For many donors, the most significant part of their net worth is real estate. Thus, donors regularly make real estate charitable gifts. As a general rule, many charities prefer gifts of cash, stocks and bonds because these types of gifts are easy to transfer, value and liquidate. In contrast, gifts of real estate may bring legal and financial liability that gives rise to numerous issues the charity must navigate.
Real estate is a unique asset, and each gift must be properly tailored to the property and the donor's expectations, while protecting the charity from any issues that may arise. Charities and donors must ensure they are informed about the benefits and pitfalls of gifts of real estate.
This series about donating real estate will discuss the definition of real estate, charitable deductions for real estate gifts, charitable gift options and some best practices. This article will discuss funding charitable lead trusts (CLT) with real estate assets.
Structuring Real Estate Gifts
Real estate can be an excellent asset to donate to charity. Usually, a donor will receive a greater tax benefit by gifting real estate, rather than donating the cash proceeds from a sale of the real estate. If a donor sells the real estate first and then donates the cash proceeds, the donor will be taxed on the gain from the sale. When the donor transfers the property to a charity before the sale, the capital gain may be bypassed. One exception to the bypass of gain is when there is a prearranged sale. Part I of this series touched on the prearranged sale rules. If the IRS deems a transaction a prearranged sale, the donor will not bypass the gain.
Charitable Lead Trusts
There are three main varieties of lead trusts: grantor lead trusts, super lead trusts and non-grantor lead trusts. A charitable lead trust is viewed as the inverse of a charitable remainder trust. Whereas a charitable remainder trust benefits one or more charities upon its termination, a charitable lead trust benefits the charity with the lead interest. Payments are made to a qualified charity for a term, and upon the expiration of the term, the remaining assets of the trust are distributed to the grantor or other non-charitable beneficiaries, such as family members.
The trust must make an annuity or unitrust payment at least annually to one or more qualified charities to be considered a qualified charitable lead trust. Reg. 20.2055-2(e)(2)(vi). Lead trusts can be funded during life or at death as a testamentary trust. If drafted to make unitrust payments, the trust will make at least annual payments to one or more charities for a certain percentage of the trust as the trust is revalued each year. Generally, the trust will be revalued every January 1 of the trust term. With annuity payments, the trust will make the same certain dollar amount payments based on a percentage of the trust's value at the time of funding.
The charitable interest is vested for the duration of the trust term, often referred to as the lead interest, because they are receiving the payments first. Upon the expiration of the term, the trust corpus either reverts to the trust grantor or is transferred to other non-charitable beneficiaries, such as the family members of the grantor. The grantor or non-charitable beneficiaries' interest is the remainder interest. Lead trusts are not tax-exempt trusts. The taxation of the lead trust and the benefits to the donor depend on how the lead trust is drafted. Each type of lead trust has unique income, gift or estate tax benefits.
A charitable lead trust has no payout restrictions. A charitable lead trust may pay out as little as 1% or as high as 100%. The designated payout percentage to charity and the length of the trust term will determine the charitable deduction for gift, estate or income tax purposes. If the trust distributes appreciated property to satisfy the trust's required payment, the gain is recognized as if the asset were sold and then distributed.
The income tax charitable deduction limitations on grantor lead trusts are subject to lower percentage limitations because lead trusts are considered gifts "for the use of" rather than "to" the charity. The income tax charitable deduction is limited to 30% of the donor's adjusted gross income (AGI) when funded with cash and 20% of the donor's AGI when funded with long-term capital assets. Any unused charitable deduction may be carried forward up to an additional five years, for a total of six years to take the full deduction.
The trust term may be for the life of the donor, for a term of years or for the lesser of life or a term of years. If the trust is a grantor lead trust, part of the charitable deduction will be subject to recapture if the donor does not live to the end of the trust term. Sec. 170(f)(2)(B). A lead trust does not have a limitation on the term. There have been qualified lead trusts created for a term of 30 to 35 years.
Real estate may be a great asset to fund a charitable lead trust, depending on the donor's goals. The best types of real estate assets for CLTs have the following characteristics: (1) income-producing real estate; (2) real estate that produces passive income, such as fixed-payment rental or lease income; (3) real estate unencumbered with debt; and (4) real estate the trust intends to hold long-term i.e., will not be sold within the trust. In many cases it may be wise for the grantor to add liquidity during the funding of the trust to protect against fluctuation in income, property tax and other incidentals. If the trustee cannot satisfy the required payment to charity, the trustee may have to sell part or all of the property to satisfy the charitable payment, which will result in the trust or the donor recognizing gain from the sale. The grantor can experience significant tax benefits when funding the CLT with favorable real estate assets.
i. Grantor Lead Trusts
Under Sec. 673(a), a lead trust qualifies as a grantor lead trust if at least 5% of the trust corpus reverts to the donor upon expiration of the trust. All income and gain produced by the trust will flow through and be taxable to the donor's personal income tax return.
The primary benefit of the grantor lead trust is the income tax deduction for the present value of the income that is projected to be paid out to one or more charities over the term. Only lead trusts that qualify as grantor lead trusts create an income tax deduction.
