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Home , Gift (law)

~ p NationalConference on Planned Giving. October 22-25 2003

CiNC{N'~Ti' U'S'A

THE REAL GIFT:

FRIEND OR FOE

Friday, October 24, 2003 2:00 p.m.-3:15 p.m. & 4:00 p.m.-5:15 p.m.

Allen F. Thomas, JD, CRE Vice President of Planned Giving and The Devereux Foundation Villanova, PA 19085

669 I0 Introduction and Objectives

In our session this afternoon, we will explore both the opportunities and the pitfalls in accepting real estate gifts. Although this is not intended to be a primer on real estate , we will review some of the underlying legal issues as they impact the value and marketability of real estate.

Recently, real estate assets have out-performed other asset classes. For instance, in December 2002 the national median sales price for an existing single family home was $164,000, a 7.1% increase from December 2001. This was the strongest annual increase in existing single family median sale price since 1980. This return outpaced both stocks and bonds in 2002. Thus, real estate represents a type of asset that we, as charities, should find desirable to accept as current gifts and as assets in support of charitable planned gifts. We will review some new and creative ways to accept such gifts in order to minimize the risks associated with real estate.

Unlike other assets that are considered fungible, real estate is in every instance unique. Each real estate asset in the world is unique and distinctive from any other real estate asset. Every real estate asset has a set of characteristics- legal, physical, functional and economic that distinguishes it from any other real estate asset. Some of the characteristics are good and some are negative.

Our first objective today is to appreciate the various important characteristics of real estate in order to identify the positive and the negative attributes of a particular real estate donation. We want you, as a development or planned giving officer, to be able to analyze a proposed real estate gift and determine what the benefits and the risks are with that donation.

Our next objective is to help you understand techniques that are appropriate for funding planned gifts with real estate. Certain real estate, due to its characteristics, is not suitable to fund a particular planned gift.

Lastly, we want to help you adopt strategies that will increase your charity's legacies through the acceptance of real estate. Our overall goal is to make you more informed about and comfortable with real estate donations as an augmentation of your planned giving program.

II. Overarching concerns/limitations on the value of real estate

The legal, physical, functional and economic characteristics of a particular provide both the value to a real estate asset as well as limitations on that value. As you deliberate about accepting a real estate gift, you should review these characteristics to ascertain the benefits to be derived and the constraints that will impose limitations on its utility. You conduct this review in an investigative and analytical period generally referred to as "due diligence." I would suggest that the principle areas that affect value to a not for organization are the following:

670 mo Legal and restrictions

BO Type of real estate offered

CO Economic constraints and due diligence

III. Legal ownership of and restrictions on real estate

AD The form of ownership is critical to understand whether a donation will yield value to your charity.

The form of ownership can detract substantially to the value of a real estate gift. Two illustrations will reflect this. If a sole individual owns his or her residence and wishes to donate it to your charity, you can easily obtain an appraised value of that residence. There is ordinarily a market and current transfers to help identify value for the house. On the other hand, much like a privately held business, it may be very difficult to appraise the value of a limited partnership interest in a property. The limited partnership interest may be more constrained by the partnership agreement than the underlying value of the real estate asset. Who would be a ready and willing buyer of that limited partnership interest. An appraiser would be challenged to arrive at a firm opinion of value. So, I would suggest that the form of ownership is as important to scrutinize as the physical asset itself. The IRS has indicated that an appraiser should lower the appraised value of fractional interests in real estate that may be difficult to sell. Real estate ownership comes in many forms. Among them are the following:

BII Who holds to the real estate? 1. One individual 2. Two or more individuals 3. Corporation- The shareholders of the corporation do not have personal liability for the activity of the corporation. Generally, income is taxed to the corporation and then any dividends to the shareholders are taxed to the shareholder, i.e., double taxation. If shares in a corporation holding real estate are donated to a charity, what fights are granted to a shareholder under the corporate documents? How marketable are the shares? Is the corporation publicly traded or privately owned? Is the corporation a C corporation or an S corporation? Shares in an S corporation donated to a charity cause the S corporation to convert to a C corporation which would be detrimental to the other S corporation shareholders.

