Vogeler, Alan R.

English

Case Western Reserve University School of Law

Case Western Reserve Law ReviewVolume 11 | Issue 21960Tax Problems Incident to Family Planning withReal EstateAlan R. VogelerFollow this and additional works at: https://scholarlycommons.law.case.edu/caselrevPart of the Law CommonsThis Symposium is brought to you for free and open access by the Student Journals at Case Western Reserve University School of Law ScholarlyCommons. It has been accepted for inclusion in Case Western Reserve Law Review by an authorized administrator of Case Western Reserve UniversitySchool of Law Scholarly Commons.Recommended CitationAlan R. Vogeler, Tax Problems Incident to Family Planning with Real Estate, 11 Wes. Res. L. Rev. 258 (1960)Available at: https://scholarlycommons.law.case.edu/caselrev/vol11/iss2/15WESTERN RESERVE LAW REVIEWTax Problems Incident To Family PlanningWith Real EstateAlan R. VogelerGIFTSThe same considerations which govern all family tax planningare applicable also to planning with real estate. In the usual familysituation the mother and father together have an income greater thanthat of their offspring. Because of the progressive income tax rates,the more that income is spread among a number of taxpayers, thelarger will be the amount left in the family for personal use.Three federal taxes, namely, the income tax, the estate tax, andthe gift tax, are involved infamily tax planning. If a hus-THE AUTHOR (A.B., 1938, Kentucky, LL.B., band gives to his wife income-1940, Kentucky, LL.M., 1941, Michigan) is a producing property with aCincinnati attorney and instructor in Taxation,Salmon P. Chase Law School. value of $66,000 or less, andif he has made no previoususe of his lifetime gift tax ex-emption,' no gift tax will be incurred upon such transfer. But sucha gift will result in no savings of income tax because the income fromthe property will be reported on a joint return with the husband.Whether or not such a gift would save federal estate tax depends up-on the interrelation between the husband's estate and the wife'sestate.Assuming that the husband and wife do not have need for theincome from the particular property, a gift of the property by thehusband to his children could also avoid gift tax, could eliminate es-tate tax on the property in the husband's estate, and would probablysave a considerable amount of income tax. If there is a third gener-ation, the gift might take the form of a life estate to the childrenwith the remainder to the grandchildren, and thereby avoid a secondgeneration of estate taxes.If the donor has used up his lifetime exemption and is in a highgift tax bracket so that he hesitates to make large gifts, he can stillgive valuable real estate whose present value is not reflected in thegift. If the donor owns a building worth $200,000, he could form afamily corporation with preferred stock of $175,000 (with a lowpreferred dividend, if earned) and common stock of $25,000, andtransfer the building to the corporation in return for all of the stock.The common stock could then be transferred outright to the children1. INT. REv. CODE Oi 1954, §§ 2521, 2523(a).[AawhFAMILY PLANNING WITH REAL ESTATEand grandchildren. These gifts of common stock totaling $25,000would result in no gift tax if there were five or more donees and ifthe donor's wife consented to "split" the gifts. 2 Gifts of the preferredstock could later be made within the annual exclusions, probably with-out encountering any problem as to the value of such stock. Mean-while, future increases in the value of the building would redound tothe benefit of the common shareholders, rather than to the donor(the preferred shareholder).The foregoing technique achieves somewhat the same purpose asplacing a mortgage on the property. For example, the owner of the$200,000 property might mortgage it for $150,000. He could keepthe proceeds of the mortgage in his own pocket and transfer theproperty to his children and grandchildren, who would assume themortgage. The net worth of the building in their hands would be$50,000, but their basis for depreciation would be $200,000. Themortgage of $150,000 could be paid off in future years out of thedepreciation reserves, which are deductible from the income eachyear. Through this method the donees would eventually own a$200,000 investment and the donor would have retained $150,000.A similar saving could be achieved through a sale of the real es-tate. Assume the basis of the property to the father is $100,000 andits value is $200,000, of which $40,000 is attributable to the landvalue and $160,000 to the building. The father could sell the prop-erty for its fair market value to the children for a small downpay-ment, with the balance being secured by a mortgage. The deprecia-tion deduction would furnish the children a sufficient amount ofmoney to pay to the father over a period of time most of the balanceof the purchase price.If the father donates the entire property, he will, of course, incurgift taxes, but the basis of the property in the hands of the donee willinclude not only the donor's basis, but also the amount of gift tax paidby the donor with respect to the gift.3 If the terms of the gift requirethe donee to pay the gift tax, then