Suppose that the time seems right to sell your building, but you cringe at the thought of letting Federal and California taxes confiscate up to 37.1% (and up to 42.1% on depreciation recapture!) of your hard earned gains. Tax laws have long provided a way to escape these confiscatory taxes, by using a Capital Gains Bypass Trust (“CGBT”). [1] You can use a CGBT to completely “bypass” these taxes when you sell your building.  That can leave you with way more money to reinvest after the sale. 

Benefits of a CGBT

If you own a highly appreciated building, a well-planned CGBT can provide significant benefits for you:

  • Freedom to Sell your building when it makes sense economically (like now, when cap rates are low and multiples are at historically high levels), without fear that income taxes on the gains will erode your reinvestment proceeds
  • Escape From the Dreaded 3.8% Obamacare Tax on net investment income
  • Cash Flow Increases, sometimes doubling the cash flow you have available to spend
  • Reduced Management Headaches – no more troublesome tenants, no more toilets to repair and other maintenance hassles, no more bureaucratic property owner red tape
  • An Immediate Income Tax Deduction
  • Reduced Liability Risks
  • Diversification
  • Meaningful Estate Tax Savings
  • Preservation of Values For Your Heirs 

Tax Rules for a CGBT

Whenever the tax law gives a benefit, it does so only if you follow the “rules.”  The Internal Revenue Code and related regulations set forth rules that must be followed in using a CGBT.  Some of the rules relate to how the CGBT can be structured, while others prevent or punish abuses of the tax benefits.  Fortunately, the structuring rules provide a great deal of flexibility in designing a CGBT to meet the different objectives of different property owners.

The CGBT can be established by real living people, and also by entities such as partnerships, LLCs or corporations.

The CGBT needs to specify the non-charitable beneficiaries who will get the income during the duration of the trust.  These beneficiaries are usually the individuals that set up the CGBT, and/or members of their family (including spouses, children and grandchildren).  You can also include trusts, partnerships, corp-orations and other entities.

The duration of the trust will normally last for one or more persons’ lifetime.  It can also last for a fixed term of up to 20 years or for certain combinations of lifetimes and a fixed term.

The value which remains in the CGBT will benefit your chosen charity at the end of its duration.  The actuarial remainder value must total at least 10% of the value of the property when put in the CGBT.  You calculate this actuarial value from IRS tables.  These tables take into account the expected duration of the CGBT, current interest rates, the planned payout, and the value of the property contributed.

If the contributed property is real estate, the donor needs to get a qualified appraisal to determine the value used in this calculation. 

Two Basic Types of CGBT

A CGBT comes in two basic types:  (1) Annuity Trusts, which pay a fixed percentage of the initial value of the property contributed every year; and (2) Unitrusts, which pay a fixed percentage of the value in the CGBT recalculated every year.

Annuity Trusts promise a level payment for the term of the trust.

Payouts from Unitrusts can vary up or down depending on returns from the investments in the trust.

Due to restrictions in the law, Annuity Trusts will only work for lifetime CGBTs for beneficiaries at least 72 years of age in today’s low interest rate environment.  But, younger clients can still do annuity CGBT’s for up to 20 years, and Unitrust CBGTs work even for beneficiaries who are at least 27.  

Several Flavors of Unitrusts Give Planning Flexibility

Unitrusts come in a number of flavors, offering considerable planning flexibility.

In “Standard” flavor Unitrusts, the payout rate is a constant percentage fixed at the outset of the changing value of the trust’s investments.

In “Net Income” flavor Unitrusts, the payout is the lesser of such fixed percentage or “income” for the given year.  Income can be defined in ways that differ from what would have been taxable income, which can provide interesting planning opportunities.

If you select a Net Income Unitrust, we can structure it to make additional payments in good years to “make up” for any years in which the net income is less than the fixed percentage. We call this flavor “Net Income with Make Up” Unitrusts.

Finally, a trust can provide situations where it will change from one of the Net Income Unitrust flavors to a Standard Unitrust flavor. This is a “FLIP” Unitrust.  It works particularly well if you want lower distributions in the early years (when you anticipate not needing or wanting a lot of distributions from the trust) and want higher, more stable distributions in later years (say, after retirement or another event reduces your other income) without regard to income in those years. 

The Problem of Encumbered Property

Unfortunately, donation of property subject to encumbrances will normally trigger some income tax for the donor.  As a result, donors normally fund with unencumbered property, even if they need to pay-off mortgages before contributing the property to the trust.  Sometimes, however, the income tax deduction from creating the trust is used to offset the income recognized as a result of selling or refinancing other properties to remove encum-brances on property contributed to a CGBT.

If your property has recourse debt on it, it cannot be used to fund a CGBT until the debt has been paid-off or converted to non-recourse debt.  In some cases, we can divide the property into separate interests, one which retains the debt and one which remains unencumbered in order to get around this problem. 

