FROM NASCAR CONDOMINIUMS TO PRIVATE MAUSOLEUMS: KEEPING THE VACATION HOME IN THE FAMILY - PART 3
By Wendy S. Goffe
Some family homes serve as a magnet that pulls the family together. Others become the family battleground, literally and figuratively. Stories of family arguments over ownership of a vacation home abound. Yet, families continue to desire and invest in these properties.
There are a number of motivations behind the initial purchase of a recreational cabin. These include:
A. The desire to create a sense of family, cultural identity, or other affinity. Vacation communities are often defined by race, religion, or other commonalities, including sexual orientation or even a passion for NASCAR racing. People gravitate toward these communities to vacation with others who share similar values or lifestyles.
B. The opportunity to conspicuously display wealth. The grand homes of Newport, Rhode Island are early examples of this motivation.
C. The opportunity to teach children to appreciate the benefits of nature. The Transcendentalist writers, including Henry David Thoreau, Ralph Waldo Emerson, and Walt Whitman, first documented their experiences in nature and their philosophy that a personal spiritual transformation could take place by getting away from the city to a restorative environment in the 19th century. In 1854, Henry David Thoreau recorded the experience of his retreat to Walden Pond in "Walden." Art Buchwald said about his own summer home on Martha's Vineyard, "I think for most people summer houses have more meaning than homes in winter, because all the memories, usually, of summer places are happy ones. When you're in the city, you're just in the city, but here I have been happy." Joyce Wadler, At Home With Art Buchwald: A Defiant Jester, Laughing Best, The New York Times (July 27, 2006).
D. The wish to get away from any reminders of routine daily living. The following quote from the New York Times encapsulates the desire to "get away from it all":
Forget the Tuscan villa, the chateau in Provence and the pied-a-terre in Paris. They're so cliché, not to mention overpriced. Savvy second-home hunters are packing their passports, pouring through foreign classified ads and snapping up homes in far-flung countries from Argentina and Bulgaria to Nicaragua and Turkey.
Even though these places may lack the glamour of Cannes and are sometimes harder to get to than Timbuktu, they are picturesque, not overrun by Americans and, in some cases, even fashionable. Best of all, there are still bargains to be found.
Denny Lee, A Second Home in Bulgaria?, New York Times, Oct. 28, 2005.
The sociological component of second home ownership is fascinating and important to a thorough understanding of the underlying issues that arise in families around this property, but it is a subject beyond the scope of this outline. (For an analysis of the sociological component, see Jeremy A. Blumenthal, "To Be Human": A psychological Perspective on Property Law, 83 Tulane L. Rev. (forthcoming 2009), available at http://ssrn.com/abstract=1334692.; Ken Huggins, Essay--Passing It On: The Inheritance, Ownership and Use of Summer Houses, 5 Marquette Elder's Advisor 85 (Fall 2003); Judith Huggins Balfe, Passing It On: The Inheritance and Use of Summer Houses (1999); and Judith Huggins Balfe, Passing it On: The Inheritance of Summer Houses and Cultural Identity, 26 The American Sociologist 29 (Winter 1995).) This outline focuses mainly on the equally important legal component of how families succeed in passing on ownership of a cabin from one generation to the next, with an emphasis on charitable planning, followed by a brief discussion of some unusual transfer issues--cabins on public land, and cabins in British Columbia. The more daunting task of ongoing management is also discussed below.
Few families successfully transfer ownership of a cabin or vacation property by accident. Families that do accomplish this Herculean feat do so only with a great deal of advanced multi-generational planning, often with mechanisms to adjust the plan as circumstances and needs change. In this chapter, the term "cabin" is used collectively to refer to vacation properties of all shapes, sizes, styles, and fair market values.
Cabins are frequently located in desirable areas where property values have appreciated at a rate far beyond a family's other assets. Often, a cabin may represent a large percentage of a family's financial holdings, posing complex estate tax and liquidity issues for the senior generation. For the junior generation, keeping a cabin in the family can create financial burdens. It can also bring the challenge of reaching a consensus among family members as to how to deal with this property, whether they want the property or not.
The legal mechanism for transferring the property is only the first of many challenges. Following the transfer, the next generation must determine how to maintain the property; how to pay taxes, insurance, and maintenance; and how to divide its use among the family members. The transfer itself is relatively easy compared to maintaining harmony among its owners following the transfer.
II. Creating a Master Plan.
Before a plan to transfer the family cabin can be implemented, it is helpful if the family can reach a consensus, in the form of a master plan, as to how that transfer will take place. (See James S. Sligar, Estate Planning for Major Family Real Estate Holdings, 133 Trusts & Estates 148 (Dec. 1994) ("Sligar, Major Family Real Estate Holdings") for a comprehensive discussion of master plans; Stephen J. Small, Preserving Family Lands, Book I: Essential Tax Strategies for the Landowner (Landowner Planning Center 3rd ed. 1998); Stephen J. Small, Preserving Family Lands, Book II: More Planning Strategies for the Future (Landowner Planning Center 1997); and Stephen J. Small, Preserving Family Lands, Book III: New Tax Rules and Strategies and a Checklist (Landowner Planning Center 2002).) The most successful transitions involve detailed and thoughtful advanced planning developed jointly by the senior and junior generations. The use of a mediator or other trained neutral third party can be invaluable in developing a master plan. (See Olivia Boyce-Abel, When to Use Facilitation or Mediation in Estate and Wealth Transfer Planning, Family Office Exchange, Vol. 9 No. 35 (1998), and Robert Solomon, Helping Clients Deal With Some of the Emotional and Psychological Issues of Estate Planning, 18 Probate & Property 56 (March/April 2004) ("Solomon, Helping Clients") for discussions concerning the role of a facilitator.)
