We work with a lot of clients who own highly appreciated rental properties, most of which are owned by older couples who do all the maintenance themselves. But when one spouse dies, the other is frequently left unprepared to manage and maintain the properties.
What options are available to surviving spouses when this happens? They can sell the rentals. Or they can keep the properties and hire someone to manage and maintain them. But if they are charitably inclined, they can also gift the rentals to a charity in exchange for a gift annuity. And for the benefit of heirs, they can purchase a life insurance policy to replace the donated assets.
A charitable gift annuity is similar to a charitable remainder trust, except that the charity is responsible for investing the money and guaranteeing the donor a monthly income for life regardless of investment results. With a charitable gift annuity, the surviving spouse can avoid taxes on the sale of the rentals, benefit a charity and receive an income for life.
If, however, the spouse wants to leave the rentals as a legacy to children, then he or she will have to hire someone to manage and maintain the properties until his or her death. Good help is hard to find, and if you find it, it is usually expensive. Besides, the children may have no desire to keep the rentals. They all have their own lives, and if one of them wants to cash out, a sibling conflict may result–which can be worse than not leaving a legacy.
A good way to avoid such conflicts is to gift the rentals to charity and avoid the income and estate taxes on the sale of the rentals. The full amount of the proceeds from the sale of the rentals can then be used to fund a charitable gift annuity.
Often, this gift annuity will provide a monthly income sufficient to provide the surviving spouse with a generous income for life. The annuity will also pay the premiums to replace the value of the rentals with a life insurance policy that will provide a tax-free benefit to the children that they can easily split among themselves.
The end result of this strategy is that everyone is better off. Most importantly, the surviving spouse gets a larger income stream for life than if he or she sold or kept the rentals. The kids get an inheritance that is easily divided free of conflict. The charity gets what’s left from the sale of the rentals after paying the surviving spouse an income for life.
What’s missing here? How can this outcome be better than the other choices? Simple: Uncle Sam is left out of the equation! Let’s look at an example to see how this all works.
Consider a 70-year old woman named Mrs. Smith. Twenty years ago, she and Mr. Smith sold their home for $400,000 and moved into a nice apartment in downtown Gresham, Ore. They used the proceeds to buy a six-plex apartment building. Mr. Smith stayed busy with maintenance and management of the apartments. Mrs. Smith spent most of her time helping the Mount Hood Community College Foundation raise money for scholarships.
Two years ago, Mr. Smith died in his sleep. Mrs. Smith tried to manage the apartment building for a while but found that she didn’t have the necessary skills. Now she has a property management company taking care of the apartments. Given the added expenses and the loss of Mr. Smith’s $3,000 per month pension at his death, the financial situation didn’t look good, and there seemed to be no choice but to sell the apartment building.
Then one day she talked to someone on the Mount Hood Community College Foundation Planned Giving Committee. After working through the numbers, we came up with a solution (see graphic).
In this hypothetical scenario:
If Mrs. Smith were to keep the rentals, she would only net $1,000 per month after expenses to manage and maintain the properties. If she sells them, she will have to pay $246,000 in taxes. The remaining $754,000 would only safely provide $3,140 per month income. And her heirs would only inherit the $754,000 principal left at Mrs. Smith’s death.
If, however, she donates the rentals to her favorite charity, the charity can sell the rentals. And because the charity is tax- exempt, it will not incur the $246,000 in taxes.
Therefore, the charity will have the full $1 million to invest and can guarantee Mrs. Smith $5,417 per month for the rest of her life. With this added income, Mrs. Smith can easily afford the $1,600 per month insurance premium to guarantee $1 million tax-free to her heirs, rather than $754,000 principal if she sold the building.
And to top it off, Mrs. Smith has $3,817 per month in income versus $3,140 if she sold the rentals. Add to this her $1,000 per month Social Security income, and she can live quite comfortably on almost a $5,000 per month income.
Granted, for simplicity, we haven’t calculated the step-up in basis for her husband, nor have we included the tax benefits of the $1 million gift to charity, as they will offset each other to some extent. And as tax laws change over time, one or the other may not even be available in the future.
Mrs. Smith donated her apartment building to Mount Hood Community College Foundation and lived happily ever after knowing that her generous contribution would provide many deserving students with scholarships, and she would be provided with income for life. And, in the end, her children received a tax-free life insurance benefit equal to the value of the rentals, but with much less potential for conflict between their heirs.