Bill, What can we do with this rental house?
© Bill Broadbent, S.E.C.-CCIM, Arnett& Broadbent, Inc. San Luis Obispo, CA
This was the question my clients posed to me in mid-June of 2000. They had purchased the house new in 1960 for about $17,000, moved in and lived there for 30 years. Adding a small room and some other remodeling had increased their cost basis in the property. They moved to a larger, nicer home in 1990 and rented the smaller home to a tenant who had just notified them of her intention to move the end of August.
I told them they had several alternatives, which were;
- Sell for cash and pay the long-term capital gains tax. This would cost them roughly $40,000 in taxes.
- Sell on the installment basis with a good down payment ($40-$50,000) and carry a note for the balance of the purchase price. The note could be amortized over 25 years, all due and payable in 7 to 10 years. In the short run this would defer some tax and probably earn them a higher rate of return than those funds would earn in a savings account or money market fund. Due to their tax bracket it probably wouldn’t save them much in taxes over the long run.
- They could defer any tax on their gain by exchanging this house for other income producing property of equal or greater value. This alternative is available under Section 1031 on the Internal Revenue Code. This would keep them involved in real estate ownership. If necessary they could employ a professional property manager to take care of all management details and leave them free to travel if they wanted to avoid "hands on management responsibilities".
- They could set up a Charitable Remainder Unitrust (CRT). They could self-trustee their own Trust as I have done with my CRT, or they could engage an institutional trustee to manage it for them. When the trust is set up the property is deeded into the CRT thereby avoiding all capital gains taxes. They would also get a deduction for the fair market value of the remainder interest contributed to the trust AND they would receive an income from the trust for the rest of their lives. Upon the death of the last spouse the assets of the CRT would be distributed to the beneficiaries they had named. All beneficiaries must be IRS qualified non-profit institutions.
I then loaned them a 15 minute videotape that I helped script in the mid 1990’s which was produced by the Cal Poly University Foundation. Its title was "A Gift That Returns Income and shows how a CRT can be funded with real estate.
A week later they made another appointment and indicated that of the four alternatives I had presented, they wanted to explore the CRT option further. In late June I showed them a preliminary tax analysis based on an estimated current value of the property, their ages, and tax bracket. This preliminary analysis indicated they would receive about $80,000 in deductions, which they could use over the next five years to offset tax on other income.
They could look forward to an annual income of over $17,000 payable quarterly if they chose a 7% pay rate from the CRT. If the trust assets earned more than 7% annually their income would increase. For Example, suppose the Trust assets earned 10% the first year. On a beginning asset value of $250,000 this would be $25,000. With a payout of $17,000 (7%) this would leave an $8,000 surplus which remains in the Trust. The following year the 7% payout rate would apply to $258,000 which means that my clients would receive $18,060. Historically this has usually been the case under the supervision of a good money manager. When the Trust assets earn more than the payout rate it provides the donors with a hedge against inflation.
Next we interviewed two potential trustees. My clients decided on the Cal Poly Foundation to be their trustee. In July we reviewed the CRT document normally used by the Foundation. My clients wanted four organizations to benefit from the ultimate disposition of the CRT assets. Two educational institutions would receive 47% each, local health and organization and botanical organizations would each receive 3%.
Now it was early August and it was time to deal with some property issues. They property needed work in order to command a top price. The Trustee would need an appraisal of the property before the CRT was finalized. I arranged for an appraiser to inspect the property and begin the process. He told me an "as is" value would be about $250,000 but fixed up, about $275,000m/l. I encouraged them to do the fixup. They were willing to pay for it in the short run as long as they could recoup the additional cash expenditure within a reasonable period of time. We agreed to structure the donation of the property in such a way that when it was sold they could recoup the fixup money spent.
By mid-September some minor repair work had been completed, the house had been fumigated for termites, a badly needed interior paintout was finished, and new carpet had been installed throughout the house. Total cost about $12,000. We sent the appraiser back in to finish his work. His final appraisal came in at $280,000, which confirmed my recommendation on the fixup. Our value had gone up from $250,000 "as is" to $280,000 fixed up; a $30,000 increase at a cost of $12,000.
By the end of September the trust agreement was completed and signed by all parties and the property was deeded into the CRT. The house was then listed for sale at a price above the appraised value due to strong market conditions and a shortage of houses in its price range. Within a month an offer was received from a local real estate company working with the Buyer. A final contract was negotiated at a price that was still a little higher than the appraisal and escrow was opened.
During this time endowment agreements were worked out with the two educational institutions so that the ultimate use of funds would be used for specific purposes set forth by the donors.
By mid-December escrow closed, the Trust was funded. The Buyers of my clients rental house were enjoying their new home.
In early April 2001 my clients will receive their first quarterly distribution of income from their CRT.
Ed Arnett or Bill Broadbent, S.E.C.-CCIM
Arnett & Broadbent Inc.
SINGLE AGENCY REAL ESTATE REPRESENTATION1380 Broad St.
San Luis Obispo, CA 93401-3910
(805) 543-9100
e-mail to bill@arnettbroadbent.com
Copyright © 1997 Arnett & Broadbent, Inc. All rights reserved.