A good facilitator can significantly increase the possibility of a successful outcome. Solomon, Helping Clients, supra, at 58. Family conflict is inevitable; a good facilitator can help families deal with conflict productively to mediate a mutually satisfactory resolution. Often, the presence of a mediator can provide objectivity and bring family members closer to a consensus when emotions might otherwise take center stage and derail the process.
Once the family members are informed of the various options (which may include setting aside portions for conservation purposes, selling portions to raise capital to support the remaining property; and transferring portions to succeeding generations), the first step in creating a master plan is to have the facilitator interview each family member.
The interview process is an opportunity for each family member to freely express his or her wishes and apprehensions with respect to the property. Not all family members have to participate in the interview process, but all should be given the opportunity. A trained non-family member serving in an intermediary capacity ideally allows the family members to focus on common interests rather than their differences. To do this successfully, the participants need to feel confident that the mediator is not aligned with the interests of any of the family participants or the estate planning attorney. Id.
Having met with as many family members as are willing to participate, the neutral third-party would prepare a report summarizing their findings, identifying areas of consensus, if any, and pointing out areas where feelings and opinions diverge. This report can be shared by the family members, and used by the members of the senior generation and their attorney to begin to develop the master plan.
In some cases, the facilitator's report provides sufficient information so that family members can make meaningful decisions with respect to the property jointly. If the family is unable to reach an agreement, one or more family meetings guided by the facilitator could follow to resolve areas of dispute, further define areas of agreement, and continue building a consensus. The development of a master plan with the assistance of a trained neutral third-party is especially useful when the senior generation has already ceded control of the property to the next generation and questions and issues concerning actual management have arisen.
Often, the next step in developing a master plan is the creation of a mission statement to address the family's goals and values with respect to the cabin. Issues to address in the mission statement could include:
A. What is most important to the family about the cabin?
B. What does the family value most about how it uses the cabin?
C. How would the family like to see the ownership of the cabin affect the ways the various members interact?
Of course, the use of a facilitator in estate planning is not going to be accepted by all clients. It is understandably difficult to impress upon clients the value that could be added by employing a facilitator to guide this process. At a minimum, the lawyer could offer to distribute a survey to family members that they could respond to anonymously, in order to give the senior generation insight into the wishes and apprehensions of the next generation. As a result of the facilitator's work or the lawyer's survey, the senior generation may discover that some or all of the members of the younger generation honestly have no interest in retaining the cabin. They also may be able to determine the apprehensions of those who do want to retain the cabin and resolve those issues before the cabin becomes a battleground.
It may be the case that, rather than transferring all of the property to the next generation as part of the master plan, the property may need to be divided into separate portions, each to be dealt with differently. The different uses may include development, conservation, and residential use. Next, with the help of the estate planning attorney, the family can identify techniques to accomplish these objectives, which are described below.
III. Conservation and Preserving Open Space.
Frequently, families determine that certain portions of their land should be preserved as open space. They may also choose to restrict development or other uses on the donated property, the retained property, or both. Outlined below are a number of methods for transferring an easement or the real property to charity.
A. Conservation Easements.One common way to restrict development is with a conservation easement. (See Nancy A. McLaughlin, Questionable Conservation Easement Donations, 18 Probate & Property 40 (Sept./Oct. 2004) for an analysis of the IRS's closer scrutiny of conservation easements and also an excellent list of further resources.) A conservation easement is a permanent restriction on the use of privately owned land to promote conservation. Granting a conservation easement typically reduces the value of the underlying real property for development purposes. For a family's purposes this can also have the effect of preserving a property's natural beauty and reducing gift and estate tax costs when the property is transferred between generations.
The Internal Revenue Code ("I.R.C.") permits income, and gift or estate, tax deductions for a grant of a conservation easement over certain real property. I.R.C. §§170(h), 2055(f), 2522(d). The Pension Protection Act of 2006, Pub. L. No. 109-280, 120 Stat. 780 (the "Pension Protection Act") amended I.R.C. §170 to permit a deduction of up to 50% of a donor's contribution base for certain conservation easements rather than the previous deduction of up to 30% of a donor's contribution base otherwise allowed under I.R.C. §170(b)(1)(C), but only for 2006 and 2007. I.R.C. §170(b)(1)(E). Furthermore, it extended a taxpayer's ability to carry forward unused deductions for 15 years, rather than 5 years as under prior law. I.R.C. §170(d)(1)(A). The Food Conservation and Energy Act of 2008, HR 2419, (also known as the "Farm Bill"), extended the expiration date again until December 31, 2009.
The Treasury Regulations set forth detailed requirements for deductibility, which are summarized below. Treas. Reg. §1.170A-14.