0 Limited Liability Company- Similar in some ways to a corporation, the LLC has members rather than shareholders. The members do not have personal liability for the activity of the LLC. Income of the LLC is passed on and taxed only to the members. What fights do a member have and how saleable is the LLC interest?

671 0 Partnership a. General- All partners have liability for the activity conducted by the partnership. Income of the partnership is passed on and taxed only to the partners. This is an uncommon ownership entity today with the other options available. Accepting the donation of a general partnership interest would not generally be appropriate given the open-ended liabilities. b. Limited- The limited partners have no personal liability for the c. activity of the partnership. Income of the partnership is passed on and taxed only to the partners. What fights do a limited partner have and how saleable is the partnership interest?

Co The

The Bundle of Rights theory holds that the ownership of may be compared to a bundle of sticks wherein each stick represents a distinct and separate fight or privilege of ownership. These typically include , enjoyment, control and disposition.

• title- This reflects that the owner possesses the fights and privileges of ownership, although the property may still be subject to encumbrances which we will discuss later.

0 Tenants in common- Tenants in common have an undivided ownership interest in a property, i.e., a percentage interest in the whole. The percentage interest of the tenants in common may be different between them or they may be the same. If gifted to a charity, it may be difficult for the charity to sell the fractional interest.

Example 1" An example of a tenants in common gift to Devereux was an undivided 25 % interest in a commercial shopping center located in suburban Los Angeles. This was a well located property; however, it had significant deferred maintenance and was anchored by an old ice skating rink. There were three charities and one individual real-estate developer who owned the shopping center as equal tenants in common. There were no governing organizational documents. Procedures and decision making processes were subject to negotiation between the parties. There were no written management guidelines for ownership of the property. After two years of intensive discussions, the charities were successful in selling their respective interests to the real estate developer at an attractive price.

Q Joint tenants with fight of survivorship- Joint tenants with fight of survivorship must own shares equal to one another. Upon the death of a joint tenant with fight of survivorship, his or her ownership interest transfers automatically in equal shares to the remaining joint tenants.

672 0 Tenants by the entirety- Tenants by the entirety operate the same as joint tenants with fight of survivorship but are limited to ownership between husbands and wives only. This is commonly used in residential home ownership.

0 - Generally, statutes in a limited number of states (AZ, CA, ID, LA, NV, NM, TX and WA) provide that assets acquired and owned by spouses are owned equally.

0 Leasehold interest- A lease is a contractual transfer of the use and enjoyment of part or all of a property. This is done for a term of years that may be in short or long duration.

0 - are portions of a structure that have been legally defined in a three dimensional description. This is commonly found as condominium units in a building. The owner has exclusive possession, control and use of the condominium unit and undivided use of the common elements.

0 Cooperative- This is a fractional, undivided stock ownership in a property combined with a contractual use of a defined space. Thus, the coop owner has a percentage, undivided interest in the total building represented through shares. This coop owner also has a guaranteed tenancy in a particular unit in that building.

0 Partial interest rule (IRC § 170(f)(3)(A))

• A tax deduction for the donation of a partial interest in real estate is allowed, generally, only when the partial interest given represents the donor's entire interest in the property.

0 Differentiate subdivided and fractional interests in real estate, which do not constitute partial interests. a. 100% of subdivided portion- A larger parcel of land that has been subdivided into separate smaller lots. A subdivided lot may be donated to a charity and the donor is entitled to a full tax deduction. b. A fractional, undivided interest- This is the case where the donor grants an undivided interest in the whole property to a charity, i.e., a percentage interest in the entire property. Likewise, the donor is entitled to a full tax deduction for the value of the fractional, undivided interest donated.

673 E. Encumbrances and restrictions

0 Mortgages- A mortgage or of trust is a security interest in a property that the property owner grants in favor of another to bind performance under a . If the property owner defaults under his or her contract, the mortgage holder can foreclose on the property and claim ownership or force a sale of the property.

