Saturday July 2, 2022
Case of the Week
Case:Several years ago, Martha and Frank built a very unique home on 45 acres of beautiful rolling hills and woods. Frank passed away three years ago and now Martha solely owns the 45-acre parcel and home.
She enjoys the peaceful country view out her front window. However, the university adjacent to the property is very interested in acquiring the property for future growth. Not surprisingly, Martha is concerned. She does not want a new dormitory filled with college students in her front yard. In fact, she enjoys the peace and protection of her lovely home in the wooded countryside. However, at age 80, she recognizes that eventually some planning will have to be accomplished.
After obtaining a thorough understanding of Martha's needs and desires, Martha's attorney, Paul, crafted a wonderful four-part solution which incorporated an outright sale, a unitrust, a gift annuity and a gift of a remainder interest in a home. (See Case Study "Peace in the Countryside" for a full explanation.) This solution seemed like the perfect fit until Paul discovered that Martha has a $20,000 loan against the rear 20-acre parcel. The rear 20-acre parcel of land was to be transferred into a charitable remainder unitrust.
Paul learned that prior to Frank's death, Martha and Frank took out a small loan at the local bank in order to do some simple improvements on the land. The $20,000 debt was very modest in comparison to the $1 million fair market value, so Martha did not think it was an important issue. Paul believes otherwise.
Question:Is the $20,000 debt on the rear 20-acre parcel a problem? If so, what solutions can Paul suggest? What are the rules governing encumbered property and unitrusts?
Solution:In PLR 9015049, the Service set forth specific requirements dealing with the contribution of encumbered property into a unitrust. The Service stated that if there is any personal liability on the debt, then the payment of debt with potential personal liability causes the unitrust to become a grantor trust. See Section 677. Since the Section 664 regulations preclude a unitrust from being a grantor trust, the unitrust would therefore become disqualified, meaning it would lose its tax-exempt status. Accordingly, Paul's concerns are warranted.
Martha is personally liable for the $20,000 debt. Thus, the transfer of the encumbered rear 20-acre parcel into the unitrust would disqualify the trust under the rationale of PLR 9015049. Therefore, it is essential that Martha removes the $20,000 debt prior to transferring the property into the unitrust.
In this instance, the removal of the small debt is quite simple. Because the university is purchasing Martha's front 20-acre parcel for $1 million cash, she will have ample cash from the sale proceeds to pay off the $20,000 debt. After Martha pays off the debt, she can then safely contribute the rear 20-acre parcel into the unitrust, since it is now "free and clear." At this point, Martha can realize all of the unitrust benefits.
As a result of Paul's guidance, Martha proceeds safely ahead with her four-part solution. With her newfound liquidity, steady lifetime income and beautiful hillside views, Martha finds peace in the countryside (and her annual six-figure income stream) very agreeable.
Editor's Note: There is one potential exception to PLR 9015049 -- if the debt is nonrecourse. If the obligation is solely against the property, the debt is termed "nonrecourse." If the obligation is against both the property and the owner personally, the debt is termed "recourse." If the debt is deemed nonrecourse, there is no personal liability under Section 677 and, accordingly, no grantor trust status problem. Therefore, so long as the "5 and 5" rule is met, nonrecourse debt may provide a useful exception to PLR 9015049 when funding unitrusts with debt-encumbered property. For a review of the "5 and 5" rule, see GiftLaw Pro Chapter 2.1.2.