1. Qualified Conservation Contributions.
I.R.C. §170(f)(3)(B)(iii) provides an exception to the split-interest rules, which would normally disallow a deduction for the gift of a partial interest, such as a conservation easement. To be eligible for the deduction, the transfer of a conservation easement must constitute a "qualified conservation contribution" as defined in I.R.C. §170(h)(1), by satisfying the following requirements:
Each of these requirements is further defined by the statute and regulations.a. The property contributed must be a "qualified real property interest." I.R.C. §170(h)(2).
b. The property must be donated to a "qualified organization." I.R.C. §170(h)(3).
c. The gift must be "exclusively for conservation purposes." I.R.C. §170(h)(4). The definition of conservation purposes is quite broad. The regulations provide that "conservation purposes" means: (i) the preservation of land areas for outdoor recreation by, or the education of, the general public, (ii) the protection of a relatively natural habitat of fish, wildlife, or plants, or similar ecosystem, (iii) the preservation of certain open space (including farmland and forestland), or (iv) the reservation of a historically important land or certified historical structure. Treas. Reg. 1.170A-14(d).
d. The conservation purposes must continue in perpetuity. I.R.C. §170(h)(5)(a).
There are three categories of qualified real property interests:2. Qualified Real Property Interests.
a. The entire interest of a donor other than a qualified mineral interest (I.R.C. §170(h)(2)(A));
b. A remainder interest (I.R.C. §170(h)(2)(B)); and
c. A perpetual conservation restriction (I.R.C. §170(h)(2)(C)).
3. Qualified Organizations.
I.R.C. §170(h)(3) describes those organizations that are eligible to receive qualified conservation contributions, which include the following:
a. Certain governmental units described in I.R.C. §170(b)(1)(A)(v);
b. A publicly supported charity described in I.R.C. §170(b)(1)(A)(vi);
c. A publicly supported charity described in I.R.C. §509(a)(2); and
d. A supporting organization described in I.R.C. §509(a)(3), which is controlled by a governmental unit or a publicly supported charity.
A private foundation is not an eligible donee of a qualified conservation contribution.
Many parts of the country have local land trusts or land banks, which are nonprofit organizations established to protect and preserve valuable open space and environmentally sensitive land. A land trust or land bank can take title in fee simple, or to a remainder interest, and/or it can take title to a conservation easement over property.
In addition to being a qualified organization, an eligible donee must have a commitment to protecting the conservation purposes of the donation. Treas. Reg. §1.170A-14(c)(1). The requisite commitment is deemed present if the donee is organized or operated primarily or substantially for a conservation purpose specified in I.R.C. §170(h)(4)(A). The regulations further require that the donee have the resources to enforce the restrictions that are the subject of the contribution. Id. The donee is not required to set aside funds for the enforcement of the restriction. However, in practice, many organizations require the donor of a conservation easement to make a simultaneous cash contribution to help defray the cost of enforcement actions.
4. Exclusively For Permitted Conservation Purposes.
Under I.R.C. §170(h)(4)(A) and Treas. Reg. §1.170A-14(d)(1), a qualified conservation contribution must be made for one or more of the following permitted conservation purposes:
a. Preservation of land areas for outdoor recreation by, or education of, the general public (I.R.C. §170(h)(4)(A)(i));
b. Protection of a relatively natural habitat of fish, wildlife, or plants, or similar ecosystem (I.R.C. §170(h)(4)(A)(ii));
c. Preservation of open space, including farmland and forest land, for the scenic enjoyment of the general public or pursuant to a clearly delineated governmental conservation policy (I.R.C. §170(h)(4)(A)(iii)); or
d. Preservation of an historically important land area or a certified historic structure (I.R.C. §170(h)(4)(A)(iv)).
The regulations require an undefined degree of public access to an easement, except when access restrictions are required to protect the conservation easement that gives rise to the deduction. See Treas. Reg. §1.170A-14(d)(3)(iii). Visual access is sufficient for an open space easement for the scenic enjoyment of the general public. Treas. Reg. §1.170A-14(d)(4)(ii)(B).
In the family cabin context, an easement is typically granted to preserve a natural habitat and/or an open space for the scenic enjoyment of the public. Preservation for outdoor recreation is problematic because it requires the landowner to give access to the public, which private owners don't typically desire. And, there are few opportunities for easements for historical preservation in the family cabin context.
If the property to which a conservation easement applies is encumbered by a mortgage, the mortgage must be subordinated to the easement restriction. Treas. Reg. §1.170A-14(g)(2).5. Transfer of Interest Subject to Debt.
As a general rule, the value of an easement or other perpetual conservation restriction is equal to the difference between the fair market value of the encumbered property before and after the contribution. Treas. Reg. §1.170A-14(h)(3)(i). If there is a substantial record of sales of comparable easements, however, the fair market value of the donated easement must be based on the sales prices of the comparable easements. Id. Because sales of conservation easements are not common, perpetual conservation restrictions are usually valued pursuant to the "before and after" method.a. Before And After Method.
If the qualified real property interest is a remainder interest under I.R.C. §170(h)(2)(B), the value of the contribution is the fair market value of the remainder interest. Treas. Reg. §1.170A-14(h)(2). The valuation must take into account any pre-existing or contemporaneously recorded rights limiting, for conservation purposes, the uses to which the property may be put.
b. Reserved Rights--Economic Benefit to Donor Must Be Taken Into Account.
