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 in 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.

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. However, Karl did have one complaint about the FLIP CRUT solution. Because CRUT payouts are recalculated each year based upon the January 1 value of the trust, there is an element of uncertainty associated with the future income stream. In short, Karl’s payouts could go up and down.

Question:

Karl would love to have a fixed annuity type of payout each year. Can Karl fund a charitable remainder annuity trust (CRAT) with his building? Which is better for Karl – a CRAT or FLIP CRUT?

Solution:

A charitable remainder unitrust (CRUT) is an excellent option for donors with appreciated real estate. A CRUT provides a charitable tax deduction, an income stream and a tax-free sale of the real estate. The tax-free sale of real estate inside the trust allows the trustee to reinvest the full sale proceeds (i.e., investment diversification without payment of any capital gains tax).

Because of the unmarketable nature of real estate, advisors usually recommend a NIMCRUT or FLIP CRUT payout structure. With either of these types of payouts, the trustee is not forced to make a trust distribution unless there is actual trust income. A standard CRUT or CRAT payout is generally not recommended when real estate is the only trust property since these types of trusts require trust distributions, irrespective of actual trust income. If the trustee does not make the required distributions, the trustee runs the risk of disqualifying the trust and subjecting the trustee and donor to tax penalties.

While Karl’s building is likely to sell quickly, there is no guarantee. Therefore, it is not prudent to create a CRAT, given the risk associated with the sale process. However, if Karl is willing to transfer a substantial amount of cash or stocks (in addition to the building) into the CRAT, it might work nicely. The infusion of cash or stocks into the CRAT provides the trustee with the necessary funds to make trust payments and, thus, avoid missing any mandatory payments. It is extremely important that Karl transfers the cash or stocks into the CRAT at the same time as the building transfer. Because CRATs do not allow for additional contributions, Karl may not contribute cash or stock at a later date.

Based upon his desire to enjoy a fixed annuity payout, Karl elects to transfer the building and $500,000 of appreciated stocks into the CRAT. This arrangement provides for substantial liquidity to the trust. Furthermore, when the building sells for $2 million, the lack of marketability issue will disappear. In the end, Karl loves the CRAT solution because he knows that his annuity stream will never change, and he diversified a large block of his appreciated stocks.

Editor’s Note: This case study illustrates that a CRAT, in limited circumstances, can work smoothly even though an unmarketable asset is inside the trust. However, a FLIP CRUT or NIMCRUT is often more advisable, given the great flexibility associated with those types of trusts. Before funding a CRAT with unmarketable property, it is highly suggested that one consult with a competent tax advisor.