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A charitable organization pays $100,000 for a parcel of real estate, borrowing $20,000 to acquire it. The real estate generates rental income of $10,000 during the year. The rental income ordinarily qualifies as passive income excluded from UBTI. Because the $20,000 mortgage is considered acquisition indebtedness, a portion of the rental income will be UBTI. The ratio that the acquisition indebtedness of $20,000 bears to the charity's $100,000 cost basis is 20%. Therefore, 20% of the $10,000 rental income, or $2,000, will be UBTI.
A charitable organization receives a charitable gift of real estate worth $1,000,000. The property is encumbered by a $200,000 mortgage. The mortgage is 15 years old, dating back to when the donor purchased the property. This mortgage amount is acquisition indebtedness to the charitable organization, unless an exception applies. Under the Five and Five rule, an exempt organization will not have acquisition indebtedness on property it received by gift if the debt had been on the property for at least five years and the donor owned the property for at least five years at the time of the gift. Here, the debt was 15 years old and the donor had owned the property for 15 years. Therefore, the charitable organization will not have to treat the property as acquisition indebtedness for 10 years. This will give the organization time to sell the property or pay off the debt within that time period.
Sam plans to create a $2 million non-grantor charitable lead annuity trust (CLAT). The CLAT will have a fixed payout of $100,000 per year for a 10-year term with Sam's children as the remainder beneficiaries. Sam has a choice between two assets he could contribute. First, he has $2 million worth of stock with a $400,000 cost basis. Second, he has a commercial building that he leases. Sam's accountant, Norm, has indicated that the lease payments include a net profits interest and therefore are UBTI.
If Sam funds the lead trust with the stock, the annual annuity payment will consist of dividend income and realized capital gains, totaling $70,000. Because the trust will pay out $100,000 to charity each year, it will be able to deduct the entire $70,000 from its taxable income. If the trust is funded with the commercial building, the lease income of $100,000 will be UBTI. Under Sec. 681, the trust's deduction for amounts paid to charity will be reduced to 50% of the contribution base. Consequently, the trust will pay tax on $50,000 of its annual $100,000 lease income. Therefore, the best result is for Sam to fund the lead trust with the stock.
Navigating the Unrelated Business Income Tax – Part I
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Beneficiary Designations – Part III
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