The regulations provide special rules for valuing a qualified conservation contribution. The rules are designed to take into account any economic benefit that may accrue to the donor or related parties as a consequence of the gift of the easement. Any interests retained by the donor must be subject to legally enforceable restrictions that prevent the retained interests from being used for a purpose inconsistent with the perpetual conservation purpose. Treas. Reg. §1.170A-14(g)(1). In the case of a gift of a perpetual conservation restriction covering a portion of contiguous property owned by the donor or his family, the value of the contribution is the difference between the fair market value of the entire contiguous parcel before and after the granting of the restriction. Treas. Reg. §1.170A-14(h)(3)(i) (applying the definition of "family" found in I.R.C. §267(c)(4)).
A family may want to convey a conservation easement, yet retain certain development rights over the property. There are two ways of accomplishing this: (i) The "reservation method," or (ii) the "carve-out method." The rights retained by the donor may not interfere with the scenic quality of the land covered by the easement.
The reservation method permits the grantor to convey an easement over an entire parcel and reserve a right to develop a discrete number of lots (e.g., one single-family dwelling for every 40-acre parcel) on the property.
The carve-out method permits the grantor to carve out specific portions for development. The carve-out method allows the parcels not subject to the easement to be developed and often enhances the market value of these parcels because of their proximity to the parcels subject to the conservation easement. Both methods may be useful in the development of the family's master plan.
Where certain rights are retained, or adjacent property is retained, the easement may have the effect of increasing the value of any other property owned by the donor or a related person. This occurs because the donor recognizes incidental benefits as a result of the easement. Where the value of the property owned by the donor increases due to the donation of the easement, the value of the contribution is reduced by the amount of the increase in value of the other property, whether or not the property is contiguous. Treas. Reg. §1.170A-14(h)(3)(i). A deduction may be completely disallowed if the economic benefit to the donor or related person exceeds the benefits that will inure to the general public. Id.
c. "Qualified Appraiser" and "Qualified Appraisal."
The Pension Protection Act added I.R.C. §170(f)(11), which provides statutory definitions of a "qualified appraiser" and a "qualified appraisal" for tax returns filed after August 17, 2006. I.R.S. Notice 2006-96, 2006-46 I.R.B. 1, provided transitional guidance on the new definitions under I.R.C. §170(f)(11) until the regulations are issued. Any charitable donation of real property valued in excess of $5,000 must be accompanied by a "qualified appraisal" prepared by a "qualified appraiser" to support the donation. Treas. Reg. §1.170A-13(c).
For returns filed after August 17, 2006, appraisals of real property must be prepared by an appraiser licensed or certified for the type of property being appraised in the state in which the real property is located. I.R.C. §170(f)(11)(E)(ii)(I).
d. Penalties for Over-Valuation.
Penalties may apply to the amount of the tax that is underpaid because of a valuation overstatement. I.R.C. §6662. (I.R.S. Notice 2006-96, 2006-46 I.R.B. 1, also provides guidance for substantial or gross valuation misstatements on appraisals under I.R.C. §6662.) The Pension Protection Act substantially increased the application of the penalties by reducing the thresholds for determining whether a substantial valuation misstatement has been made under I.R.C. §6662. The 20% penalty previously applied to overstatements of 200% or more. That threshold has been lowered to 150%. The 40% penalty previously applied to overstatements of 400% or more; that threshold has been lowered to 200%. The Pension Protection Act also created an appraiser penalty. I.R.C. §6695A(b). However, no penalty will be imposed on an appraiser who establishes that the appraised value was "more likely than not" the correct value. I.R.C. §6695A(c). The appraiser penalties apply to appraisals prepared in connection with returns filed after August 17, 2006. The accuracy-related penalties apply to returns filed after July 25, 2006.
e. Taxpayer Relief Act of 1997--Exclusion of Value of Certain Conservation Easement Property.
Even if a decedent did not specifically provide for a gift of a conservation easement, an executor or inheriting "family member" can grant a conservation easement on estate property. I.R.C. §2031(c). §508 of the Taxpayer Relief Act of 1997 added a new estate tax exclusion, codified at I.R.C. §2031(c). The exclusion may apply to a portion of the value of certain property with respect to which a qualified conservation easement is granted, located within the U.S. or its possessions, I.R.C. §2031(c)(8)(A)(i), and owned by the decedent or a member of the decedent's family for the three years prior to the decedent's death, I.R.C. §2031(c)(8)(A)(ii).
f. I.R.C. §2031(c) Exclusion and Deduction.
Under I.R.C. §2031(c), a personal representative may elect to exclude from a decedent's estate the lesser of: (i) the applicable dollar exclusion limitation, or (ii) a percentage of the value of the land that is subject to the qualified conservation easement. The applicable percentage is 40%, reduced by 2% for each 1% by which the value of the qualified conservation easement is less than 30% of the value of the land. I.R.C. §2031(c)(2). Thus, the full 40% of the value of the land may be excluded from the gross estate only if the qualified conservation easement is worth at least 30% of the value of the land. The maximum dollar exclusion for decedents dying after 2002 is $500,000. I.R.C. §2031(c)(1)(B), (c)(3).
