Highly appreciated real estate transferred to a CRT is a classic use of a §664 Trust, and one of the nation's largest trust administrators reports that 28% of CRTs were created with real estate as the contributed asset. However, there are potential land mines that need to be discovered and neutralized before plunging into the transaction. For what problems should the planner watch?

1. In the design of the trust, generally, stay away from standard CRUT or CRAT instruments because they lack the flexibility to deal with liquidity shortfall problems if the land doesn't sell immediately. As a rule, it's usually better to use the NIMCRUT or FLIP-CRUT. These specialized charitable remainder trusts offer more options to avoid distributing parcels of land back to the income beneficiary when income is not adequate to meet required payouts.

2. Is the property debt free? If not, there may be a problem contributing the mortgage holder's assigned interest to an irrevocable trust. The trust can't be placed in a position of paying off the note, so any property contributed to a CRT should either have the debt paid off or the mortgage transferred to another parcel that is not contributed to the CRT. Specifically, a debt-encumbered asset may generate four distinct sets of problems that need to be addressed.

• Unrelated Business Income - if a CRT earns unrelated business income for the year in which it's made, the CRT is non-qualified and subject to tax. This is a disaster if the original contribution year generated UBTI, as not only is the charitable deduction lost, the capital gains liability is accelerated. This potential malpractice error effectively negates the advantage of creating the CRT in the first place. So how does mortgaged property create UBTI? Through Unrelated Debt Financed Income (UDFI) or "acquisition indebtedness" which may occur if the mortgage has materially changed in the previous five years or if the donor has owned the property for less than five years.
• Self-dealing - the contribution of mortgaged property by a disqualified person raises some troubling issues, especially if partial interests are involved.
• Bargain Sales - require the recognition of a pro-rata capital gains tax liability.
• Grantor Trust - any trust that is non-qualified, and if there is any other owner of the asset, the CRT would be non-qualified and a tax paying entity. A number of attorneys have tried to address this concern by stipulating debt payment be made from principal or from assets outside the trust, but these suggestions create management problems for most donors and raise the issue of self-dealing.

The basic solutions include:

1. the retirement of existing debts
2. transferring debt to other non-contributed parcels as collateral
3. sell enough land in a taxable sale to finance the debt payment and offset those added tax liabilities with deductions from the donation of debt-free real estate assets
4. contribute a fractional interest in the indebted property to the charitable remainderman, if the property is eventually going to pass to the charity anyway. Some planners have advocated the contribution of an option to circumvent the debt-financed rules, but the IRS effectively shut this strategy down by ruling that no contribution exists when options are used.

3. Are there environmental problems, title defects or liens, on-going lease agreements (especially with prohibited persons)? Find out how the property is legally owned and whether or not it may be contributed to a CRT. Make sure there's no prior commitment to sell, or you run afoul of the step-transaction rules.

4. Does the IRS consider the donor a "dealer"? If so, the appreciation is not treated as a preferred capital gain, but as ordinary income on inventory; the deduction is then based on basis, not fair market value. To protect the donor's beneficial tax treatment, there are four tests under §1237 that may be worth pursuing:

1. this parcel wasn't held by the taxpayer as inventory for sale to customers in the ordinary course of business
2. the taxpayer held no other property for sale in the ordinary course of business
3. no substantial improvements to enhance the parcel's value were made
4. the parcel was inherited or held for five or more years. If all four tests are met, dealer status may be avoided.

5. If the CRT's trustee then chooses to develop and sell lots in the property, will the CRT then generate unrelated business income and be treated as a dealer and exposed to UBTI? Maybe. Seldom appreciated by most planners, a charity can have unrelated business income and just pay tax on that portion of the resulting income that is not substantially related to the charitable purpose of the charity. On the other hand, if a CRT has unrelated business income, it loses its tax-exempt status for an entire year and becomes a tax-paying trust, and that creates severe, even catastrophic, burdens.

Other articles on poorly designed trusts using land and the well designed planned gifts are available at Zero Estate Tax Planning, as well as the case studies for Berger, Moore, Williams and Sullivan. Ongoing CRT and Planned Giving Workshops available for nonprofit organizations, boards, planned giving and estate planning councils and for-profit financial services firms. Need an evaluation of potential assets going into a CRT? We provide courtesy preliminary analyses for the professional estate and gift planning community. Call for a hypothetical fact finder.

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