CGNA: Chapter 1 - Real Estate | Intermediate

CGNA: Chapter 1 - Real Estate | Intermediate

Article posted in Assets, General on 29 August 2017| comments
audience: National Publication, Bryan K. Clontz, CFP®, CLU, ChFC, CAP, AEP | last updated: 30 August 2017
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Summary

A continued exploration of gifts of real estate: fundamental solutions and major issues are explored.

This article is an excerpt from Charitable Gifts of Noncash Assets, a comprehensive guide to illiquid giving by Bryan Clontz, ed. Ryan Raffin. Published by the American College of Financial Services for the Chartered Advisor in Philanthropy Program (CAP), with generous funding from Leon L. Levy. For a free digital copy, click here, and to order a bound copy from Amazon, click here.

By Ryan Raffin

Below is a review on gifts of real estate. Real estate topics are based on the following paper I co-authored with Dennis Bidwell, “Converting Real Estate Wealth to Gifts – Opportunities and Challenges.”

For quick take-aways on gifts of real estate, see Real Estate Quick Take-Aways. For a review based on that article, see Real Estate Intermediate. For an in-depth examination adapted and excerpted

from the article, see Real Estate Advanced. For further details, see Real Estate Additional Resources or cross reference to the asset’s ownership entity (e.g., LLC, Limited Partnerships, etc).

This review of charitable gifts of real estate has five parts, and begins with a discussion of real estate tax treatment. It then examines risk scenarios and assessment. Next, it turns to a number of different challenges and solutions, followed by a brief summary of direct and indirect gifts of real estate. Finally, the review concludes with an overview of current, deferred, and life income gift structures.

Despite being a common type of asset (probably more so than any other in this book), real estate is underdonated. Thirty percent of the country’s private wealth is in real estate, yet it represents less than 3 percent of all charitable gifts. This considerable disparity makes sense. Real estate is complex, illiquid, time-consuming, and difficult both to manage and transfer. At the same time, it can be extremely valuable for charities who accept the property, and very satisfying for donors. The primary challenge is simply that charities are not asking donors to consider real estate gifts, and donors are therefore unaware real estate can be a possible donation.

Real estate gifts can backfire—environmental problems, expensive improvements, low curb appeal, and high management costs are just some of the issues that can arise. However, with proper screening and inspection, these risks can be managed or even eliminated. Indeed, many nonprofits do just that, with a real estate survey of nonprofit organizations showing that 13 percent of respondents receive over 10 percent of their total gifts in real estate form. The most efficient charitable gifts tend to come from low cost basis, high capital appreciation assets—so real estate is perfectly suited to effective planned giving.

Review Part 1: Real Estate Tax Treatment

The obvious solution for charities is for donors to sell the property and donate the proceeds. For donors, this would likely result in long-term capital gain treatment, meaning a maximum 20 percent federal tax rate (25 percent for unrecaptured Section 1250 gain) plus 3.8 percent net investment income tax, plus any applicable state taxes. This is likely not an appealing result for donors, since they have to pay taxes on money they are planning to give away.

Donating the real estate will generally lead to a better tax outcome. Gifts of long-term (meaning held over a year), unencumbered real estate to qualified public charities allow a deduction of the greater of fair market value or adjusted cost basis, up to 30 percent of adjusted gross income (AGI). The IRS allows taxpayers a five year carry-forward for any unused deduction amounts. The same gift to a private foundation gets the lesser of fair market value or adjusted cost basis, up to 20 percent of AGI— much less appealing, except in testamentary transfers where the property receives a stepped-up basis. Any transferred debt on the property results in adverse tax consequences under IRS bargain sale rules.

Any income the donated real estate generates can create a tax headache for the charity receiving it. This unrelated business taxable income (UBTI) leads in turn to unrelated business income tax (UBIT). For example, UBTI will arise from a donated property that generates income, such as a golf course. UBTI can also result from debt-financed income (see the IRS’s discussion on IRC Section 514). Two exceptions to UBTI exist. The first is the so-called “old and cold” property, where debt is placed on the property over five years before the donation and the donor has owned the property for more than five years. The second is where the charity is bequeathed encumbered real estate.

Clearly, existing real estate debt is a big tax hurdle for nonprofits. The best strategies for addressing encumbered real property involve the help of the donor in either paying off or reassigning the security interest. The possibility of UBTI is certainly one of the thornier issues that charities face when investigating prospective gifts of real estate.

Review Part 2: Risk Scenarios and Assessment

Charitable organizations may be becoming more receptive to donations of real estate. This section lists different gifts involving real estate and the accompanying difficulty and level of risk to the accepting charity. It is intended only to be a general guide—the main take-away should be that charities need formal acceptance policies based on existing risk tolerance.

Easiest:

  • Outright gift of local residential property, free of debt and with buyers readily identifiable

Easy:

  • Outright gift of local commercial or agricultural property
  • FLIP-CRUT gift of residential property

Medium:

  • Gifts of partial interests
  • Installment sales
  • Real estate gifted to multiple charities
  • Nonlocal property
  • Real estate under contract for sale
  • Real estate without an easily identifiable buyer

Hard:

  • Multiple interests in the real estate
  • Real estate located in a different country
  • Multiple tenants in the property
  • Real estate that would trigger UBTI (as discussed above)

Stay away:

  • Real estate with existing environmental or legal issues
  • Donation involving more than three layers of entities (i.e., real estate held by an LLC, owned in turn by a partnership)

Review Part 3: Challenges and Solutions

The section above illustrates the various possible gift structures, and the accompanying differences in level of complexity. Given that proposed gifts are often more than just a simple plot of land or a house, what are some commonly perceived challenges to accepting these gifts? Just as importantly, what are some possible solutions for those issues? This section breaks down perceived problems and suggests ways to effectively address them.

