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1031 versus CRTs

1031 versus CRTs. When to Recommend for Appreciated Real Assets Presented by: Martin Gates Peter S. Myers. Presentation Outline. Definition of a CRT Definition of a 1031 Real Estate Exchange Compare and Contrast Client 1: Mr. and Mrs. Phil & Ann Throp

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1031 versus CRTs

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  1. 1031 versus CRTs When to Recommend for Appreciated Real Assets Presented by: Martin Gates Peter S. Myers

  2. Presentation Outline • Definition of a CRT • Definition of a 1031 Real Estate Exchange • Compare and Contrast • Client 1: Mr. and Mrs. Phil & Ann Throp • Client 2: Mr. and Mrs. Fred Fourplex • Client 3: Mr. and Mrs. Plexthrop • Marketing Opportunities • Appendices

  3. Charitable Remainder Trusts The Basics

  4. Charitable Remainder Trusts • Charitable Remainder Trusts • You get the eggs, and the charity gets the goose when you die

  5. Charitable Remainder Trust Bob & Nancy

  6. Charitable Remainder Trust Asset placed in Trust Bob & Nancy Charitable Remainder Trust

  7. Income for life Charitable Remainder Trust Bob & Nancy Charitable Remainder Trust

  8. Charitable Remainder Trust Bob & Nancy, Dec’d The transaction is a gift to the end Beneficiary, subject to the retained right to payments for a number of years. Charitable Remainder Trust $ Charity (can be DAF)

  9. 1031 Real Estate Exchanges The Basics

  10. What is a 1031 Exchange? “No gain or loss shall be recognized on the exchange of property held for productive use in a trade or business, or for investment purposes if such property is exchanged solely for property of like-kind, which is to be held for productive use in trade or business or for investment purposes” Section 1031 defers taxes…. Does not forgive them Internal Revenue Service Code Section 1031:

  11. Taxes are deferred, not eliminated! • Since 1921, there has been a provision in the Tax Code that 100% of Realized Gain Tax is deferred in an IRC 1031 Exchange. • Capital gains can be realized whenever the investor chooses.

  12. Tax Deferral: • The tax that would be paid in a taxable transaction is deferred until the replacement property is sold in a taxable transaction • Change Type of Real Estate, for example: • Non-income (land) to income producing property • Direct to delegated property management • Offer too good to be true: • Sell for high price and realize property appreciation Why Exchange?

  13. The Realized Gain Tax Three Components: • Federal Capital Gain Tax (15%) • State Capital Gain Tax (0-9% states vary) • Recaptured Depreciation (25%) What “Tax” is Deferred by 1031?

  14. Calculation of Sample Tax Cost Step One: CalculateAdjusted Basis Original Purchase Price $300,000 Add Capital Improvements 50,000 Minus Depreciation (150,000) EqualsAdjusted Basis $200,000 Step Two: CalculateCapital Gain FMV or Sales Price $950,000 Minus Adjusted Basis (200,000) Minus Cost of Sale (50,000) EqualsCapital Gain $700,000 Step Three:Calculate Tax Capital Gain Tax Rate 15% Recapture Rate 25% State Tax Rate 0-9% Total Tax $142,500 to $205,500

  15. CRT’s Philanthropic Intent Reduce Concentration in Real Estate No Debt Allowed Decision to Form Trust Final Heirs Must be Provided for Independently 1031 Economic Intent Keep Concentration Real Estate Debt Allowed Decision Based on Holding Period Active or Passive Management Side by Side

  16. Mr. and Mrs. Phil & Ann ThropNo CRT • $4,500,000 asset to sell, with $1M basis • 24+% Capital gain tax: lose $800K • Invest remaining $3.4MM1 in an account • Earn 8% per year; withdraw an amount equal to the equivalent CRUT annuity (“apples to apples”) ($512,852, $487,631, $463,651, $440,850 and so forth) • This is called a “synthetic annuity” in the spreadsheet • The original account is gone in Year 16. • The value of the strategy nets $3.4 MM (the NPV equals the amount contributed) 1- assumes closing costs of $292,500

  17. The Spreadsheet • Amount realized $4.2M • Tax Hit (800K) • Net to invest $3.4M Beginningbalance Growth & Income Distribution Ending Balance Year 16

  18. Family benefit analysisPresent Value: With an 18-Year Term CRT • $4,500,000 asset to sell, with $1MM basis • No Capital gain tax. Invest net proceeds at 8% internal to the CRT • Nothing goes to children at death, all to charity • Initial income tax deduction is up to $450K, limited by client’s AGI (30% of $250K = $75,000) • Net Present value of the income stream: $3.8 MM The family is actually $418K better off by deploying a CRT strategy. How can this be? How much better off will the family be investing a little income in an ILIT!?

