Wednesday October 21, 2020
Case of the Week
Exit Strategies for Real Estate Investors, Part 5
Case:Karl Hendricks was a man with the golden touch. Throughout his life, it seemed every investment idea that he touched turned to gold. By far, Karl was most successful with real estate investments. It was definitely his passion.
Amazingly, Karl continued to buy and sell real estate at the age of 85. For instance, about three months ago, Karl discovered a great investment property. It was a "fixer-upper" commercial building in a great area. While other nearby buildings sold for over $2 million, the seller needed to sell quickly and was asking just $1 million.
The condition of the building turned many buyers away. It was being sold "as-is," but Karl was not deterred. He could see great potential with the building and knew it would not take much to get it to market condition. Therefore, Karl swooped in, bought the building for $1 million and instantly hired contractors to refurbish the place.
After three months of hard work refurbishing the building, the place looked like new! In the end, Karl invested $250,000 in the building bringing his total investment in the property to $1.25 million. One month after the completion of the work, Karl was contacted informally by a company that expressed an interest in the building — a $2 million interest! This was no surprise to Karl. He knew the building was another great buy.
There was one downside to the idea of selling, however. Karl held the property only four months, which meant the gain from the sale would be short-term capital gain. In other words, his applicable tax rate would be 40.8%, not 23.8%. Karl cringed at the thought of paying this much tax to the government. At the same time, Karl knew the real estate market could change direction in the next year. So, although Karl wanted the lesser tax rate, he did not want to risk holding the property another eight months.
Question:However, there was still one unresolved issue. There was a $100,000 debt on the property that Karl incurred at the time of purchase. The debt was a major obstacle to the successful completion of the FLIP CRUT plan. What solutions are available to remove the debt?
Solution:Karl has at least five solutions to the debt and FLIP CRUT problem.
- Payoff - If possible, Karl may have the resources to pay off the debt and then transfer the real estate to the FLIP CRUT.
- Release - If the parcel of land may be divided under zoning rules or if there are multiple deeds to the parcel, it may be possible to obtain a release on a portion of the property, leaving the debt on the balance. The released property may then be transferred to the FLIP CRUT.
- Bridge Loan - Karl may borrow funds against another property, pay the debt on the property in question and transfer an undivided interest into the trust. When the property is sold, the undivided portion retained by Karl is used to pay the bridge loan.
- Charity Purchase - The charitable organization may be willing to purchase a portion of the property from Karl. Following this purchase, Karl has funds to pay off the debt and transfer the remaining balance of the property into the trust.
- Personal Guarantee - While the Service has not approved this method, some counsels have suggested it is possible to transfer an undivided percentage of encumbered property into a CRT. When the property is sold, the balance of the asset is used to pay off the debt. The donor gives a personal guarantee that the trust will not be required to pay debt. So long as the transaction works as contemplated, the theory is that the issue of transferring encumbered property into a FLIP CRUT is moot after the sale and debt repayment. This is an aggressive strategy not without risk.