A number of other requirements must be met to take advantage of this exclusion. (See Robert G. Petix, Jr., Postmortem Conservation Easements: Substantial Estate Tax Savings, 30 Estate Planning 273 (2003), for an in-depth discussion of postmortem granting of conservation easements. One that should be emphasized is that an exclusion may not be taken to the extent the owner retains any development rights with respect to the property or the property is debt-financed. I.R.C. §2031(c)(4), (c)(5).
I.R.C. §2055(f) provides for an estate tax charitable deduction for a post-mortem grant of a qualified conservation easement to a qualified charity. Unlike the exclusion, there is no cap on the amount of the deduction. Furthermore, it is the estate's beneficiaries who may decide to take this deduction on a post-mortem basis. I.R.C. §2031(c)(9).
The deduction and the exclusion may be applied simultaneously to the same transfer. In the family cabin context, the result may be that the owners are able to continue using the property in the same manner as it had been used previously.
7. Planning Opportunities.
It is important to note that the application of I.R.C. §170(b)(1)(E), which allows a taxpayer to deduct 50% rather than 30% of his or her contribution base and extend the carry forward for 15 rather than 5 years, is somewhat narrow. I.R.C. §170(h)(1) defines a "qualified conservation contribution" as a contribution of a qualified real property interest to a qualified organization exclusively for conservation purposes. The definition of a qualified real property interest pursuant to I.R.C. §170(h)(2) does not include a fee simple interest in real property. Therefore, the contribution of a fee simple interest in property, even to a conservation organization is not entitled to the application of I.R.C. §170(b)(1)(E). Samuel D. Shapiro, New Legislation Affects Conservation Easements, 16 MSK Charitable Sector Letter (Mitchell Silberberg & Knupp LLP, Los Angeles, Cal.) June 6, 2008, at 2.
A donor who wishes to contribute a fee simple interest in real property but also wishes to take advantage of I.R.C. §170(b)(1)(E), could grant a conservation easement in 2008 or 2009 and then in a later year, contribute the remaining fee simple interest in the property. The second contribution would not be entitled to the increased deductibility, however.
It is also possible, in the family cabin context, to place a conservation easement on the cabin property to preserve open space, which would allow for a current income tax deduction and a reduction in transfer taxes, without changing the way the family actually uses the property.
B. Direct Gifts to Charity.In some cases, it may make sense for the family to directly contribute land that is environmentally sensitive to a charity that will hold and protect it. A direct gift eliminates the cost and complication of establishing a conservation easement. It also eliminates the complication of the ongoing operation of a charitable entity.
An outright gift will also entitle the donor or donors to either an income and gift tax deduction for an inter vivos gift, I.R.C. §170(c), or an estate tax deduction at death, I.R.C. §2055(a). Unlike the charitable income tax deduction, there are no percentage limitations on the estate tax charitable deduction, and no related/unrelated use limitations. (The fair market value of appreciated property contributed to a public charity is deductible up to 30% of the taxpayer's contribution base (the taxpayer's adjusted gross income without regard to net operating loss carrybacks). I.R.C. §170(b)(1)(C)(i), (b)(1)(B). Contributions in excess of the 30% limitation may be carried forward for five years. I.R.C. §170(d)(1)(A), (b)(1)(C)(ii). The taxpayer may elect to increase the 30% limitation to 50% of the contribution base, but the deduction is then limited to the taxpayer's basis. I.R.C. §170(b)(1)(C)(iii), (e)(i). Typically this election would be made if the taxpayer's basis in the property is very high or the deduction is so large that the taxpayer isn't likely to use it in any case. Frederick K. Hoops, Frederick H. Hoops III, Daniel S. Hoops, 1 Family Estate Planning Guide §11.8(d) (4th ed. 2005). In general, contributions to public charities and private foundations are deductible without regard to the percentage limitations described above for estate and gift tax purposes.)
The donation must be to a permissible donee, as defined in I.R.C. §170(a), which include governmental entities, public charities, and private foundations.
Where property is contiguous with public land, it may also be possible to donate the property to a government agency. However, there are limitations. For example, Congress determines the boundaries of national parks, and donations of real property are only permissible within those boundaries. Thus, even where land is contiguous with public land for National Park purposes, a land bank may be a more feasible donee.
C. Part Gift/Part Sale Transactions.
Where a family cannot afford to give the property outright to charity, there are a number of part gift/part sale options available, which are discussed below. These arrangements are most useful with property that a family does not want to pass on to further generations or heirs, or where a family desires to downsize the amount of property to be retained for future generations. With any of these arrangements, the donor and the charitable recipient need to keep in mind the potential for generating unrelated business taxable income due to property subject to acquisition indebtedness. (If property owned by the donor for less than 5 years is subject to debt that is less than 5 years old, a bargain sale may give rise to acquisition indebtedness. I.R.C. §514(c)(2)(B). A sale of property subject to acquisition indebtedness by the charity will result in unrelated business taxable income. This result can be avoided if the charity waits 12 months to sell the property. I.R.C. §514(B). If a donor has owned the property for 5 years or more and the debt is 5 or more years old, the charity may avoid payment of unrelated business income tax if it sells the property within 10 years of receipt. I.R.C. §514(c)(2)(B).) Any income earned by a charity subject to acquisition indebtedness will be treated as unrelated business taxable income unless its use is substantially related to the charity's exempt purpose. I.R.C. §514(b)(1)(A).