  19. Spreadsheeting the CRUT • Amount realized $4.2M • Tax Hit (0K) • Net to invest $4.2M Beginning balance Growth & Income Distribution Ending Balance Year 16

  20. CRT Income Taxation: WIFO • Distributions taxed to the income beneficiary • Worst In First Out • Four tiers: The most “tax expensive” income comes out first • 1. Ordinary Income & Short Term Cap Gains • 2. Long Term Capital Gain • 3. Other (i.e. muni bonds interest) • 4. Return of Principal

  21. Mr. & Mrs. Fred Fourplex • Situation: • CA residents, married, early sixties, net worth of $3 million—want more income, less work • Fourplex fully depreciated (200k taken), 300k in debt, estimated net capital gain of $ 1 million • Cash flow approximately $30k per year • Potential tax and depreciation recapture: 25% x 200k + 15% x 1000K + 9% x 1000K = $290k • Solution: • 1031 exchange into co-ownership interest in larger commercial property, with delegated management • Cash flow 6% on with new depreciation schedule • Cash flow 2x previous level plus tax shield for holding period

  22. Mr. & Mrs. Plexthrop • Situation: • Early sixties, net worth of $10 million, $7 million in investment real estate, $1million in mortgage debt • Charitable intent with desire to retain a lower % of real estate in investment portfolio • Projected gain of $6 million on real property, $2 million with mortgage indebtedness • Solution: • Form CRT with $ 4 million unencumbered real property • 1031 exchange $ 2 million with mortgage debt into passive real property interest • Defer taxes on CRT for life and for 1031 until next sale or exchange • Satisfy charitable objectives and retain appropriate % of real estate for investment portfolio

  23. CRT Marketing Opportunities: • Assets under management • Sale of an unmanaged assets (real estate, small business) without capital gain tax, move assets to diverse portfolio • Sale of low-income stock without capital gain tax, reinvest in modern portfolio • NIMCRUT: Variable annuity can provide the spigot • Life Insurance • Replacement value for what goes to charity at death

  24. 1031 Marketing Opportunities: • Broaden Advisor Role to Real Property • Help clients move into higher yielding properties, managed ownership interests, tax advantaged interests • Help clients improve risk/return of existing real estate portfolio with category and geographic diversification • Revenue Potential • Brokerage commissions from in-house reps preferable licensed for sale of both real estate and securities. • Referral agreements with specialized brokers possible with appropriate licensing

  25. Appendix CRTs

  26. Charitable Planning Basics Charitable Deductions • Amount you give to charity entitles you to an income tax deduction • Write off up to 50% of your AGI • Example • Made $200,000 this year • Contribute $80,000 to 501(c)(3) organization • Pay income tax on $120,000

  27. Charitable Remainder Trust • Donate an asset to the Trust • highly appreciated asset w/no debt • Sell and reinvest proceeds (consider safety and return) • Keep income for life • Charity gets balance

  28. Charitable Planning Basics Charitable Deductions • Donate appreciated assets (slide 11) • RE w/basis of $200,000 is worth $450,000 • If you sell RE, LTCG is taxed ($36K-$96K) • Capital gain taxes, 1245 ‘recapture’ Alternatively, consider: • Contribution of RE to charity: tax deduction of $450,000

  29. Charitable Planning BasicsSplit Interest Gift Trusts • Form a Trust • Trustmaker (“annuitant”) gets the Income for a term - a defined period of time • The other party (“charity”) gets the assets later - the Remainder • The Property is the goose. Income, rents and profits from the property are the eggs. Taxes kill the goose; hence, no more eggs.

  30. Charitable Remainder Trust What good is a CRT? • Provide future benefit to charity of choice • Take profits: Liquidate appreciated asset without paying capital gain taxes • Diversify client’s investments – convert to income-producing • Current income tax deduction • Removes asset from taxable estate

  31. CRT Variations: CRAT • Charitable Remainder Annuity Trust • Income paid back to Trust maker is a fixed dollar amount, much like a fixed annuity for life (or a set term) • Example: contribute $100,000, receive an annuity payment of $7,000 per year for life

  32. CRT Variations: CRUT • Charitable Remainder UniTrust • Income paid back to Trustmaker is a percentage of the assets in the trust each year • Example: contribute $100,000, receive payment equal to 7% of the fist-business-day-of-year value of the trust property • May be distributing income or principal

  33. CRT Variations: NICRUT • Net Income Charitable Remainder UniTrust • Income paid back to Trustmaker is the • Actual income earned in the trust that year but not too exceed • a percentage of the assets in the trust. • More like the CRUT, but pays less if investments don’t earn enough income

  34. CRT Variations: NIMCRUT • Net Income w/Make-up Charitable Remainder Unitrust • Actual income earned; but not too exceed stated percentage • When income is less than percentage, the shortfall is accrued in a “make-up account” and may be distributed in later years when actual income exceeds percentage.

