October 25, 2012 – CHARITABLE REMAINDER TRUSTS, AVOIDING THE HAZARDS OF DIRECT OR INDIRECT REAL ESTATE OWNERSHIP

CHARITABLE REMAINDER TRUSTS: HOW YOU CAN USE REIT INVESTMENT VEHICLES TO AVOID THE 3.8% MEDICARE TAX IN 2013

By Alan S. Gassman, J.D. LL.M. and Erica Pless, J.D., LL.M.

AVOIDING THE HAZARDS OF DIRECT OR INDIRECT REAL ESTATE OWNERSHIP UNDER AN IRA

By  Christopher J. Denicolo, J.D., LL.M. and Alexandra Fugate, J.D. 

This week we are pleased to welcome guest Thursday Report contributor, Erica Pless, J.D., LL.M. of the Pless Law Firm in Clearwater, Florida.  Erica can be reached at 727-362-4730 or via email at erica@theplesslawfirm.com.

We welcome individuals to submit contributions for future Thursday Report topics. If you are interested in making a contribution as a guest writer, please email Janine Ruggiero at Janine@gassmanpa.com.

CHARITABLE REMAINDER TRUSTS: HOW YOU CAN USE INVESTMENT VEHICLES TO AVOID THE 3.8% MEDICARE TAX IN 2013

In 2013, many real estate investors will find themselves paying not only a 39.6 percent income tax rate, but also a 3.8 percent Medicare tax on investment income.  But charitably inclined high-income investors can find significant relief in Charitable Remainder Trusts..

Beginning in 2013, the 3.8 percent Medicare tax imposed by the Health Care and Education Reconciliation Act of 2010 will apply to single taxpayers whose Modified Adjusted Gross Income exceeds $200,000 a year and to married couples filing jointly whose Modified Adjusted Gross Income exceeds $250,000 a year.

The tax is imposed only on “net investment income” and only to the extent that total “Modified Adjusted Gross Income” exceeds the $200,000 or $250,000 thresholds mentioned above.

Technically, the 3.8% tax is imposed on the lesser of:

1) Net investment income; or

2) The amount by which Modified Adjusted Gross Income (“MAGI”) exceeds $200,000 for single taxpayers, $250,000 for taxpayers filing joint returns, and $125,000 for all other taxpayers.

Net investment income includes most types of unearned income, including passive income from real estate investments and net capital gains, but does not include distributions from qualified retirement plans, IRA’s, qualified annuity plans, or tax-exempt bond or bond funds.

How Does It Work?

For example, John and Jane are married and file a joint income tax return. They have MAGI of $500,000, of which $150,000 is net investment income. The 3.8 percent Medicare tax is calculated on the lesser of net investment income of $150,000 or the excess of their MAGI over the threshold amount ($500,000 – $250,000 = $250,000). The net investment income of $150,000 is less than $250,000, and therefore the additional tax is assessed on $150,000. (150,000 x 3.8 percent = $5,700). John and Jane will owe an additional Medicare tax of $5,700 in addition to an income tax rate of 39.6 percent.

John and Jane and other charitably inclined investors should reconsider establishing charitable remainder trusts in 2013 to minimize the 3.8 percent Medicare tax and to receive an income tax deduction to save tax dollars under the higher rates.

A charitable remainder trust (CRT) can be financially structured to pay the donating Grantor more than 90 percent of the initial starting value using the time value of money rules. The charitable beneficiary can be a family run and controlled charity that will receive any remaining trust assets after the Grantor has received his or her stream of payments, and it can then compensate family members for legitimate charitable work that they perform. The Grantor can change the identity of the charity at any time during the retained payment term, and may serve as trustee of the trust and take reasonable trustee fees as well. The 90% of value payments come out over time as a stream of annual payments, and the Grantor only has to pay income tax on the lesser of the payments received or the actual income generated under the charitable remainder trust. Many tax advisors believe that the annual payments from the charitable remainder trust will not be subject to the 3.8 percent Medicare tax, but further guidance on this issue is expected from the IRS.

