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 that 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 a large part 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 for 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 FLIP CRUT and partial sale 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 any buyer, there was no prearranged sale problem according to Karl’s counsel.

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 trustee to handle the sale of Karl’s portion as well. (See GiftLaw Pro 4.7.5 for a full discussion on this issue.)

The CRUT would owe no taxes on the portion of the property it sells because the trust would be exempt from income taxes. Accordingly, the FLIP CRUT would meet Karl’s first goal – avoiding an immediate tax bite. However, Karl would have taxable income from the sale of his portion of the property. Thus, the goal would be to use the FLIP CRUT charitable deduction to offset any taxable income from his sale of the property.

The key question for Karl was what percentage to transfer to the FLIP CRUT and what percentage to retain. Pursuant to 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 short-term 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 tax calculation.

Based upon these considerations, Karl decided to transfer 50% of his property into the FLIP CRUT and retain 50% of the property. Therefore, upon the sale of the property for $2,000,000, the trust received $1,000,000 and Karl received $1,000,000. Karl’s deduction was $462,794 and saved him about $188,000. 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 $153,000 in taxes as a result of the sale of his portion of the property. However, Karl’s $188,000 of tax savings from his charitable deduction fully offset his $153,000 tax liability, resulting in a zero tax sale. This was exactly what he wanted! The zero tax sale plan clearly met all of Karl’s objectives. In the end, Karl walked away with $1,000,000 cash (recovering his initial investment), a $1,000,000 FLIP CRUT and a net no tax payment to the government. He thought, “Not bad for only four months’ work!”