A CRUT: A Smart Strategy for Selling a Second Home and Making a Difference by George B. (Buck) Smith, Esq. ’82 As a practicing tax lawyer, I am frequently asked what tax benefits are available to sellers of second homes. In a nutshell, there are almost none. If a seller sells for a loss, it is not deductible – either as an ordinary loss or as a capital loss. Unfairly, if there is a profit, it is a capital gain. If the seller has owned it for more than one year, under current law the gain is taxed at long term rates (15% for federal – but beware of Alternative Minimum Tax, phase out of itemized deductions, reduction of personal exemptions and other adjustments because of higher gross income) - plus whatever state taxes may apply (in Delaware, where I live, capital gains are taxed the same as other income, so the effective rate of taxation, taking into consideration all of the above components, can reach 25%). If the home was rented to the extent the IRS agrees it is business property, a loss should be recognized as an ordinary loss, which offsets ordinary income, and a gain is still a capital gain, usable against capital losses only in the year of sale. A seller of true investment property can also execute a like-kind exchange, deferring the recognition of gain if the seller purchases other rental property as prescribed by Section 1031 of the Internal Revenue Code. The United State Tax Court has rendered decisions that clearly state that a second home that has been used solely for personal purposes, and not rented, does not qualify for like-kind exchange treatment, regardless of how much it has appreciated in value. What can a seller of a second home do? If there is a loss, there is no tax but there is no tax benefit from the loss, so the scenario described below will still benefit the seller. If there is a potential gain, what I outline below will provide a significant benefit. Consider contributing the second home to a Charitable Remainder Unitrust (CRUT). In a CRUT, the donor withdraws a percentage of the fair market value of the CRUT each year based on the value as of the prior December 31. The minimum withdrawal is 5%. The withdrawal can benefit either just a single donor, or a donor and a spouse, or a donor and a child, depending on the age difference between the donor and the second income beneficiary. Based on IRS tables, the projected remainder at the end of the term of the CRUT must equal or exceed 10% of the beginning CRUT value. The CRUT can pay out for a term of years or for one or more lives – so long as the 10% test is met, it qualifies. The donor is permitted to be the trustee of the CRUT and to name a successor. The donor receives an immediate income tax deduction for the present value of the contribution to the CRUT. The longer the term and the higher the percentage of withdrawal, the smaller the deduction. The closer the donor stays to the 5% and the shorter the term, the greater the deduction. Assuming the members of the first graduating class of 1975 are all now 65 and are married, the actuarial life expectancy for the couple is 22 more years. The donor forms the CRUT, contributes the property to the CRUT by deed and then looks for a buyer. This does not work if the seller and buyer have already signed a contract – the IRS calls that “assignment of income” and taxes the donor as if the donor sold the property. If the CRUT sells the property, there is no tax because Widener University School of Law is named in the CRUT to receive the remaining proceeds of the trust after the donor dies. Let’s use the following assumptions. The donors are both 65 years old. They purchased their second home at the beach (or at the shore, for New Jersey alumni) for $300,000 in 1990 and it is worth $700,000 today (it was worth more a few years ago, but the value has dropped). They have never rented it, but they have claimed second home interest and property taxes. They and their children no longer want to spend significant time at the second home but also hate the thought of paying tax on the sale. They are also charitably inclined. The tax on the gain of $400,000 is estimated at $100,000, leaving them $600,000 (the mortgage was paid several years ago). Instead of the above, they form a CRUT with a 5% required payout, payable on a monthly basis, to be paid for both their lifetimes, and name Widener as the beneficiary after they both die. They transfer the second home to the CRUT in April 2010 and then sell the second home later this year to an unrelated third party (for purposes of this example, I am ignoring commissions, transfer taxes, etc.). Using April 2010 IRS tables, they receive a charitable income tax deduction of $237,531. They can offset up to 30% of their Adjusted Gross Income for 2010. If they cannot use it all in 2010, they can use any remainder, on a rolling basis, for the following 5 years. Hypothecating an incremental tax rate of 35% for them (federal and state), they reduce their taxes by $83,136. What is their 5% income stream worth? If you assume the pot of money from the sale (remember, it hasn’t been taxed) will yield annual income (interest and dividends) of 3% and annual appreciation of 5%, over their 22-year remaining combined lifespan, they will receive $1,047,563 of distributions. Widener will receive a remainder of $1,291,406. What if the kids complain that they won’t inherit as much as if dad and mom kept the house or sold it, paid the tax and then kept the remainder? First, there are income taxes. Then, there may be federal estate taxes and state inheritance/estate taxes. The parents (our donors), using their tax savings in 2010 and their annual distributions, could purchase a second- to-die life insurance policy outside the gross estate for federal estate tax purposes and leave those proceeds income tax free and estate tax free for the kids – what is called “reforestation”. While this approach will not work for everyone, it is one tool in the toolbox of tax planning that should not be ignored. It can also be used for rental property, stock and other assets. George B. (Buck) Smith ’82 is the founding partner of the law firm of Smith Feinberg McCartney & Berl, LLP which has offices in Georgetown and Lewes, Delaware. He concentrates his practice in the areas of real estate, income tax planning, estate planning, estate administration, elder law, Medicaid planning and business sales and planning.