Can I Fund a Charitable Remainder Trust with Encumbered Property?
Assuming you have done the math to determine the debt portion is not too large, the answer is, generally, yes. For many charitable gift planners, funding Charitable Remainder Trusts (CRT) with encumbered property has become more challenging since the IRS issues PLR 9015049.
Even before PLR 9015049, donors were not able to easily transfer old and cold property (i.e., the debt was placed on the property five years before the gift, and the donor had previously owned the property for five years). However, planners can implement the following techniques which have become even more popular in the aftermath of PLR 9015049.
When a donor wants to transfer encumbered property to a CRT, ask two questions:
1. Is the property old and cold?
2. Will the donor be free from personal liability for the debt following the funding of the CRT?
If the answer to both questions is yes, the property can be transferred to the CRT subject to the debt encumbering the property, and the bargain/sale gift rules (to compute the charitable remainder interest) will apply.
Let's examine the second question, "Will the donor be free from personal liability?" It's possible that the donor will not be liable for the obligation if it is non-recourse by contract or by statute. An obligation is non-recourse if the lender may recover the amount owed only from the property securing the loan, without personal recourse to the property owner. So, in the event of a default, the lender may only recover its debt by foreclosing and obtaining the sale proceeds from the collateral to reduce the amount owed. The lender may not obtain a judgment against the borrower for any amount beyond the value of the encumbered property; that amount beyond the value is called deficiency. Most states have some type of anti-deficiency legislation, so it is important to do some research and review the loan agreement or promissory note.
What if the answer to either question is no? Your planning solution may be to structure a Co-Tenancy Agreement. The following pages include a commentary on the Co-Tenancy Agreement technique.
Funding a CRT with Real Property Encumbered by a Mortgage Loan
There are some tax issues involved in funding a CRT with encumbered property, and a proposed structure for this gift that should successfully resolve those issues in favor of the trust, the charitable remainder beneficiary and the donor.
The donor should fund the trust with an undivided fractional interest in the property. For example, if the value of the property is 100, and it is encumbered with a mortgage loan of 30, the donor might transfer to the CRT an undivided 70% interest in the property, retaining for herself an undivided 30% interest in the property. The donor and the trustee would enter into a co-tenancy agreement describing the rights and obligations of the donor and trustee as co-owners of the property. For example, the co-tenancy agreement might provide that all net operating income and expenses of the property (other than debt service) would be divided proportionately between the co-tenants. One provision of the co-tenancy agreement would be an indemnity by the donor, holding the trust harmless from any liability to make payments of interest or principal on the mortgage loan. If payments on the loan are required prior to sale, the donor alone would make payments on the loan. When the property is sold, the mortgage obligation would be satisfied from the portion of the sale proceeds allocable to the donor (30% in our example).
A CRT funded with encumbered property raises several difficult tax issues. Summarized below are the primary tax issues:
- Grantor Trust Rules
- Unrelated Business Taxable Income
- Self-dealing
- Charitable Contribution Deduction
- Capital Gain Recognition