Feature

by Erik Dryburgh

The need for nonprofit organizations to secure space in the San Francisco Bay Area has never been greater. With last year’s explosion in the commercial sector, many nonprofit organizations were driven out of the city. A nonprofit currently renting space may wish to propose to the owner of their building that a charitable gift in the form of building space may meet the owner’s estate planning and tax objectives.

The following example illustrates several methods and benefits for establishing a charitable gift. A landlord owns a building, now worth $1,000,000, with a tax basis of only $100,000 (due to the appreciation in value and years of depreciation deductions). The building is rented to a nonprofit organization that finds it suitable for current and anticipated future needs. The owner is planning to retire from the property management business by selling the building and reinvesting in a portfolio of stocks and bonds in order to secure his or her retirement income.

According to this scenario, the nonprofit approaches the property owner with several ideas that meet the goals of both the owner and the nonprofit.The most straightforward idea is a bargain sale (part gift and part sale) in which the owner sells the building to the nonprofit for less than its fair market value. The reduced price benefits the owner by providing an income tax deduction for the value of the portion of the building donated to the nonprofit. In this example, if the owner sells the building to the nonprofit for $600,000, then there is a $400,000 deduction that can be used to offset other sources of income. The owner also has taxable gain on the sale side of the transaction, essentially equal to sales proceeds ($600,000) minus a pro-rata share of the tax basis ($40,000) or $560,000. The nonprofit also could offer a limited down payment, with the balance of the purchase price paid through an installment note. The nonprofit does not have to come up with the entire $600,000 at the time of sale, and the owner secures a steady stream of income and a tax deferral.

A slightly more complicated yet effective tool is the charitable remainder trust (CRT). In this case, the owner contributes the building to the CRT (designed and drafted by either the owner’s or the nonprofit’s legal counsel). The CRT pays the owner (and perhaps the spouse) income for life under one of several permissible formulas (such as lifetime payments to the owner based on 6% of the value of the trust, re-valued on the first day of each year). At the termination of the trust, the assets held by the trust are distributed to the nonprofit.

The owner obtains a current income tax deduction for the present value of the trust’s remainder interest donated to the nonprofit. For example, if the landlord is age 70 and the CRT provides for a payment equal to 6% of the trust’s annual value, the deduction is in the range of $485,000. Further, the CRT is tax-exempt (much like the nonprofit). Thus, the owner avoids the capital gains tax that otherwise is due if the building is sold outright by the owner (CRTs are typically suggested for individuals who are otherwise interested in selling an asset). Again, in this example, if the owner sells the building personally, his capital gains tax (federal and California) is in the range of $240,000 with after-tax proceeds of approximately $760,000 for retirement investments. On the other hand, the CRT can sell the property without incurring capital gains tax, leaving the trust with the full $1,000,000 to reinvest for the purpose of generating the owner’s income stream. Often the tax savings from the deduction, plus the additional income earned courtesy of the capital gains tax avoidance (not to mention the satisfaction of making a charitable gift supporting the nonprofit), will help make up for the fact that the owner cannot pass on the building’s value to heirs at the time of death.

This simple example illustrates how a CRT supports the achievement of the owner’s goals while, at the same time, enables the nonprofit to secure a substantial future gift upon termination of the CRT. How does this help the nonprofit secure the building? The nonprofit proposes not only that it serves as charitable remainderman of the trust, but also that it has the opportunity to purchase the building from the trust when the trustee decides to sell (which is typically immediately after the building is contributed). If the nonprofit is successful in purchasing the building from the trust, it obtains the funds to purchase the building back when the owner passes away and the trust terminates.

To carry the above example a step further, assume the nonprofit buys the building from the trust at its $1,000,000 value. From the owne's perspective there are numerous benefits. First, there is an income tax deduction of $485,000. Second, the sale of the building by the trust does not trigger capital gains tax. Third, the owner is no longer responsible for managing the building. Fourth, the owner is guaranteed a steady retirement income of $60,000 during the first year; with increases in subsequent years assuming the CRT earns more than 6% on its investments (the excess earnings over the owner’s annual payments are added to principal, increasing the trust value on which the following year’s 6% payment is calculated). In fact, if the trust earns 9%, the owner may expect to receive over $1,209,000 in income payments during the remainder of his life.

From the perspective of the nonprofit, it acquires ownership of the building (for which it paid $1,000,000). Second, it receives all of the trust assets for an estimated 16 years (the owner’s actuarial life expectancy). If the trust earns 9%, the trust assets are projected to grow to over $1,605,000.

The above example assumes that the nonprofit buys the building for cash. Another option is that the nonprofit purchases the building with a promissory note. In this case, the CRT holds the note, the nonprofit pays the annual interest and principal amount, and the CRT in turn uses these funds to pay the owner his 6% income interest. While this approach is of great benefit to the nonprofit in that it does not have to spend the full $1,000,000 up front, it may not be as advantageous to the owner. The value of the note is unlikely to grow over time and the owner’s payments most likely remain fixed at $60,000 per year (not as attractive as an income stream that grows over time).

Another alternative is for the CRT to continue to hold the building and collect rent from the nonprofit, using rental payments to fund the owner’s 6% income interest. This approach requires no additional funds from the nonprofit, secures a large future gift for the nonprofit, and provides the owner with a substantial income tax deduction. However,this approachleaves the owner in much the same situation as before, managing the building. Further, there are technical tax difficulties with owning real estate inside a CRT. For these reasons, real estate contributed to a CRT is often sold promptly.

Gifts of real estate in general and CRTs in particular are complicated, necessitating the help of competent counsel (for both the donor and the nonprofit). Nonetheless, a creative use of a charitable gift may accomplish the goals of both parties.

Originally published in the Spring 2001 issue of Artistic License, a publication of California Lawyers for the Arts. The opinions expressed in this article are those of the author and do not necessarily reflect the viewpoint of the SFAA or the SF Apartment Magazine. The information contained in this article is general in nature. Consult the advice of an attorney for any specific problem. Erik Dryburgh is a principal at Silk, Adler & Colvin, a law firm specializing in legal issues for charities and non-profit organizations. He practices exclusively in the areas of charitable giving and nonprofit organizations. © Copyright 2001.