1. Bargain Sale.
A donor may enter into a purchase and sale agreement with a charity for an amount less than the fair market value. The difference between the actual sale price and the fair market value may be treated as a charitable deduction. I.R.C. §1011(b). The donor must allocate his or her basis in the property pro rata to both portions, based on its fair market value, and report gain on the difference between the sale price and the basis allocated to the sold portion (but not the donated portion). Id.
2. Gift in Exchange for a Charitable Gift Annuity.
If appreciated property is used to fund the annuity, the taxable gain, calculated under the bargain sale rules, must be fully recognized by the donor in the year the annuity is created (unless the donor is the only annuitant). Treas. Reg. §1.1011-2(a)(4).
A charitable gift annuity is a contractual arrangement by which the donor transfers cash or other property in return for a specific charity's promise to pay annuity payments to one or more persons. The donor receives a charitable deduction equal to the amount transferred less the present value of the stream of annuity payments. The annuity could be for the life or lives of any two persons, although typically it would be for the life of the donor, the life of the partner, or both lives.
Like the donor of a charitable remainder trust, the donor of a charitable gift annuity receives an income tax charitable deduction for part of the value of the assets contributed. Unlike a charitable remainder trust, however, payments may be made to no more than two persons (consecutively or on a joint-and-survivor basis), and may not be made for a term of years. Furthermore, a charitable gift annuity is a contract involving a transfer of assets to a single charity, whereas, a charitable remainder trust is a trust arrangement that may benefit multiple charities.
3. Gifts of a Remainder Interest in a Personal Residence.
A family may benefit from giving a residence to a charity, subject to the reservation of a life estate. The home involved must be a personal residence, but need not be the primary residence. Reasonable surrounding grounds, determined by the customary lot size in the area, may also be included in the charitable gift. The gift of the remainder interest could take effect at the end of one or two lives, or a term of years.
While the gift of a remainder interest itself is made by means of a simple deed, there should also be a separate agreement regarding the rights and responsibilities of the charity and of the life tenant or tenants. This arrangement allows a donor to retain a measure of control and access to the property for life, but typically doesn't reduce the ongoing cost of owning the property.
Customarily, life tenants will be required to pay property taxes, utilities, liability and casualty insurance, maintenance expenses, and minor repairs. To avoid disputes during the occupancy period of the life tenant, the agreement should assign responsibility for the cost of capital improvements, and provide a procedure for reviewing subleases, a procedure for the sale or mortgage of the property, and criteria for the removal of tangible personal property and fixtures by the life tenant at the end of the term. A procedure for resolving disputes should also be agreed upon ahead of time between the tenant and the remaindermen, including the rights of recovery by one party from another, including reasonable attorney's fees. There should also be a procedure for receiving notice of default on any debt secured by the property and an opportunity to take steps to cure a default and to bid for the property in a foreclosure sale. Finally remaindermen should have a right of entry for inspection.
For lifetime gifts, the donor receives income and gift tax charitable deductions for the present value of the charity's remainder interest. I.R.C. §§170(f)(3)(B)(i), 2522(c)(2). If the property is appreciated the donor does not recognize any capital gain. If the gift is made on a testamentary basis, the donor's estate is entitled to an estate tax charitable deduction for the present value of the charity's remainder interest. I.R.C. §2055(e)(2).
This arrangement is most useful with a residence that is not subject to a mortgage and for property not intended to be passed on to further generations or heirs. But, once the gift is made, it might be possible for another family member to re-acquire the remainder interest from the charity at a later date, the value of which would be subject to a discount valuation as a fractional interest.
A family may own an operating farm and wish to discontinue operation of the farm, after the current generation. But, they may wish to retain the appurtenant residence. These families may benefit from a fractional gift of a remainder interest in the farm. Treas. Reg. §1.170A-7(b)(4). (A farm is defined as land that is used for the production of agricultural products, including crops or timber, by either the owner or the tenant. Treas. Reg. §1.170A-7(b).)
The remainder interest in a home or farm typically has a duration of one or two lives (anything longer would produce a negligible charitable deduction), but may also be a remainder following a term of years. Treas. Reg. §1.170A-7(b).
D. Charitable Remainder Trusts.
Charitable remainder trusts ("CRTs") can be useful for the transfer of real property to charity when the donor is not able or willing to give up ownership without a retained financial benefit. The rules applicable to CRTs are extremely technical and complex. (See Robert J. Rosepink, Charitable Remainder Trusts and Pooled Income Funds, 865 Tax Mgmt. Portfolio (2000) and Sanford J. Schlesinger & Martin R. Goodman, Back to Basics: A Primer for Charitable Remainder Trusts, 32 Estate Planning 9 (March 2005) for a thorough discussion of this topic.) But generally, the CRT is an irrevocable trust that makes distributions--at least annually--to one or more non-charitable beneficiaries for a term of not more than 20 years, or for the life or lives of the individual beneficiaries. I.R.C. §664(d). When the non-charitable interest or interests terminate, the remainder interest passes to one or more qualified charitable organizations. I.R.C. §664(d)(1), (2).