Although the annuity or unitrust payments are transferred to charity, the grantor must report these amounts as income on his or her own personal tax return. Sec. 170(f)(2)(B). If the trust recognizes capital gain, the grantor must recognize the gain despite the gain being held in the trust until maturity. Any passive income earned by the property will be fully taxable as ordinary income to the donor. Given this tax treatment, grantor lead trusts are not often funded with real property. Instead, a donor may wish to fund a grantor lead trust with cash or appreciated stock.
ii. Super Lead Trusts
Lead trusts may be drafted to obtain both an income tax deduction and a gift tax deduction. This trust structure operates both as a non-grantor lead trust, but includes the added benefit of both an income and gift tax deduction with the trust corpus passing to the grantor's family upon expiration of the term. This is known by tax experts as an intentionally defective grantor lead trust. The trust is also commonly called a super lead trust.
The trust must be drafted such that it is not included in the grantor's taxable estate, but must have a retained power for the trust to be considered a grantor lead trust to obtain the income tax deduction. To accomplish this, the grantor may not retain a reversion or control over the distribution of income. Sec. 2036(a).
The most popular way to qualify the lead trust as a grantor lead trust is to include in the trust document a right to reacquire trust assets by a non-adverse party exercising the right in a non-fiduciary role. Under Sec. 675(4), the grantor shall be treated as the owner of a trust if the power of administration is exercisable in a nonfiduciary capacity by any person without the approval or consent of another person in a fiduciary capacity. The term "power of administration" includes a power to reacquire the trust corpus by substituting other property of equivalent value. If the trust is drafted with such a right by a non-adverse party acting in a non-fiduciary role, the grantor is additionally entitled to an income tax deduction.
The donor is entitled to an up-front income tax deduction and will be personally taxed on the trust income and any recognized capital gain. Because the underlying structure is a grantor lead trust, the super lead trust is not usually funded with real estate due to the high likelihood of significant adverse tax consequences to the donor. Passive income generated from real estate will be fully taxable to the grantor.
iii. Non-Grantor or Family Lead Trusts
A non-grantor lead trust is drafted with the remainder passing to a non-charitable beneficiary, such as the grantor's family members. Non-grantor lead trusts are often referred to as family lead trusts because the remainder passes to the grantor's family members.
The goal of a non-grantor lead trust is to generate a gift or estate tax deduction, which allows the assets to be passed to family with reduced gift or estate tax implications. Unlike grantor lead trusts, a non-grantor lead trust does not produce an income tax deduction for the grantor.
In contrast to the grantor lead trust, a non-grantor lead trust operates as its own taxable entity and must file IRS Form 1041. This means the trust pays taxes on income and capital gain recognized by the trust, instead of the income and capital gain flowing through the trust to the grantor. The difference is that the trust, as its own entity, owes any potential taxes rather than the grantor personally. Non-grantor lead trusts create a gift tax deduction in the year the trust is funded. If the trust is drafted as a testamentary non-grantor lead trust, an estate tax deduction is created.
A non-grantor trust can be drafted to make either unitrust or annuity payments to one or more charities. The trust may be drafted as an inter vivos trust or a testamentary trust. The choice to draft the trust with annuity or unitrust payments is of importance for leveraging the amount transferred to family. Because annuity payments remain static over the trust term, non-grantor lead annuity trusts are favored because the remainder amount transferred to family may be larger with careful administration of the trust. However, when the trust may have applicable generation skipping transfer taxes (GSTT), unitrust payments may be more appropriate because GSTT implications can be eliminated when drafted correctly. When drafted with unitrust payments, the applicable fraction to determine GSTT implications is computed when the trust is funded. If structured as an annuity trust, the applicable fraction is computed when the trust is terminated, thus creating uncertain GSTT implications.
For either drafting option, the grantor will need to file a Form 709 U.S. Gift Tax Return and report the taxable gift. However, the grantor may not pay any gift tax in the year of the gift due to the current very high lifetime unified exemption. In the year 2021, the lifetime exemption is $11.7 million per individual. Transfers through a charitable lead trust will not provide a step-up in basis, the non-charitable beneficiary's basis in the property will equal the grantor's basis. If the non-charitable beneficiary later sells property gain will be recognized.
As established above, real estate is not generally considered a good asset for funding a grantor or super lead trust. This is because the donor will be taxed on the income and gain from the funding asset. However, unlike the grantor and super lead trusts, the non-grantor lead trust is its own entity for the purposes of taxation. So long as there is no unrelated business taxable income (UBTI), the trust is allowed to take an unlimited income tax deduction for its distributions to qualified charities. Sec. 674(c)(1). If the trust has UBTI, the deduction is limited to 50%. Sec. 681(a). Absent UBTI, any income or gain in the trust will be offset up to the amount of the trust's annual payouts to charity. Only income and gain in excess of the annual payout will be taxable to the trust. Therefore, non-grantor charitable lead trusts may be a great solution for real property projected to significantly increase in value over time.
