Case:

Karl was a man with the golden touch. Throughout his life, it seemed every investment idea that he touched turned to gold. Karl’s passion was real estate, and he was very successful in his investments.

Karl continued to buy and sell real estate at the age of 85. His latest venture led him to 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.

Once the building was completed, Karl leased the building to a Fortune 500 company. The lease contract was for 10 years and it included an “option to buy” provision. The lease income represented a 12% return on investment for Karl, so naturally he was very happy with his investment. However, after seven years, the property value grew to $3 million and Karl decided it was time to sell the property. The Fortune 500 company did not elect to exercise its option to buy during the seven year time period.

Karl learned about the benefits of a FLIP CRUT, and he decided that looked like the perfect solution. (See Part 1 for the benefits of a FLIP CRUT.) Karl’s attorney was very familiar with CRTs and was positive regarding the proposed solution. However, Karl’s attorney was concerned with one issue in particular – the prearranged sale.

Question:

If Karl transfers leased property subject to an “option to buy” to a FLIP CRUT, would this constitute a prearranged sale? When the property is eventually sold, will Karl avoid the capital gains on the property or must he recognize the capital gains personally?

Solution:

Unfortunately, there are few, if any, private letter rulings (PLRs) or cases that deal directly with prearranged sale of leased property subject to an option to buy. In fact, there are very few prearranged sale decisions on record and most of them only generally restate the basic rules. While obtaining a private letter ruling for Karl’s situation is the safest approach, Karl’s attorney may use current prearranged sale rulings to quantify the risk and advise Karl accordingly.

In general, in order to bypass capital gain, there cannot be a binding obligation to sell when appreciated property is transferred either outright to charity or to a charitable trust. See Ferguson v. Commissioner. Therefore, any contributed property must be transferred to the charity or to the trust with no legally binding obligation to sell. If there is a legally binding obligation in existence, then Karl would trigger the capital gain on the sale of the property. For instance, in Revenue Ruling 78-197, the Service treated the proceeds of a company's redemption of stock as income to the donor if the donee is legally bound or can be compelled by the corporation to surrender the shares for redemption.

Based upon the rulings in this area, an “option to buy” can be framed either way. From Karl's standpoint, his attorney would take the position that the prearranged sale rules do not apply unless the Fortune 500 company exercised its option prior to transfer. If the company has not exercised the option, then the trustee of the FLIP CRUT has no binding obligation to sell. Indeed, the property may continue to be leased pursuant to the lease contract for three more years after the transfer, indicating the trustee is under no binding obligation to sell.

From the Internal Revenue Service’s (IRS) standpoint, it may take a position that the Fortune 500 company could, or might, compel the trustee of the FLIP CRUT to sell pursuant to the lease contract. The IRS may determine that this option to purchase may equate to a prearranged sale even though the right was not exercised prior to the time of transfer.

While both arguments have merit, the main flaw with the position of the IRS concerns the assignment of income doctrine. That doctrine assigns income to the taxpayer who earns it or owns the property that produces the income, even though the taxpayer may assign the income to someone or something else. For example, when money exchanges hands, contracts are signed or shareholders vote, the income realization event (i.e. the sale of the property) is clearly “triggered” or at the very least has substantially begun. Thus, income recognition was inevitable to the taxpayer because the mechanics of a sale had already occurred (e.g., sales contract). The income would be assigned to the taxpayer, even if a taxpayer decided to transfer the property to charity or a CRT. It is just a matter of timing and completion.

However, if the property is transferred to the CRT subject to a "potential" sale, where is the triggering or sales event? Under the facts, there is no sale pending. The mechanics of a sale have not occurred. If Karl did not transfer the property to a FLIP CRUT this year, he would not realize income this year. In short, there is no income to assign because there is no sale.

In order for the IRS to potentially prevail, it seems important that the Fortune 500 company make some substantial steps toward purchasing or exercising the option prior to transfer. Without such steps, Karl’s attorney does not believe the prearranged sale rules and the assignment of "potential" income comes into play. Therefore, Karl’s attorney advises Karl of the modest risk involved with proceeding as planned. He also informs Karl of the benefits of obtaining a private letter ruling.

As a person who believes that with great risks come great rewards, Karl is not too concerned about the modest amount of risk involved with his proposed plan. Thus, after mulling over the options, Karl elects to proceed with the FLIP CRUT solution immediately and bypasses the private letter ruling process.