks like the perfect solution. However, there are two potential downsides to this plan. The two remaining issues are as follows:

1) What is the charitable income tax deduction for gifts of short-term capital gain property?
2) What are the tax characteristics of the FLIP CRUT payouts to Karl?

For a discussion of these two issues, see “Exit Strategies for Real Estate Investors, Part 2.”