For example, John is a 60 year-old, single, wealthy man and has $2,000,000 of REIT stock, which has a tax basis of $500,000.  If he sold the stock in 2013 instead of transferring it to a CRT, he would pay capital gains and Medicare taxes of $349,400.

If he instead transfers the stock to a CRT, assuming normal rates and John retaining an annuity interest of $100,000 per year for 20 years, the contribution of the assets to the CRT is considered to be a $266,090 charitable contribution deduction for income tax purposes.  If John is in the 39.6 percent tax bracket, this results in approximately $105,000 in income tax savings.

John’s charitable deduction may be limited to a percentage of his adjusted gross income under current law, but he can carry forward any unused amount to apply toward future income over the next 5 years.

John would have to pay income tax on the annuity distributions that he receives from the trust to the extent that the trust has taxable income. When the CRT sells the donated assets the next year there is no income tax or Medicare tax imposed on it, but John’s $100,000 per year payments will carry out the income stored up in the CRT to the extent of $100,000 until it has all come out to him, so his payment of tax on the $349,400 gain is deferred and spread out over 4 or more years.

The Trick

Consider Holding Investments in the Form of Charitable Remainder Trusts 

Charitable remainder trusts will therefore be a great match with investments in 2013 if Congress and the President do not change what the law is now set to be.

If the income interest is sold during the term of the charitable remainder trust the capital gains income is stored up in the charitable remainder trust and will not be taxed until all ordinary income has been paid out.

After the CRT term has expired or the income beneficiary dies, the assets in the trust pass to charity. Additional estate planning may be necessary to ensure that enough assets remain for family members. For example, life insurance can be purchased in a life insurance trust with some of the tax dollars saved so that there will be something for the family when the remainder interest in the CRT passes to the charity.

The CRT will therefore be a home run for many taxpayers, especially those who sincerely want to benefit charities.

The Trap

Make sure to keep a lookout for any further guidance from the IRS on whether CRTs will be subject to the Medicare tax. While many tax advisors believe that CRTs will not be, we will not know for sure under the IRS issues guidelines. Also be ready to make adjustments in case CRTs are ruled subject to the Medicare tax.

All of the above and more is explained in the new book entitled The Annihilation of Wealth. This book is written by Alan S. Gassman, J.D., L.L.M. and Erica G. Pless, J.D. L.L.M.  Click HERE to see the book.  To purchase a copy of the book click HERE to be directed to our Amazon.com page.

AVOIDING THE HAZARDS OF DIRECT OR INDIRECT REAL ESTATE OWNERSHIP UNDER AN IRA

The tax benefits of owning real estate in an IRA plan certainly seem appealing at first glance. Under a self-directed IRA, you can control your investments. The earnings on your investments in a Roth IRA grow tax-free, and you are taxed on contributions the year they are made. In a traditional IRA, any contributions are not taxed until they are withdrawn years down the road.

Anyone considering using these tax-advantaged vehicles for an investment in real estate should proceed with caution, however. It can be extremely dangerous to hold private real estate or a direct small investment company or LLC under an IRA because of the IRS’ strict rules on self-dealing and conflict of interest Prohibited Transactions.

A “Prohibited Transaction” is defined under Section 4975 of the Internal Revenue Code. A few of those prohibited transactions include any direct or indirect: (1) sale, lease, or exchange of property between a plan and a disqualified person; (2) a loan or any extension of credit between a plan and a disqualified person; (3) furnishing of goods, services, or facilities between a plan and a disqualified person; and (4) transfer or use of the income or assets of a plan to a disqualified person (including using the assets indirectly for the benefit of that person). A violation of one of these rules, even if the benefit flowing to the owner from the IRA is $1.00, can result in large taxes and penalties, including having to pay taxes on the entire balance of your IRA, as if you cashed in the entire account. These prohibited transactions apply to uses of your IRA by you, your family, your beneficiaries, or any disqualified person.

These strict rules prevent you from using any of your IRA assets directly without a penalty, and even the smallest benefits or service can subject you to tax liability. Using assets from the IRA to pay off a personal credit card bill, for instance, is not allowed. Another example would be if the IRA owns rental property directly or via an LLC, and you go into the house and put a $6.00 paint touch-up on a wall then you have committed a prohibited transaction.  The same is true if a person related to you, or a business that you own paints the house or provides some other service to the property. If you sleep inside the house for just one night, there is an argument that you have derived an indirect benefit and the IRA can be disqualified from its tax exempt status.