  1. Real estate gifts are too time-consuming. An effective up-front screening procedure is necessary to avoid considerable time investment without a completed gift. A quick information-gathering form or conversation can save time and effort by screening out high-risk gifts at the outset.
  2. Tax and legal complexity. Identifying these issues is half the battle—investigate the property in more depth. A gift officer talking through the various possible problems with the donor is probably the best way to complete the due diligence. Based on the results, it may be necessary to engage outside counsel.
  3. Environmental concerns. A notorious, but overblown, concern with donated real estate is environmental hazards or liabilities. The simple solution is to have a qualified professional perform an environmental assessment. Although this may cost the organization anywhere from $1,000 to $2,000, it is a necessary precaution. Also consider environmental liability insurance, if the policy is appropriate for nonprofits.
  4. Management and holding period concerns. This is a “once bitten, twice shy” scenario for donee charities. Assessing potential gift acceptance problems is not enough—charities must consider the maintenance, management, and other holding costs. These post-closing issues need evaluation before gift acceptance, and the donee should develop a plan to address them. The charity, as the new owner, should expect to receive calls for maintenance issues from the tenants unless it hires a property manager.
  5. Market and liquidity concerns. Similar to maintenance and management, market and liquidity issues appear for charities who already own the real estate, but can be avoided by thorough planning before closing. If a buyer is easily found, then there is no issue. Similarly, a real estate broker can assess the marketability and value of the property, so the nonprofit is not left holding an unsellable property. The donee organization must complete IRS Form 8282 if the property is sold or disposed of within three years of acquisition.
  6. Internal acceptance processes. If the nonprofit has never considered accepting real estate gifts, it likely will have no framework for deciding whether or not to accept. Conversely, if it has a real estate acceptance program or policy, it is much more likely to successfully accept and liquidate donated real estate. Plans and people in place to assess the proposal and implement next steps are essential. Many, if not most, real estate opportunities require a timely response.
  7. Benefit-cost analysis. All gifts come with a cost, and real estate—even the simplest transaction—is no exception. A minimum gift value helps establish a baseline on whether the proposed gift is worth the nonprofit’s effort. It should develop a formula for estimating the cost and time versus the value of the gift. A simple multiplier may work, or a calculation of net present value. Many minimums are in the $50,000 to $250,000 range.
  8. Getting to closing on a complicated real estate gift. Once the donee organization evaluates a gift, and takes necessary precautions, what is left to do? If it wants to accept the gift, the parties should put everything in writing. The timeline, expectations, and responsibilities of everyone involved should be clearly stated in an acceptance letter or memorandum of understanding which all parties read and accept. Not only will this put everyone on the same page, but it can be used as a roadmap for completing the gift.
  9. No one offers gifts of real estate. The best real estate gift policies and procedures are useless if a nonprofit gets no donation inquiries. To optimize the program, charities should emphasize their ability to receive real estate in communications to constituents and potential donors. Further, when researching donors, the organization should make special note of real estate holdings that show potential. Correspondingly, potential donors and their agents should make note of charities that advertise their acceptance of real estate gifts (including completed gifts with third-party charities).

Review Part 4: Direct and Indirect Gifts of Real Estate

There are various options for accepting other than a binary yes or no—transfer of ownership is not the only way to complete the gift. A small but not insignificant proportion of nonprofits utilize a supporting organization to receive the property. They can also employ more complex, risk-reducing legal strategies, such as creating a put option, utilizing an agent, or working through an LLC. Finally, the nonprofit can outsource the gift to another public charity which will liquidate the real estate within a donor-advised fund.

Sometimes use of different legal strategies or external organizations can be a more effective manner of completing a real estate gift. This is important when considering the goal of maximizing net contributions and minimizing risks and costs. Most importantly, this allows a charity to capture a gift (indirectly or by risk mitigated means), that it would otherwise decline in its traditional gift acceptance process.

Review Part 5: Current Gifts, Deferred Gifts, and Life Income

A current gift in this context means that the nonprofit donee will receive the donated land in the present, even if the gift is structured as a charitable lead trust. Lead trusts are often utilized as a way for those with very large estates to transfer their real estate assets to younger family members. However, donee nonprofits may not want property that does not generate any revenue.

Deferred gifts flip the script. These typically involve gifting real estate after the donor’s death, and are commonly structured either as a bequest, transfer on death deed, or gift of a remainder interest in a personal residence or farm. In these cases, the donor retains lifetime use, and after transfer, the charity is free to use or sell the land as it sees fit.

Life income plans combine elements of current and deferred gifts. Often taking the form of either a charitable remainder trust or gift annuity, these involved the donor transferring the real estate to a nonprofit in exchange for a stream of income. Charitable gift annuities are contracts, while charitable remainder trusts are, as the name indicates, trusts (with either a percentage-based unitrust payment model, or an annuity payment model). In either variation, the charity will usually sell the land to meet its payment obligations, and the donor will receive an income tax deduction for the gift portion of the land (since the IRS treats the portion which is exchanged for the income stream as a “sale”).

Conclusion

Real estate is certainly the most commonly-owned asset class discussed in this book, and yet is also relatively infrequently donated. Despite being a highly lucrative asset for nonprofits, many shy away from it due to perceived risks and complexity. Although there are certainly challenges (including aspects like UBTI, environmental problems, holding period and property management concerns, etc.), none of these are necessarily preclusive. Proper policies, assessment, and planning can avoid many of these issues from the outset. If those steps are taken, then real estate becomes a much less daunting type of gift for charities to accept.

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