John and Sally have a portfolio of apartment complexes that they would like to pass to their two children, Mary and George. The couple purchased one of the complexes many years ago for $4 million and it is now worth $14 million. They also have $1 million in public securities that they would be willing to fund the trust with as well. They had purchased the stock for $500,000 many years ago. The complex is generating fixed income and appreciating at an average rate of 2%. John and Sally are interested in funding a non-grantor lead trust to benefit their favorite charity, but are unsure whether it should be structured with annuity or unitrust payments. The couple contacts their estate planning attorney for advice on how to draft the trust. The attorney recommends funding the lead trust also with the $1 million in securities to add liquidity in case of any incidental costs related to the apartment complex.
The attorney prepares illustrations of both payment structures to highlight the benefits of each. The attorney recommends a 10-year trust term making at least annual payments of 7% to their favorite charity, with the assumption of combined income from the securities and apartment complex generating $1,050,000 of income (7%) with combined conservative asset growth at a rate of 2%. In either trust drafting structure, the trust will not recognize capital gain based on the yearly 2% anticipated growth of the complex and securities, if they are retained within the trust. If the trust sells the securities or the apartment complex, the trust will recognize the capital gains.
If the trust is drafted with 7% annuity payments, the couple will receive the following tax benefits. The trust will create a charitable gift tax deduction of $10,052,385, leaving a taxable gift of $4,947,615. The trust will make annual payments of $1,050,000 for a total of $10.5 million to charity over the 10-year term. Assuming the complex and stock portfolio continue to generate income equal to the annual payments to charity, the trust will not owe income tax. Upon the expiration of the 10-year term, George and Mary will receive the apartment complex and securities with an approximate value of $19,005,664 considering the 2% appreciation growth within the trust.
If the trust is drafted with 7% unitrust payments, the tax benefits would change. The charitable gift tax deduction would be $7,696,125, leaving a taxable gift of $7,303,875. The trust will make a payment of $1,050,000 to charity in the first year and approximate payments from the trust may total $11,497,207. Considering the same 2% appreciation growth, George and Mary will receive the complex and securities with an approximate value of $18,284,916.
The couple realizes the major difference between the two payment structures is the differing amounts to charity and to their children. Understanding a gift of $10.5 million to charity is significant, the couple decides to draft the non-grantor trust with annuity payments to better leverage the gift to their children.
Non-grantor lead trusts can be structured as testamentary lead trusts with the same ability to structure the trust with either annuity or unitrust payments. The major difference with testamentary non-grantor lead trusts is that the trust creates an estate tax deduction rather than a gift tax deduction.
Tom and Lisa have approximately $28 million in assets and are looking for a tax-favored way to pass their $4.5 million office building to their nephew, Ron, age 40. He is relatively successful financially, but his aunt and uncle desire to increase his retirement security. The office building is generating about $250,000 in annual income and is expected to continue generating that amount for many years to come due to long-term fixed leases with the tenants. Tom and Lisa are interested in retaining the income generated from the office building during their lives, but would like to use the income stream to benefit their favorite charity once they pass on and eventually give the building to Ron. With this information, they approach their estate planning attorney who recommends a testamentary annuity lead trust with zero estate tax. Excited about the possibilities, they ask the attorney to draft the trust.
The attorney recommends the trust be funded with the $4.5 million office building and $500,000 in public securities to provide liquidity. The attorney recommends drafting a testamentary lead trust making 7% annual annuity payments for a term of 14 years. At their passing, approximately $22.7 million will be transferred to their heirs through their estate plan and the office building and securities will fund the lead trust. The attorney assumed the unified credit based on the $11.7 million current value for 2021. With a charitable estate tax deduction of $4,686,395 and estate costs of 1%, the net taxable estate is reduced to $23,033,605. The tentative tax of $9.1 million is reduced by the unified credit, including portability of unused spousal exclusion to the surviving spouse, and the charitable estate tax deduction created with the testamentary lead trust producing a net estate tax of $0. The trust will make annual payments to charity of $350,000 for a total of $4.9 million over 14 years. The trust will not owe income tax on the payments to charity if the charitable payments exceed the trust's income. Upon the expiration of the 14-year term, the office building and securities will be transferred to Ron. Happy with the zero tax estate results, Tom and Lisa include the trust in their estate plan.
Whether structured as a living lead trust or testamentary lead trust, with annuity or unitrust payments, non-grantor lead trusts are a very tax-favored gift vehicle to benefit family members. As with all lead trusts, an attorney will be necessary to draft the trust. An attorney should first be consulted when considering lead trusts to discuss the income, gift and estate tax implications.
If structured properly, charitable lead trusts can be a great gift vehicle for high-net-worth donors looking to donate real estate. While lead trusts can be drafted to return assets to the grantor or transfer assets to the grantor's family, providing potential income tax, gift tax or estate tax savings, it is important to choose the type of lead trust that fits the funding asset. For donors with significant real estate holdings, the non-grantor lead trust will nearly always be the most appropriate lead trust vehicle. As a last reminder, when funding a lead trust with real estate it may be more tax beneficial if the trust is funded with property that is producing income and is not intended to be sold by the trust. The flexibility in drafting lead trusts allows the donor and their attorney to find a structure that best fits their needs.