A charity needs to be extremely concerned about accepting a donation of real property that is subject to a mortgage. A gift of a mortgaged property to a charity will cause the bargain sale rules to apply.

0 - An is a grant by a property owner of a specific use in his or her property to another. This is commonly found where a property owner grants to another the fight to cross over his or her property. It also could be a negative easement whereby the property owner refrains from using his or her property. An easement can be in perpetuity or for a term of years.

Example 2: Devereux received a farm of 460 acres, which had been owned by a well-known family trust. In addition to the farm, there was a significant business including a large herd of prize, nationally recognized Angus bulls. Personnel associated with the farm were a manager and a butcher shop with 4 full-time employees. The annual overhead for the herd, manager and butcher shop was $250,000. The family trust initially desired to donate the farm subject to a perpetual agricultural easement, i.e., that the farm would remain in open space and never be developed. No charity would accept these conditions. Devereux finally agreed to a 25- year non-development, agricultural easement that expired in 1998. We closed the butcher shop after 2 years and gradually sold off the herd over 20 years. The farm is now amidst choice residential homes and is under contract for several million dollars.

0 Leases- A lease is a fight of use in a property granted to another for a term of years. Leases may provide positive benefits to a property such as a commercial building rented at current market rates or it may detract from the value if the rent is significantly below market. A charity must be very careful to examine the nature and content of any lease on a property to be donated. For instance, does the lease grant the tenant a fight to purchase the property at a predetermined price or a first fight of refusal to purchase if another offer is received?

0 - This is a contractual agreement similar to a lease whereby one or more individuals are granted a fight to use a property for his life or their lives. A donation of a personal residence or a farm subject to a retained life estate will be discussed later.

674 0 Zoning restrictions- In most jurisdictions ( although not all), real property is subject to zoning which restrict how a property may be used. An analysis of the zoning restrictions impacting a donated property should be performed on any gift of real estate.

0 Deed restrictions- These are privately imposed restrictions that constrain real estate. Any property may have deed limitations that run in perpetuity or for a specified time which limit the use of a property. Courts of law will uphold these so long as they do not violate public policy. A title search will reveal all deed restrictions.

0 Property - A property reversion is a provision in a deed, which causes the property to revert or return to the previous owner when a specified condition is no longer maintained or a future event occurs. The existence of a reversion may likely limit the marketability of a property.

Example 3" Devereux owns an administrative/educational facility that was given to us subject to a provision that Devereux must continue to use the property for administrative or educational uses. If we discontinue our charitable use of the property as stipulated in the deed, title reverts to the donor. We are prohibited from selling or leasing the property. This represents a significant limitation on the ownership of the property. However, we carefully examined the impact of this reversionary clause and determined that it is an acceptable condition for us.

0 Oil and mineral fights- These are royalty fights or legal interests in the extraction of oil or minerals from the ground.

FQ The condition of legal title and who holds title will affect the value of any real estate donation.

GO The ability to sell, or alienation of title, determines whether the real estate has recognizable value to the charity.

IV. Types of real estate that your charity may accept should be clearly delineated in a gift acceptance policy or guideline.

AD Real estate varies from simple to very complex. In ascending order from simplest to most complex are the following property types:

0 Vacant, unimproved land- This is land that is in its natural state with no improvements constructed on it and no agricultural purposes being made on it. This requires little management and relatively few concerns.

675 0 Farmland- Similar to vacant, unimproved land, farmland is differentiated by a lease or to a farmer granting the farmer the use of the property. Certain oversight is required to ensure that the farmer is caring for the property appropriately. Income and expenses from the lease or license must be accounted for.

Q Timberland- Under a timber agreement, the property owner grants a timber company the fight to cut and remove trees from the land. The landowner may be paid by the acre or by the amount of timber harvested. These arrangements require additional management attention to monitor the permitted activity.

Q Detached single-family residence- The typical single-family home situated on its own dedicated lot is a common gift. These are usually simple to accept as donations or in exchange for a charitable gift annuity. Absent unusual problems, the detached single-family residence can be managed easily and sold for predictable value. You should prepare a projected estimate of carrying costs and settlement expenses prior to accepting this donation.