This can also apply if your IRA owns, let=s say, 20% of an LLC that invests in real estate with some friends or colleagues of yours.  If you contribute time or effort to the success of the LLC or inadvertently pay any of the LLC expenses directly, or receive any personal benefit, such as perhaps attending a barbecue paid for by the LLC that your IRA owns 20% of, then your IRA could be disqualified.

As a result of this, it is expected that IRS audits of IRAs that are handled by the few custodians willing to make these types of investments will be subject to a high rate of audit.

In addition, with individual high-earner taxpayers facing a 39.6% tax rate and a 3.8% additional Medicare tax on REIT distribution income, more of these taxpayers will want to place REITs under their IRAs or pension accounts, and may purchase municipal bonds, depreciation and interest sheltered individual real estate investments, and other items under their personal names for a more tax efficient allocation.

A hard rain is going to fall on those who do not plan ahead for the 2013 tax increases.  Many investors will want to trigger capital gains before the end of 2012 by making taxable sales to related individuals or trusts in order to capture profits at the 15% capital gains rate, instead of 20% or 23.8% (if Medicare tax is applicable) which allows a new tax basis for depreciation of the property by the purchasing entity.  The related party sales rules have to be carefully navigated to make this happen, or else you will be taxed at the ordinary gains rates rather than capital gains rates.

The Trick

Investors who want real estate exposure under their IRAs will be much safer purchasing a publicly traded security, such as a REIT that invests in real estate through a traditional and conservative IRA custodian.

 The Traps

The first trap is risking the problems described above by having real estate held directly or indirectly under an IRA.

A second trap is inadvertent triggering of the Unrelated Business Taxable Income regime under Internal Revenue Code Sections 511-514. If an IRA owns an asset that produces unrelated business taxable income, it will have to pay taxes on that income. Likewise, where the IRA owns an LLC that produces or sells goods, provides a service unrelated to the enterprise, and produces income it will probably be considered as UBTI. So, if the IRA operates a business, or receives income from a leveraged investment (money borrowed to purchase real estate or stock that is purchased on margin) it is subject to unrelated business income tax, and may require filing of additional tax forms and payment of tax related to such income.

APPLICABLE FEDERAL RATES

We are providing this month’s, last month’s, and the preceding month’s Applicable Federal Rates, because for a sale you can use the lowest of the 3.  To view the chart please click here.

NEWS AND UPCOMING EVENTS

THURSDAY, OCTOBER 25, 2012, 4:00 p.m. – 4:50 p.m.
Please join us for The 4-4-4 Show, a monthly Clearwater Bar Association continuing education webinar series that qualifies for 1 hour of continuing education credit and is moderated by Alan S. Gassman, Esq.  This month’s topic is “Lawyer Ethics in a Digital World: Hot Topics and Important Tips on How to Survive!” with well known expert Joe Corsmeier, Esquire.  To register please visit:www.clearwaterbar.org.

TUESDAY, OCTOBER 30, 2012 12:30 pm – 2:00 pm
Professor Jerry Hesch, Alan S. Gassman, Kenneth J. Crotty, and Christopher J. Denicolo will be presenting a Bloomberg BNA Tax & Accounting webinar entitled Year-End Tax Planning: Do’s and Don’ts for Estate Tax Planners.  To register please visit: http://www.bna.com/yearend-tax-planning-w17179870140/.  If you are unable to attend the webinar and would like to receive a complimentary copy of the PowerPoint presentation please email Janine Ruggiero atJanine@gassmanpa.com .  Any questions, comments and suggestions for this program will be very much appreciated.

 MONDAY, NOVEMBER 5, 2012 12:30 pm – 1:00 pm
Please join us for Lunch Talk, a free monthly webinar series from the Clearwater Bar Association.  This month’s topic is What Lawyers Need to Know About Surveys – How to Read Them and What to Check with guest speaker David Brittain.  To register for the webinar please visit: www.clearwaterbar.org.