  35. CRT Variations: FLIP-CRUT • “Triggered” Charitable Remainder UniTrust • Like a NIMCRUT but payout is tied to some future event, which “triggers” the start of the payments • distributions begin @ age X, or when illiquid property is sold (until then, might be minimal amt. available to distribute)

  36. Appendix 1031 Exchanges

  37. Who Can Take Advantage of 1031s? Any tax paying entity is entitled to the benefits of Section 1031. Corporations, Partnerships, Individuals, Limited Liability Companies, and Trusts can take advantage of Section 1031. Even foreigners who own property in the U.S. can use the Section 1031 exception to their benefit.

  38. To defer taxes under IRC 1031, the Investor MUST: • Acquire like-kind property • Exchange into property of equal or greater value • Reinvest all equity • Acquire equal or greater debt • ID a replacement property to exchange into within 45 days, close replacement property within 180 days in the same tax year • Use services of Qualified Intermediary (cannot take possession of proceeds of sale)

  39. What is Like-Kind Property? In a 1031 real property exchange, the exchanger may exchange real property for any other real property located in the United States or its possessions, if the replacement property is held for productive use in a trade or business or for investment. Retail Condos 1031 PROPERTY Duplexes Raw Land Commercial Apartments Single Family Industrial Property

  40. 1031 Exchange is Flexible • Exchange into a single or multiple properties • Exchange your entire equity or a portion of your equity • Pay taxes, “Boot” only on the portion you choose not to defer

  41. Requirements for 100% Tax Deferral • For full tax deferral, an Exchanger must meet 2 requirements: • Reinvest all net exchange proceeds • Acquire property with the same or greater debt • RELINQUISHEDREPLACEMENTBOOT • VALUE $950,000 $1,200,000 • -DEBT $200,000 $ 500,000 -0- • -COSTS $ 50,000 • NET EQUITY $700,000 $ 700,000 -0- • $0 Analysis:There is no “boot” which results in no (taxable) gain.

  42. 1031 Exchange Time Limits • 45-Day Rule: The exchanger must identify the potential replacement property or properties within 45 days of closing the relinquished property. • 180-Day Rule: The exchanger must acquire the replacement property or properties within 180 days of closing the relinquished property or the due date of the exchanger’s tax return (including extensions) for the year of transfer of the relinquished property, whichever occurs first. • There are no extensions for any reason. • The time limits begin to run on the date the exchanger transfers the relinquished property to the buyer and are strictly construed. • The “date of transfer” will be the date of transfer of the benefits and burdens of ownership for tax purposes (not necessarily the date on the settlement statement). 45 days Identification Period Exchange Period 180 days (total)

  43. Replacement Property Rules • The 3 Property Rule= Maximum number of replacement properties you may identify is three properties without regard to FMV of the properties. • The 200 Percent Rule= Can identify any number of properties as long as their total FMV does not exceed 200% of the total FMV of all relinquished properties. • The 95% Rule= Can identify any number of replacement properties as long as you close on 95% of all identified properties.

  44. What is Tenant-in-Common Ownership? • Tenant-in-Common (TIC)ownership is a form of acquiring and owning real estate with multiple owners. • Undivided fractional interest • Each owner receives own deed • Full benefits of ownership • Generally qualifies for 1031 Exchange Tenant-in-Common Propertyoffers individual investors access to commercial properties typically reserved for REITS, Pension Funds & Insurance Companies

  45. Replacement Property Alternatives Fractionalized Ownership – “Tenant-in-Common” Relinquished Property (100%) TIC 1 TIC 2 TIC 3 TIC 4

  46. IRS Revenue Procedure 2002-22 • Issued March 2002 • The IRS acknowledged the TIC Market through this ruling. • It provides direction for investors and real estate providers. • The Tenant-in-Common structure, for tax purposes, is not a partnership. • The IRS established 15 guidelines for Tenant–in–Common 1031 structures. (Not a safe harbor)

  47. Potential Advantages of TIC Ownership • Potential to diversify properties by region and types • Turn key structure expedites reinvestment • Institutional quality properties for smaller exchanges • Ability to match taxpayer’s equity and debt • Potential estate tax discounts • Ability to do future 1031 exchanges

  48. Potential Disadvantages of TIC Ownership • Lack of liquidity • Less flexibility and control with delegated management • Sponsor fees vary and may exceed initial tax advantages of exchange • 1031 tax risk (legal opinion vs private letter ruling • Due diligence of deal sponsors and larger commercial properties

  49. Why are TICs Generally Offered as Securities*? • Purchase of a complete financial package or arrangement • Investor’s reliance upon expertise of Sponsor • Persons investing money in common enterprise • Invest with expectation of a profit • Meet definition of investment contract *1946 Supreme Court Case – SEC v. W.J. Howey Co. - 1946

  50. Securities versus Real Estate

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