Estate and Gift Tax Consequences

The property in the CGBT will not be included in the estate of the donors or beneficiaries.  However, if the beneficiaries are other than the donor and spouse, the actuarial value of the interest for such other beneficiaries is treated as a gift.  This gift amount will use part of one’s lifetime transfer tax exclusion (currently, $5.45 million per person).  It could generate a gift tax to the extent that the exclusion has been exhausted.  And, if the donor is a beneficiary, and others are beneficiaries after the donor dies, there may be a value included in the donor’s estate. 

Taking Care of Younger Generations with Wealth Replacement

Since the remainder will go to charity, many owners who establish CGBTs look to replace some or all of the wealth that their children, grandchildren or other heirs would have gotten otherwise.  Fortunately, in today’s market, that can usually be done efficiently with properly structured life insurance.  Such wealth replacement can often be paid for by using only a part of the additional cash flow that the CGBT produces and/or a part of the other income tax savings from the income tax deduction for setting up the trust. 

Example – Selling Tom and Sue’s Building

The Facts:Tom and Sue own several apartment buildings.  Tom is 70 and Sue is 66.  Tom and Sue would like to sell the building on Broadway, purchased 30 years ago for $240,000.  Tom and Sue want to sell this building to ease their management headaches, get some diversification into their portfolio, and take advantage of near bubble level apartment prices.  And, they hope to increase their cash flow a bit.

The Broadway building is fully depreciated, and has a remaining income tax basis of only $60,000.  Still, in today’s hot, low cap rate environment, the building has a market value of $2 million.

Tom and Sue’s net cash flow from the building is only $60,000 per year (less in those years that require substantial maintenance expenses, which they know will be more common as the building gets older).  All of this cash flow is fully taxable as ordinary income as they have no depreciation left.  The cash flow looks pretty good compared to the initial purchase price, but does not excite them in comparison with the current inflated value of the building.

Result of an Outright Sale:  If Tom and Sue sell the Broadway building outright for cash, they would lose about $730,000 to income taxes, leaving them with only about $1,270,000 to reinvest.  But, they think they can earn a 6% total return on the money they reinvest (on average, over the long term).  That would still give them a little cash flow boost to about $76,000 per year.

On the other hand, Tom and Sue cannot bear the thought of writing a check to the government for nearly three-quarters of a million dollars when the building sells.

A Better Result – Using a CGBT:  Instead of selling the Broadway property directly, Tom and Sue set up a CGBT for themselves.  Then, the CGBT sells the building. They structure the CGBT to pay them 6% per year of the value in the CGBT each year.  We call that a “Unitrust” amount.  [They could have structured the payment to be over 12% per year and still met the 10% minimum remainder value test!] Now they have the full $2,000,000 to reinvest, and expect to get $120,000 per year in cash flow, twice the cash flow that they were getting before and about 157% of what they would have earned from the proceeds of a taxable sale.

Plus, they get an income tax deduction of more than $630,000 to use to reduce taxes on their unitrust payment and other income.  They can use this tax deduction over six years, and estimate it can save them about $240,000 or more over that period.

Wealth Replacement:  Since Tom and Sue want to replace the value of the building for their children, they elect to purchase a joint and survivor life insurance policy in an insurance trust that will be outside their estate.  Given their good health, they can do so for less than 2% per year of the value of the building each year, still leaving them with a net boost in spendable cash flow.  They could also have devoted the estimated $240,000 of income taxes they expect to save from the charitable deduction to the insurance.  In that case, the remaining premiums for the life insurance would likely be less than 1% of the value of the building.

Non-Tax Benefits: Tom and Sue also set up the CGBT so that, after they pass away, much of the money in the CGBT will be administered by their grandchildren.  Tom and Sue used this to help build social responsibility and self-esteem for their grandchildren.  They believe that, ultimately, the opportunity this gives their grandchildren might be the most valuable part of the legacy they leave behind.

 

The Bottom Line

A well-planned CGBT can work for you to enable you to sell your highly appreciated building free of income taxes on the sale, while giving you substantial income tax deductions usable over six years.  It enables you to “Do Well by Doing Good.”

In Tom and Sue’s example above, the total tax savings equaled about 50% of the value of their building.  The result was that they had more than enough cash flow to buy life insurance to replace the value that will go to charity, and still leave Tom and Sue with more money to spend than the building was netting for them.

[1] Internal Revenue Code § 644 calls this a “charitable remainder trust”. 

Kenneth Ziskin is an estate planning attorney who focuses on integrated estate and tax planning for apartment owners.  He also assists owners’ families with probate and trust administration. He holds the coveted AV Preeminent peer reviewed rating for Ethical Standards and Legal Ability from Martindale-Hubbell, and a perfect 10 out of 10 rating from legal website AVVO.COM.  

Ken’s website at www.ZiskinLaw.com  has information about his estate planning process and reviews of his work by his clients. Ken offers free consultations for AOA members, and can be reached at (818) 988-0949. 

This article offers only a brief introduction to the subject matter and is not intended as advice on which owners can rely.   Every situation is different and laws can change.  Ken can help you evaluate and compare other strategies for avoiding or deferring capital gains taxes.  Your savings from focused planning may be higher or lower.  Please get advice from counsel you retain for your own planning. This article was drafted in May, 2016.