A CRT may be structured as either a charitable remainder annuity trust ("CRAT") or a charitable remainder unitrust ("CRUT"). A CRAT pays the noncharitable beneficiary a fixed dollar amount that is specified in the trust agreement, so the payout from a CRAT does not vary from year to year. A CRUT pays a fixed percentage (no less than 5% and no more than 50%, I.R.C. §664(d)(1)(A)) of the value of the trust property, thus distributions can fluctuate based on the increase or decrease in value of the trust. Because CRAT distributions cannot increase over time, it is less frequently used. (Revenue Procedures 2003-53 through 60 (August 4, 2003) contain eight model CRAT agreements. Revenue Procedures 2005-52 through 59 (August 22, 2005) contain eight model CRUT agreements. For comments and alternate provisions to consider, see Conrad Teitell, A Closer Look at Those New Specimen CRUTs, 145 Trusts & Estates 57 (January 2006); Richard L. Fox, A Guide to the IRS Sample Charitable Remainder Trust Forms, 33 Estate Planning 13 (January 2006); and J. Michael Pusey, Exploring the New Model Charitable Remainder Annuity Trust Forms, posted on the Planned Giving Design Center website, www.pgdc.com/tsf/item/?itemID=91086.)
A CRT is exempt from income tax unless it has unrelated business taxable income. I.R.C. §664(c). (Until December 31, 2006, if a CRT had any unrelated business taxable income in a year, all of its income that year would be subject to income tax. Id. Beginning January 1, 2007, §424 of the Tax Relief and Health Care Act of 2006, Pub.L. No. 109-432, 120 Stat. 2922, amends I.R.C. §664(c) so that any unrelated business taxable income in a CRT will simply be taxable, but will not disqualify the entire CRT for that tax year.) If no unrelated business taxable income is generated, tax is paid by the annuity or unitrust recipient as distributions are received, according to the tier system set forth in I.R.C. §664(b). As a result, the trustee may transfer appreciated assets held more than one year, and liquidate and reinvest the proceeds, without immediate capital gain tax consequences.
In the year of funding, the grantor of an inter vivos CRUT may claim an income tax deduction for the present value of the remainder interest that will pass to charity, subject to certain restrictions. I.R.C. §§170(f)(2), 2522(c)(2). One of those restrictions is that, to qualify as a charitable remainder trust, the actuarial value of the remainder eventually passing to charity must have an actuarial value of at least 10% of the value of the trust estate at the date the trust is funded. I.R.C. §§664(d)(1)(D), (d)(2)(D). A CRUT may have multiple recipients, either concurrently or serially. But additional recipients (and young recipients) reduce the likelihood that the trust will meet the 10% threshold.
Use of a CRUT for the sale of the property would generate cash flow and a charitable deduction for the donor. Furthermore, the charitable remainder beneficiary is not limited to charities with a conservation purpose, as with the outright gift of a conservation easement.
One method for forming a CRUT funded with real estate is to design the trust so that no more than the net trust income is distributed until the occurrence of a triggering event--an event that is not discretionary or within the control of the trust or any person, Treas. Reg. §1.664-3(a)(1)(i)(c), (a)(1)(i)(d)--at which time the CRUT would begin paying out the full unitrust amount as of January 1 of the year following the year in which the event occurs. See Treas. Reg. §1.664-1(a)(7), (d)(1)(iii), (f)(4). This is sometimes referred to as a "net income with makeup charitable remainder trust" or "NIMCRUT." The sale of the real property could be the triggering event. After the triggering event, deficiencies from earlier years can be made up in later years when trust income exceeds the required set percentage amounts for such amounts. This allows payment of the unitrust amount to be deferred until after the year in which the sale takes place and allows for the possibility of a lack of liquidity in prior years.
At the end of the noncharitable term, the donor will give up ownership of the underlying real property.
The biggest challenge with this technique is impressing on the donor the importance of contributing the property prior to entering into the sale transaction. If the property is not transferred to the CRUT in time, the sale may be recharacterized as a sale subject to capital gains tax, followed by a contribution of the proceeds to the CRUT.
E. Gifts to Charitable Entities.
Rather than an outright gift to charity or a CRT, a family may wish to give property to an entity that it controls or participates in the management of. Two particularly useful recipients are the supporting organization and the private operating foundation.
1. Gifts to Private Operating Foundations.
A private operating foundation is a charitable entity that may be controlled by the family members and that is exempt from income tax under I.R.C. §501(c)(3). See Michael D. Martin & Mark B. Weinberg, Private Operating Foundations: Helping Clients Explore "Hands-On Philanthropy," 14 Probate & Property 18 (Sept./Oct. 2000). The foundation would need to be established and operated to use the property exclusively for charitable or educational purposes that will confer a benefit upon the public and not the donors or their family members. Public uses include hiking and riding trails and open spaces that can be viewed by the public.
Among the many compliance limitations that apply to private operating foundations and their donors. One is that the donor family will not be able to use or have access to the donated property in any manner that is more advantageous than the public's access to the property.
Contributions to a private operating foundation are treated as if made to a public charity. I.R.C. §4942(j)(3); Treas. Reg. §53.4942(b) 1. In contrast, the deduction to a non-operating private foundation is limited to the lesser of (1) 20% of the taxpayer's contribution base or (2) the excess of 30% of the taxpayer's contribution base over the amount of charitable contributions allowable to public charities, determined without regard to the 30% limitation. I.R.C. §§170(b)(1)(C)(i), (e)(1)(B)(ii). Excess deductions may be carried forward for five years.