the value of the gift will be re-duced by the gift tax payable with respect thereto, which, in turn, willreduce the gift tax.4If the building has a basis of $100,000 and the father sells it for$200,000, the sale by him would result in a maximum capital gainstax of $25,000 and would leave him $175,000 available for gifts.Assuming that there were $36,000 worth of annual exclusions avail-able for the donor's two children and four grandchildren (assuminga "split" gift), the gift to them of $175,000, after deduction of theexclusions, would result in a gift tax of 24 per cent in the $250,000to $500,000 gift tax bracket, or approximately $35,000. This means2. INT. REV. CoDEp o 1954, S§ 2503(b), 2523(a).3. INT. R.V. CODB op 1954, § 1015 (d).4. S. H. Harrison, 17 T.C. 1350 (1952).1960]WESTERN RESERVE LAW REVIEWthat the total tax cost of transferring to the children and grandchil-dren the net proceeds from the sale of the building would be $60,000.Further, the basis of the money in the hands of the children could notbe increased because the gift tax paid could not be used to increase thebasis to an amount in excess of fair market value.5If, instead of selling such building, the donor gave it to his twochildren and four grandchildren, his gift tax in the 24 per cent bracketwould be $39,360, all of which could be added to the $100,000 basisof the children and grandchildren. Their basis would then be $139,-360, and the subsequent sale of the building by them for $200,000would result in a profit of $60,640 and a maximum capital gains taxof $15,160 (approximately $2,527 of which would be payable byeach child and grandchild). Adding this tax to the $39,360 gift taxpaid by the donor, a gift of the building prior to the sale would resultin a maximum tax of $54,520. The result of donating the buildingprior to its sale, rather than selling it and donating the net proceeds,would be a minimum family saving of $5,480.The saving may be substantially greater if the four grandchildrenhave no income other than the profit on the sale. One-sixth of thetotal profit paid to each grandchild would give him $10,100 of in-come. Of this amount $5,050 would be a capital gain deduction,leaving as his adjusted gross income $5,050, from which the grand-child could deduct the $500 optional standard deduction and the $600personal exemption. The net taxable income of each grandchild thenwould be $3,950, the income tax on which is $829. This would be anadditional saving of approximately $1,700 per child, compared tothe $2,527 maximum capital gain tax previously mentioned, or $6,800further saving to be added to the $5,480 minimum tax saving avail-able in this family situation. Even greater tax savings might beachieved if the children and grandchildren sell on an installment salebasis.6SALESSales at less than fair market value between family members re-sult in gifts.' However, it may not be the intention of the seller inselling property to a family member to make a gift and, therefore,it is advisable to know prior to the sale what the fair market valueof the property is. When property is sold by one family member toanother family member at what an independent real estate appraiserindicates to be its fair market value at the time, this in itself shouldnegate the existence of a donative intent on the part of the seller.Interesting questions are raised when the consideration paid by5. INT. REv. CODE OF 1954, § 1015 (d).6. Seep. 222.7. INT. REV. CODi OF 1954, § 2512(b); I.T. 3335, 1939-2 CuM. BULL. 193; and see Reg-inald Fincke, 39 B.T.A. 510 (1939), wonacq., 1939-1 CuM. BULL. 47.[Mar&cFAMILY PLANNING WITH REAL ESTATEa son or daughter to a parent for the transfer of the property iseither an agreement to support the parent for life or an agreementto pay a fixed dollar amount as an annuity. The case of SarahBergan' provides the ground rules covering this type of situation.Sarah was seventy-four years old when the older of her two sistersdied leaving a net estate of $220,000 to each surviving sister. Sarahagreed with her other sister, Margaret, that Sarah would take only$50,000 of the $220,000 left her by the decedent and would transferthe other $170,000 to Margaret, if Margaret would take care ofSarah for the rest of her life. At Sarah's death, the Commissionerclaimed that the transfer of the $170,000 balance of decedent's es-tate to Margaret was a taxable gift by Sarah and, in addition, thatthe gift was made in contemplation of death, so that the propertytransferred was includable in Sarah's estate. The Tax Court foundthat the value of the agreement to support Sarah, who at the timethe deal was made had a life expectancy of 6.86 years, was $32,400.The court held that the transfer was not made in contemplation ofdeath, but that the excess of the amount transferred over the fairmarket value of the consideration constituted a taxable gift.The value of an annuity can usually be determined. The Com-missioner has published tables which specify the value of annuitiesreceivable at various ages.9 However, there is a problem in deter-mining what amount of yearly support would be required where theannuity contract between parent and child calls for "support," ratherthan for fixed amounts. Further, the obligation of an