 FRIDAY, JANUARY 18, 2013
Save the date for a three day weekend in Ft. Lauderdale!  The Florida Bar Continuing Legal Education Committee, the Health Law Section and the Tax Law Section present Representing the Physician 2013: Practical Considerations for Effectively Guiding Physicians and Their Practices.  The seminar will be held at the Sheraton in Ft. Lauderdale, Florida.   Speakers include Lester J. Perling, Esq., on the topic ofFederal and Florida Health Law: Hypothetical Situations that Are Often Overlooked by Physicians and Their Counsel, Alan S. Gassman, Esq., on the topic of It’s Not Just Health and Tax Laws: Charting Florida Waters When Designing Physician Arrangements – Laws You Wish You Knew, James G. Sheehan, Esq., Jeff Howard, Don Weinbren, Esq., Michael D. O’Leary, Esq., Charles L. Wasson, III, on the topic of Protecting Medical Practices From Liability-Related to Malpractice, Employment Matters, and Privacy Issues, Kimberly Brandt, Esq. and Gerald M. Morris, Esq.  For more information on the event please click here to view the brochure.  To register for the event please visit www.floridabar.org/CLE.

Christopher Denicolo, J.D., LL.M. is a partner at the Clearwater, Florida law firm of Gassman, Crotty & Denicolo, P.A., where he practices in the areas of estate tax and trust planning, taxation, physician representation, and corporate and business law.  He has co-authored several handbooks that have been featured in Bloomberg BNA Tax & Accounting, Steve Leimberg’s Estate Planning and Asset Protection Planning Newsletters and the Florida Bar Journal.  is also the author of the Federal Income Taxation of the Business Entity Chapter of the Florida Bar’s Florida Small Business Practice, Seventh Edition Mr. Denicolo received his B.A. and B.S. degrees from Florida State University, his J.D. from Stetson University College of Law and his LL.M. (Estate Planning) from the University of Miami. His email address is Christopher@gassmanpa.com.

Kenneth J. Crotty, J.D., LL.M., is a partner at the Clearwater, Florida law firm of Gassman, Crotty & Denicolo, P.A., where he practices in the areas of estate tax and trust planning, taxation, physician representation, and corporate and business law. Mr. Crotty has co-authored several handbooks that have been published in BNA Tax & Accounting, Estate Planning, Steve Leimberg’s Estate Planning and Asset Protection Planning Newsletters, Estate Planning magazine, and Practical Tax Strategies.  Mr. Crotty is also the author of the Limited Liability Company Chapter of the Florida Bar’s Florida Small Business Practice, Seventh Edition. He, Alan Gassman and Christopher Denicolo are the co-authors of the BNA book Estate Tax Planning in 2011 & 2012. His email address is Ken@gassmanpa.com.

Thank you to our law clerks that assisted us in preparing this report::

Kacie Hohnadell is a third-year law student at Stetson University College of Law and is considering pursuing an LL.M. in taxation upon graduation. Kacie is also the Executive Editor of Stetson Law Review and is actively involved in Stetson’s chapter of the Student Animal Legal Defense Fund. In 2010, she received her B.A. from the University of Central Florida in Advertising and Public Relations with a minor in Marketing, and moved to St. Petersburg shortly after graduation to pursue her Juris Doctor. Her email address is Kacie@gassmanpa.com.

Alexandra Fugate earned her B.A. in English from the University of Florida in 2008, and J.D. from Stetson University College of Law in 2012. She has been a Guardian ad Litem for the past two years, a judicial intern for the Twelfth Circuit in Bradenton, and was recently admitted to the Florida Bar. She wants to pursue a career in business, employment, and labor law. Her email is Alexandra@gassmanpa.com.

Eric Moody is a third-year law student, scheduled to graduate in December 2012, at Stetson University College of Law and is considering pursuing an LLM in estate planning upon graduation. Eric is also an Articles and Symposia Editor for Stetson Law Review. In 2009, Eric received a B.S. in Business Management from the University of South Florida. His email address is Eric@gassmanpa.com.