0 Residential condominium or attached townhouse- Both of these property types are similar to the detached single-family residence except for underlying legal fights and obligations of adjoining property owners. There are commonly homeowner association documents that prescribe the expectations of the parties. Often there is an association fee for the maintenance and care of the common elements. A charity should carefully analyze the cost of any association fees in addition to the costs described in the preceding paragraph.

0 Timeshare or vacation interval property- Often a charity is presented with the donation of a timeshare or vacation interval. Although this may seem a simple transaction, a charity should decide whether this property will be worth the on-going cost and management attention. How will the charity use the timeshare? If it is in a choice location, it could be routinely auctioned off at a fund-raising event. There is very little resale value to timeshares.

0 Income producing properties- Income producing properties are likely the most valuable to receive as donations and also require the greatest due diligence, management expertise and organizational patience. Successful acceptance and utilization of income producing properties depends upon real estate expertise at the board or management level, preferably both. a. Ground lease- A ground lease is a lease of vacant property, generally for a long-term, upon which the tenant constructs building improvements. The term customarily ranges from 30-99 years. The tenant is obligated to pay all real estate taxes and other

676 carrying costs. These lease arrangements are maintenance free for the ground owner and offer attractive returns for a long period of time. The credit worthiness of the tenant is important for the success of the landlord's interest. bo Triple-net single tenant property- This is a lease for land and building improvements that are leased to a single tenant. The legal obligations for the maintenance and care of the property are routinely negotiated between the landlord and tenant. Such an arrangement is fairly management intensive and may require the engagement of professional property management services. C. Multi-tenant commercial properties- Except for real estate operated as a business described below, multi-tenant commercial properties are the most intensive of real estate assets. The landlord has complete responsibility for the maintenance, care and leasing of the property. A charity will need professional resources to assist in the ownership of multi-tenanted buildings. The rewards of owning such properties are significant; however, there are clear risks of market downturns, vacancy and releasing costs. Among the properties in this category are the following: i. Office ii. Retail/shopping center iii. Industrial iv. Apartments v. Storage do Real estate that is a business- These types of real properties may be regarded more as businesses than real estate. They provide a component of personal service that elevates the activity above real property rental. Not only do they require specialized business expertise, but the income from such activities constitutes unrelated business taxable income (UBTI). If a trust has any unrelated business taxable income, all income received by the trust in that year will be taxed. This would include any capital gains on the sale of real estate owned by the trust in that year, which otherwise would be exempt from taxation. i. Hotels/motels ii. Restaurant iii. Marina iv. Recreational or mobile home park

BO Your gift acceptance guidelines should differentiate between real estate that may have operational value to the charity, i.e., is it related to the charity's mission, and that which is unrelated to your charity?

Co If the real estate is unrelated to the charity's mission, how will you manage the property?

677 The management of real estate can be very intensive and time consuming. Aside from the potential liabilities associated with a property, property management constitutes the second greatest concern about a real estate donation. Before accepting a real estate gift, the charity should have a clear plan for how the property will be managed and cared for while it is owned by the charity. If it is a simple asset such as

DO What is the strategic objective with the real estate, hold or sell?

EO How management intensive is the real estate?

FO Do you have the internal capability to oversee the real estate?

0 Do you have fiduciary board expertise in real estate?

HO Can the donor assist with management after the donation? If attempted, has the donor reserved a partial interest in the property?

VO Economic Constraints and due diligence

AO What are the possible liabilities and are they acceptable?

1. Mortgage(s) a. Bargain sale rule- Any capital gain on the mortgaged property is payable by the donor in proportion to the percentage that the mortgage amount bears to the appraised value of the property.

Illustration: Mrs. Jones donates a property with a fair market value of $500,000. There is a $150,000 mortgage on the property at the time of donation that the charity assumes responsibility for. Mrs. Jones' basis in the property is $200,000. The reportable capital gain owing by Mrs. Jones is as follows:

The capital gain would have been $500,000 minus $200,000 or $300,000.

