This infrequently used technique can be very powerful when working with high net worth clients.
We will look at a couple examples where InKnowVision has used this structure to create significant income and estate tax savings and paired this technique with wealth replacement trusts in order to deliver full value to the family.
In this presentation we will explore how to present the concept to clients and also take a look into the variables that go into the ultimate calculation.
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Because the amount claimed as a charitable contribution deduction most often exceeds $5,000.00, the fair market value of property must be established by a qualified independent appraisal. For purposes of the computation, the fair market value is reduced by any indebtedness secured by the property.
If any part of the real property is subject to exhaustion, wear and tear, or obsolescence, a special factor is used in valuing the remainder interest in that part. Further, if any part of the property is subject to depletion of its natural resources, such depletion is taken into account in establishing the present value of the remainder interest. Depreciation and depletion are computed using the straight-line method over the asset's useful life
The term "estimated useful life" means the estimated period (beginning on the date of contribution) over which the property may reasonably be expected to be useful for its expected use. The estimated useful life is not limited to the measuring term of the life estate or term of years preceding the remainder interest; rather, consideration is to be given to the provisions of the governing instrument or applicable local law, if any, relating to the use, preservation, and maintenance of the property. For this purpose, the estimates of engineers or other persons skilled in estimating the useful life of similar property may be used. As an alternative, the taxpayer can use a depreciable schedule for similar property class pursuant to Reg. §1.167(a)-11(b)(4) in effect on the date of transfer.
Life estate agreements are most frequently measured by the lifetime of one or more individuals; however, the agreement can also be measured by a term of years or by the longer of the life or lives of individuals and a term of years. If the agreement is measured by one or more lives, the individuals must be in being at the time the agreement is created. If the agreement is measured by a fixed term of years, there is no minimum or maximum term for federal tax purposes; however, state law may impose limitations. It should be noted that if an individual who is a measuring life is terminally ill at the time of the transaction, the mortality component prescribed under IRC §7520 need not be used to determine the present value of the remainder interest. For this purpose, an individual who is known to have an incurable illness or other deteriorating physical condition is considered terminally ill if there is at least a 50 percent probability that the individual will die within one year. However, if the individual survives for eighteen months or longer after the date of the transaction, that individual shall be presumed to have not been terminally ill at the time of the transaction unless the contrary is established by clear and convincing evidence.
The life tenant retains all beneficial lifetime rights in the property. This includes the ability to rent the property and receive the income therefrom. The gift agreement should contemplate this possibility and establish responsibilities for property management and maintenance should the life tenant vacate the property.
Another option available to donor and charity is to sell the property and divide the net sales proceeds according to each party's interest at the time of sale. For this purpose, a present value of the remainder interest is calculated using the net sales proceeds and the date of sale. Any expenses, such as outstanding property taxes that would otherwise be attributable to the life tenant are deducted from the life tenant's share prior to distribution. The present value of the remainder interest is then distributed to charity with the remaining proceeds distributed to the donor. The donor will realize gain based on their proportionate share of the sales proceeds.It should be noted that the gift agreement cannot compel the charity to sell its interest prior to the expiration of the measuring term stated in the gift agreement; to do so, according to Rev. Rul. 77-305, could defeat the charity's remainder interest in the residence itself.21 The decision to sell must, therefore, be voluntary on the part of both parties and not subject to a condition subsequent in the gift agreement
Yet a third option involves the donor contributing the balance of the life estate thereby accelerating the gift of the remainder interest. In such cases, the donor is entitled to receive an additional charitable contribution income tax deduction based on the present value of their remaining life or term of years estate. For this purpose, the present value of the remainder interest is calculated using the fair market value of the property on the date the retained life or term of years estate is transferred. The present value of the remainder interest is subtracted from the fair market value of the property to produce the present value of the remaining life or term of years estate. This amount qualifies for charitable contribution deduction purposes.
In many cases an individual's personal residence or farm represents a major component of their estate. Likewise, ideal candidates for life estate agreements are retired, may have modest income, and may be in need of or desire supplemental income. In a traditional life estate agreement, the donor contributes the entire remainder interest in the property to charity. However, the donor is not required to do so. As an alternative, a prospective donor can offer to sell a portion of the remainder interest in conjunction with a contribution of the remaining portion. In such cases, the charity may offer payment in the form of cash, an installment note, or a charitable gift annuity (if available). In essence, the concept represents a sophisticated form of bargain sale.Because the purchasing charitable organization must make payment from sources exclusive from the contributed remainder interest, acceptable candidates for this technique are generally older and have property that is debt-free or significantly debt-free.
Any person making a gift of a remainder interest in a personal residence or farm in any amount should file a federal gift tax return (Form 709) for the year in which the gift is made, even if no gift tax is due. The reason? Even though contributions of a remainder interest in a personal residence or farm to charity qualify for the unlimited gift tax charitable deduction under IRC §2522, charitable contributions of a partial interest are not one of the specific exceptions under IRC §6019 that relieves donors from having to file a gift tax return.