Case of the Week

Case:

Karl Hendricks was a man with the golden touch. Throughout his life, it seemed every investment idea that 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 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.

After Karl learned about the benefits of a FLIP CRUT, he eagerly wanted to move forward. It looked like the perfect solution. (See Part 1 for this discussion.) However, there was still one question in Karl's mind.

Question:

Karl took depreciation on the building for several months. Although the amount of depreciation was not significant, Karl wondered, "What are the tax consequences when transferring depreciated property into a FLIP CRUT?"

Solution:

It is not uncommon for a donor to own real estate that he or she has depreciated, such as rental or commercial property. As a result, there may be some depreciation-related capital gain issues or depreciation recapture issues.

If a donor has taken accelerated depreciation, the depreciation recapture rules require a donor to realize ordinary income upon sale of the depreciated property in an amount equal to the excess of accelerated depreciation over straight-line depreciation. See Sec. 1250. So, if Karl elected to sell the property himself, some of the gain would be recaptured as ordinary income.

For gift planning purposes, any gift of the accelerated depreciation property will be subject to the income tax reduction rules. See Sec. 170(e). Basically, the initial fair market value charitable deduction will be reduced by the ordinary income recapture component. In this case, Karl did not take any accelerated depreciation, so the depreciation recapture rules will not affect his FLIP CRUT charitable deduction.

Although Karl did not depreciate his property on an accelerated schedule, he did depreciate the building on a straight-line basis. As a general rule, if a donor has long-term capital gain attributable to straight-line depreciation, it is subject to a higher capital gain tax rate of 25% instead of 15% or 20%. This 25% tax rate is not as beneficial as the lower tax rate. However, it is better than the higher ordinary income tax rates. Also, unlike accelerated depreciation, the transfer of property subject to straight-line depreciation does not reduce a donor's charitable deduction if the depreciation-type gain is long term.

With respect to charitable gifts, a gift of depreciated property to a FLIP CRUT will not trigger any income tax to Karl. Instead, the trustee will take Karl's cost basis and properly account for the tax characteristics of the property when sold using the four tier accounting rules. As a result, Karl may receive some depreciation-type gain as unitrust payouts in the future (depending on the trust investments and performance).

In this case, Karl's depreciation gain attributed to straight-line depreciation is short term because he held the property for less than twelve months. Unfortunately, Karl will not enjoy the benefits of the 25% tax rate but instead will realize short-term capital gain income at his ordinary income tax rate. Moreover, Karl's charitable deduction is subject to the reduction rules under Section 170(e). This is due to the short-term capital gain nature of the property. (See Part 2 for a discussion of the reduction rules.)

In the end, the depreciation issue is not a significant factor in the outcome and benefits of Karl's FLIP CRUT. Proudly, Karl moves forward to a successful financial and charitable conclusion. He funds the FLIP CRUT and enjoys capital gains savings, a lifetime income stream and an $825,000 income tax deduction.