The percentage that the mortgage bears to the fair market value is $150,000 divided by $500,000 or 30%.

Mrs. Jones reportable capital gain is 30% of $300,000 or $90,000.

bo Will the property income support sufficient payments to cover debt service on the mortgage(s)? C. Are there any past due mortgage liabilities at the time of donation, which must be paid to avoid foreclosure?

678 0 Real estate taxes, and water or sewer to be paid.

0 Insurance policy premiums, both fire and extended as well as general liability

0 Contractual payments to be made to others, i.e., real estate broker or property manager.

0 Lease obligations to tenants under existing leases.

0 Property owners' association dues.

7Q Deferred maintenance that must be performed for safety or legal reasons.

BO Are you satisfied that there are no environmental or hazardous conditions on the property?

0 Have you had a Phase I environmental study performed? A Phase I environmental study is an accepted historical review of the uses that have been associated with a property. This is based upon local records and aerial photography that is documented over a long period of time. Such a review will explore uses of adjacent and nearby properties. This study also includes a physical inspection of the property for any of contamination. A typical price of a Phase I study would be $1,500- $2,500.

0 You may need additional studies. A Phase II environmental study would focus on soil samples or other materials to be analyzed by a laboratory. These tests can be expensive.

0 Who will pay for the environmental studies, your charity or the donor?

Co What are the market conditions for the ownership or sale of the property? What investigations have you undertaken to determine market conditions?

0 Will the property produce positive cash flow or net sales proceeds for your charity and how long will that require?

VI. Is the real estate donation intended to fund a deferred (or lead trust) gift and, if so, is that appropriate?

AO Charitable gift annuity- Real estate donations can fund charitable gift annuities (except in New York) and offer opportunities for a donor to utilize an illiquid

679 asset to fund an annuity that will provide income for the rest of his or her life. Perhaps an older couple would like to convert a second home into an income- producing annuity. The charity must be very careful to perform due diligence and be certain of the property's value. Unlike an outfight gift of real estate, the charitable gift annuity is a contract that obligates the charity. I would strongly recommend that you defer payments on the annuity for a year or more to allow time for the sale of the real estate. Be sure to calculate the charitable gift annuity on the net value you expect to receive after deducting carrying costs such as real estate taxes and insurance. Also be sure to deduct a brokerage commission of approximately six percent (6%) for the sale of the property. Your charity should be conservative on the value. You also may negotiate an annuity rate that is slightly lower than the ACGA table to create a cushion on the transaction for unanticipated costs. Lastly, there may be state statutory requirements for the establishment of a reserve at the time the charitable gift annuity is written. If the charity or donor is in a state jurisdiction that requires such a reserve, you should anticipate that the funds for the reserve will need to come initially from the charity's unrestricted endowment until cash flow from the real property sale is received. Often the donor will agree to pay for costs associated with the property until it is sold. 1. Example 4: Devereux accepted a residential condominium that funded a current charitable gift annuity. The property was vacant and did not generate any income. By agreement, the fixed expenses and condominium fees were paid by the donor until the property was sold. The condominium was marketed for a year before it sold. Although we negotiated a lower than ACGA rate on the annuity and properly estimated net proceeds, in hind sight we should have done a deferred charitable gift annuity to allow for the time to sell the property. 2. New York State statute prohibits funding of a charitable gift annuity with real estate.

B. Charitable Unitrust

0 Charitable remainder unitrusts are an excellent vehicle to donate real estate subject to the issues noted below. If there is any concern about the charity taking title to the real estate due to environmental concerns or other possible liabilities, placing the property in a unitrust solves those concerns because the unitrust is a separate and distinct legal entity. This is particularly appropriate given the limitation on liability that a trustee has under CERCLA, the Comprehensive Environmental Response, Compensation and Liability Act of 1980 which has been amended several times since its inception. The most recent amendment limits the liability of a trustee to the value of the assets in the trust. Previously, such liability was not limited. In most cases, the unitrust will want to dispose of the property and convert the real estate to liquid assets. In this situation, a NIMCRUT or Flip-CRUT is ideal.