Private foundations of any sort are subject to strict regulation and scrutiny by the IRS. Unlike a private foundation, which is generally limited to passive grant making to public charities, a private operating foundation directly operates a charitable activity or program, and dedicates its funds to operating that program, such as a nature reserve. Specifically, the foundation could use the funds to perpetuate the preservation of environmentally sensitive land. The family of a private operating foundation donor may control the management of the foundation.
In spite of the many technical compliance requirements, in the appropriate situation the private operating foundation can provide a family with considerable flexibility in its charitable giving.
2. Gifts to Supporting Organizations.
A "supporting organization" is another form of family foundation, which is described under I.R.C. §509. Generally, the tax benefits of a supporting organization are more generous than those of a private foundation, but the donor does not retain as much management or control over the use of the funds.
The advantage of the supporting organization is that generally the tax benefits are more generous than those of a private foundation because it is treated as a public charity for purposes of calculating the donor's deduction. This comes at the expense of the donor's management or control over the use of the donated property. In return for the greater tax benefits of a supporting organization, the family of a supporting organization donor may participate in but not control the supporting organization.
A supporting organization must identify the charitable organizations or purposes it will support and must affiliate with an established public charity or charities. I.R.C. §509(a)(3)(A); Treas. Reg. §1.509(a)-4(c)(1). While more costly to establish, a supporting organization offers significantly greater freedom from the technical compliance requirements of a private foundation, and is often the preferred charitable vehicle.
A supporting organization, which is affiliated with or controlled by a governmental unit or a publicly supported charitable organization, could also be the recipient of a contribution of real property. I.R.C. §509(a)(2), (a)(3).
A supporting organization could be funded, in part, with a portion of the family's real property intended to be set aside for conservation purposes. The supporting organization could then support another charity, such as a state or local public park agency, land trust, historical society, or conservation organization, by donating the land to the supported charity and/or providing funds for the supported charity to conduct conservation programs on the land, or both.
F. Taking Advantage of Current Use Restrictions for Property Tax Purposes.
Many taxing authorities have programs whereby a property owner may agree to keep property in its current use, typically as timber or agricultural land. In return, the landowner receives a reduction in property tax for as long as that restriction is maintained. These arrangements differ widely across the country.
IV. Sale and Development of Property.
As part of the master plan, the family may simply decide to sell some of the property to raise funds to maintain what is remaining and/or to reduce the ongoing costs of maintaining the property. More ambitious families may develop and then sell certain parcels. The proceeds can be set aside in a trust, or transferred with the cabin into any of the entities discussed below, for ongoing management of the cabin.
A. Sale of a Conservation Easement.
A landowner may not be able to afford to place a conservation restriction on his retained property. Or he may have little income against which a deduction may be taken. In some cases, the local government or a land bank may be willing to purchase a conservation easement on environmentally sensitive land. The value of the easement would be the value of the land without the easement less the value of the land with the easement. If the land is part of the seller's homestead, he could treat the transaction as a sale of his principal residence and shelter up to $500,000 in gain if married. Treas. Reg. §1.121-1(b)(3). Otherwise, capital gain rates will apply to the proceeds. A landowner may also sell a conservation easement through a charitable remainder trust. See Joan B. Di Cola, Alternatives to Donating a Conservation Easement, 31 Estate Planning 489, 491-494 (Oct. 2004).
B. Exchange of a Conservation Easement.
The sale of a conservation easement will generally trigger capital gain tax. Instead, a landowner may be able to defer that tax by using a like-kind exchange of a conservation easement, pursuant to I.R.C. §1031, for other land. For example, a family could exchange a scenic conservation easement for additional land without triggering tax.
Treas. Reg. 1.1031(k)-1 provides a detailed guide for exchange transactions. A deferred exchange occurs when an owner acquires qualifying replacement property in exchange for qualifying relinquished property. To qualify, the exchange (1) must involve like-kind properties; (2) must be an actual exchange and not merely a sale for money that is reinvested; and (3) must comply with specific time requirements.
The property involved in the exchange must be (1) qualifying property and (2) like-kind property. Property is generally divided into four classifications for tax purposes: Property held for business use; Property held for investment; Property held for personal use; and Property held for sale. Only property held for business use or for investment qualifies for exchange treatment under §1031.
In those instances in which property has more than one use (i.e. the duplex that has one unit occupied by the owner, or a farm with a residence), the sale can be allocated between the two uses. Both business and investment property qualify for §1031 treatment, so a commercial property used in business (a building) can be exchanged for raw land held for future appreciation (investment).
The requirement of "like-kind" refers to the nature of the real estate as to its owner, rather than a comparison of physical characteristics of the property, or its prior or subsequent use. There are no holding periods under §1031. But, the length of time the property has been held by a taxpayer may help to show its particular use. In PLR 200651030 the Service indicated that a holding period of 2 years was sufficient to show a qualified use.
The property can be located in any state (and the U.S. Virgin Islands). Foreign property will not qualify. Personal property (except for certain personal property held as business assets), stocks, bonds and partnership interests do not qualify.