Case of the Week

Case:

Karl Hendricks was a man with the golden touch. Throughout his life, it seemed every investment idea 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 only asking $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 renovate the building.

After three months of hard work renovating 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 informally contacted by a company expressing an interest in the building – a $2 million interest! This was no surprise to Karl. He knew the building was another great buy.

However, there was one downside to the idea of selling. Karl only had the property for 4 months which meant the gain from the sale would be taxed as 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 trend downwards in the next year. Although Karl wanted the 23.8% tax rate, he did not want to risk holding the property another 8 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 on Karl's situation and goals, a FLIP charitable remainder unitrust (CRUT) is an excellent option. Prior to any binding sale agreement, Karl could transfer 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 is no prearranged sale problem.

Once the property is transferred into the FLIP CRUT, the trust would list and sell the property. Even if the property sold for $2 million, the trust would not owe taxes on the sale because the trust is exempt from any income taxes. Therefore, the FLIP CRUT meets Karl's first goal – avoiding an immediate 40% 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 meets Karl's second goal.

So far, Karl was very pleased with the FLIP CRUT option. It looked like the perfect solution. However, there are two potential downsides to this plan. The two remaining issues were as follows: 1) What was the charitable income tax deduction for gifts of short-term capital gain property and 2) What were 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."