680 0 Concern with IRS Letter Ruling 9015049 (1990)- In Letter Ruling 9015049, the donor proposed to fund a charitable remainder unitrust with real estate that had mortgage debt for which the donor was personally liable. The IRS ruled that a unitrust funded with mortgaged property is not qualified because the trust would be paying obligations for which the donor was responsible. The IRS has not ruled on whether the decision would be different if the mortgage debt was non-recourse to the donor, i.e., the donor is not personally liable for the debt. The letter ruling remains the current position on this issue. Do not fund a charitable remainder unitrust with mortgaged real estate. The obvious solution is to have the donor pay off any mortgage debt before transferring the property to the unitrust.

0 Concern with IRS Letter Ruling 9501004 (1995)- In this letter ruling, a donor proposed to grant an option to purchase a debt-encumbered property to a charitable remainder unitrust at a very low option cost which was significantly below fair market value. In this way, the unitrust would not take title to the mortgaged property. Instead, it would sell the option to an arms length buyer at fair market value and realize the donation while side stepping Letter Ruling 9015049 discussed above. The IRS ruled that the unitrust is not qualified and therefor no deduction is allowable to the donor. The purported option is simply an attempt to avoid the restrictions that would apply to a direct transfer of mortgaged property to the unitrust.

0 Undivided Fractional Interests- If a donor funds a charitable remainder unitrust with an undivided fractional interest in a property and the donor retains ownership in the remaining undivided fractional interests of that property, the IRS regards this as a violation of the self-dealing provisions of the code. A donor must sever his or her interests in property funding a charitable remainder unitrust. The guidance on this issue is do not fund a CRUT with an undivided fractional interest in real property if the donor (or any immediate family) has a continuing ownership interest or other interest in that property.

Co Non-Grantor Charitable Lead Trust- With historically low interest rates, the charitable lead trust is exceptionally appealing. This vehicle is well suited for funding with real estate given the fight property type. A long term, single credit tenanted property with steady income is appropriate to fund the CLUT. The income stream is dependable and there is little management of this asset so long as the tenant is responsible for the upkeep and care of the property. All capital appreciation while the asset is in the trust will be exempt from estate taxation. Thus, a charity can receive an income benefit for a stated period of time and the real property funding the trust can be transferred from one generation to the next with significant exemption from estate taxes.

681 0 Retained Life Estate- This is a conveyance of a personal residence or a farm to a charity and the donor reserves a life estate for one or more lives or a term of years. The donor is entitled to a tax deduction for the net present value of the remainder gift to the charity. The greatest risk is that the property is not maintained during the period of the life estate or that repairs become necessary for safety reasons. Will the donor pay for the maintenance and repairs or will this become the responsibility of the charity? Will the donor pay real estate taxes and insure the property? The charity should evaluate the donor's ability to care for the property during the life estate and codify the specific details of the arrangement in a written agreement with the donor.

VII. Valuation of real estate and donor relations

No For tax deductibility, any donation of real property with a value of $5,000 or more must be supported by a qualified appraisal. The donor has the obligation to secure a qualified appraisal dated not earlier than sixty days prior to the date of the gift or later than the tax filing taking the deduction. This is not the duty of the charity. It is not uncommon for the donor to request that the charity pay for the appraisal. Your gift acceptance policies should address whether you will pay for an appraisal.

No For a gift of $500 or more, the charity must acknowledge receipt of the gift by signing form 8283. The donor must file the 8283 with the IRS. The charity's signing of the form only acknowledges that the gift was received on a certain date. In the case of real property, the date of the gift would be the date that title is delivered to the charity.

Co The IRS requires the charity to file "tattletale" form 8282 if the property is sold within two years after the date of the gift. The charity has an obligation to file form 8282 with the IRS if the property is sold within two years from the date of the gift. Form 8282 indicates the date that the asset is sold and for what amount of .

VIII. Closing remarks and questions

682