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Sunday April 20, 2014

Article of the Month

Unprearranged Prearranged Sale

"How can I be sure the real estate sale will be done properly?"

Donors have been asking this question for many years. If a property is transferred into a charitable remainder unitrust, the income to the donor is dependent on the value received from the property. Donors are frequently very appreciative of the charitable work of their favorite organization, but may have doubts about the real estate expertise of that same organization.

The "Prearranged Sale," simply put, exists under state contract law when there is a binding agreement to sell the property. In effect, there is an identified purchaser, an identified price and a legally-enforceable agreement to sell the property. The worst of all circumstances is that case where the donor has a legally binding written contract to sell and has received earnest money or a down payment.

In Private Letter Ruling 9029021, the IRS cited the well-known "Anti-Pomona" Revenue Ruling 60-370 and noted that the ability to bypass capital gain was negated by "an express or implied obligation to sell the contributed property and purchase tax exempt securities." While there certainly would be a reasonable argument that this principle should be limited to sale and reinvestment of tax exempt securities, the IRS has taken a fairly firm and consistent position on the prearranged sale issue. Donors and their counsel are advised to exercise care in this area.

Given this rather "hardline" position by the IRS, is there any latitude for creativity? How close to the sale is too close? Well, it is essential to be certain that the trustee can "pick the purchaser and pick the price." However, it may be possible to have a sale with reasonable safety in a very short period of time, so long as the rules are followed quite carefully. The key is that there is no "binding obligation" when the trust is funded. See Rev. Rul. 78-197, 1978-1 C.B. 83.

Can the charity serving as trustee offer added alternatives to the prospective donor? Depending upon the level of aggressiveness of the donor and his or her legal counsel, it may be possible to move up the risk spectrum and still stay on the correct side of the law. The four possible options include no negotiation, buyer waiting in the wings, a contingent oral agreement and a contingent escrow agreement.

No Negotiation Strategy

The best strategy is for the donor to transfer the property to the charity outright or in trust prior to any negotiations with prospective buyers. Under Rev. Rul. 78-197, there clearly is "no binding agreement" and the charity or trustee may then list the property for sale. After a period of negotiation with various buyers, the property may be sold. This arrangement is clearly within the bounds contemplated by Rev. Rul. 78-197 since there is no "binding agreement" as of the date of the gift.

What if the property has been listed? What if there is an offer on the property? Under the "no binding agreement" test, the listing does not create a binding legal right with respect to a buyer. Although the listing may create a legal obligation to pay a commission to the real estate agent, this is merely a specific cost of the sale and does not cause a ripening of the gain. Therefore, property subject to a listing but not under contract can be transferred into a charitable trust or outright to a charity.

If there has been an offer or multiple offers without acceptance by the seller, once again there is no binding agreement under Rev. Rul. 78-197. Therefore, the mere presence of offers does not preclude transferring the property to a charity or a charitable remainder trust.

Buyer Waiting in the Wings

What if the property has been listed and one or more buyers have made offers near the listing price? Does the ability of the charity to receive the property and quickly sell to an available buyer cause a ripening of the capital gain?

Fortunately, it is permissible to have buyers waiting in the wings. With any luck, there is more than one active potential buyer. Since this is to some extent a matter of practical proof, it is very helpful to show that two or more prospective buyers were waiting in the wings when the property was transferred. If several buyers are vying for the property, there clearly is no binding agreement under Rev. Rul. 78-197.

An excellent strategy to follow with a buyer waiting in the wings is to transfer the property to the charity outright or to the trustee on day one. On day two, the charity or trustee lists the property for sale in an appropriate public newspaper or other venue. On day three, there is no activity. On day four or later, the charity or trustee makes contact with the prospective buyer and both parties sign a sale agreement. If the charity or trustee desires additional safety, it merely can extend the period of time before signing the agreement with the prospective buyer. The purpose of the four-day process is to establish a clear record that there is no binding agreement under Rev. Rul. 78-197.

Contingent Oral Agreement

A more aggressive donor may permit the charity or trustee to explore the potential sale of the property with purchasers prior to the actual gift. The charity or trustee offers property for sale on a contingent basis and discloses that it does not own the property, but if it acquires the property during the future identified period, it is willing to sell the property.

Through the contingent listing, the charity or trustee may find prospective buyers. In some cases, the charity or trustee may even enter into a contingent sales contract with a specific time limitation and an identified buyer.

Under the principles of Palmer v. Commissioner; 62 T.C. 684 (1974) and Rev. Rul. 78-197, there is no binding agreement between the donor and the buyer. In this case, the donor has not met the buyer and has had no contact. Since the donor has no contact with the buyer, there cannot be a binding agreement between the donor and the prospective purchaser.

It should be noted that this strategy has not been tested in Tax Court. It relies on a fairly reasonable interpretation of Rev. Rul. 78-197.

Contingent Escrow Agreement

The contingent sale to a buyer strategy may be taken one step further. The charity or trustee can also enter into an actual contingent escrow. Both the charity or trustee and the prospective buyer complete the customary escrow processes, as though the charity or trustee actually owns the property. However, all parties are under notice that any actions taken are explicitly contingent upon the charity receiving the property. A few days before the anticipated closing, the donor then gives the property to charity outright or in trust. In two to five days, the property is sold and proceeds are available to the charity or trustee.

Once again, this strategy has not been tested in Tax Court. However, the donor has no contact with the buyer. Therefore, the donor may reasonably maintain that there is "no binding obligation" between the donor and prospective buyer. Because there is no obligation for the donor to make the gift to the charity, this transaction passes the test of Rev. Rul. 78-197.

Your Aggressiveness Temperature?

What is your aggressiveness temperature? These strategies move from the reasonably safe to the very aggressive. While each donor and his or her counsel must make the decision, the preferred choice is always to seek the safest course of action that will result in a completed gift. At some point, the charity may for policy reasons decline to serve as trustee if the course of action is deemed too aggressive. Most legal counsel tend to prefer the less-aggressive strategies, but recognize that there are some circumstances in which organizations may wish to consider the more aggressive approaches. While it is probable that even the most aggressive approach will be victorious in Tax Court or Federal District Court, many donors and charities are not willing to run that level of risk.

Nevertheless, having a clear understanding of the various rules concerning prearranged transactions is essential for all gift planners and professionals who are advising donors. This decision should appropriately be made by the donor, based on a reasonably accurate quantification of the risk levels by his or her professional tax advisor. While most donors will also choose the safer strategies, it is fundamentally the prerogative of the donor to have the available information and make the decision.

Published April 1, 2014

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