individual topay an annuity is probably not as valuable as a similar obligation ofan insurance company. Thus, there might be a gift if the sameamount were paid for a private as for an insured annuity.If property is sold to a controlled corporation for use by the cor-poration in subdividing, the corporation will realize ordinary incomewhen the property is sold, but the original seller may well have capi-tal gain. In this connection the case of Aqualane Shores, Incorpo-rated v. Commissioner is important." In that case a father and histwo sons created a real estate development corporation and trans-ferred to it for $250,000 property that they had acquired for$69,000 the year before. The corporation, which had capital ofonly $9,600, paid $9,000 down to the sellers, and agreed to pay thebalance in five annual installments. The corporation proceeded tosubdivide the real property but never made any further payments onthe purchase price. The Tax Court, which was affirmed by theCourt of Appeals for the Fifth Circuit, held that: (1) the transferto the corporation actually constituted a nontaxable exchange, (2)8. Estate of Sarah A. Bergan, 1 T.C. 543 (1943).9. Treas. Reg. § 21.72-9 (1956).10. 269 F.2d 116 (5th Cit. 1959), affirming 30 T.C. 519 (1958); see also James RealtyCo. v. Commissioner, 176 F. Supp. 306 (D. Minn. 1959).1960]WESTERN RESERVE LAW REVIEWthe stock had been issued for the property, (3) there was no gain orloss to the sellers, (4) the basis to the corporation was, therefore,the original $69,000 purchase price, and (5) the income received onsubdivision by the corporation (to the extent it exceeded $69,000)was all ordinary income.Where a transferee of property is to derive ordinary income fromits subsequent sale, a nontaxable exchange should be avoided; other-wise, the transferee will have to use the transferor's low basis. Suchan exchange was avoided in the recent case of Crosby Company ofBeaumont v. United States." In that case nine children owned realproperty as residuary beneficiaries of their deceased father's trustestate. All but one of the beneficiaries were married, and when theysubscribed for the stock of a corporation formed to acquire the realty,the shares, under Texas law, were community property owned one-half by the spouses of the married beneficiaries. Following incorpo-ration, the real estate was sold to the corporation by the nine indi-vidual beneficiaries for $1,000,000, of which only $5,000 was paidin cash and the balance was represented by installment notes payableover 20 years. This sale resulted in a long-term capital gain to thebeneficiaries of the trust of $850,000. The court held that since thestock of the corporation was owned by 17 persons (under communityproperty laws), whereas the real estate had been held by nine per-sons, the persons who transferred the property to the corporationwere not in control of the corporation immediately after the transferand, therefore, the transaction did not constitute a nontaxable ex-change.It has previously been noted that if various phases of a subdivi-sion development are performed by different taxable entities, tax sav-ings may be obtained through the use of multiple surtax exemptions. 2Yet, this path is not without any danger. For example, in George K.Heebner, Jr.,'3 the petitioner was an architect, builder, and contractorwho received substantial income from 1949 through 1952 from thecontracting and building business. In 1951, learning that Nash-Kel-vinator needed a warehouse near Philadelphia, Heebner found landsuitable to Nash-Kelvinator, acquired an option on it, arranged forprospective construction loan financing from a bank, and found aninsurance company which would purchase the property upon comple-tion if Nash-Kelvinator would take a long-term lease. Heebnerbought the land in his own name and then contracted with his con-struction company to build the warehouse. Nash-Kelvinator agreedto lease the warehouse upon its completion. All of the formal agree-ments were executed after Heebner had obtained commitments from11. 1959-2 U.S. Tax Cas. 5 9669 (E.D. Tex. 1959).12. See note 41, p. 152.13. 32 T.C. No. 109 (Sept 10, 1959). See also Rev. Rule. 59-345, 1959 INT. REv. BULL.No. 42, at 9; and see note 59, p. 184.[MarhFAMILY PLANNING WITH REAL ESTATEall interested parties. The Tax Court held that the profit on the saleby Heebner to the insurance company was ordinary income from thesale of property held by him primarily for sale to customers in theordinary course of his trade or business.This was a case where, in effect, all of the steps were taken atone time. The real estate developer did not acquire title to the prop-erty until he knew that it could be sold after a warehouse had beenbuilt thereon. While Heebner avoided any risk of loss by arrangingthe package deal before expending any money, by doing so he in-curred ordinary income tax on the sale of the property. It appearsobvious that if capital gain is desired upon a sale, the property mustbe acquired before definite commitments for a subsequent sale havebeen made.When real property is sold to a corporation controlled by theseller (or to the seller's wife or minor children) and the property isleased back to the seller, care must be taken to provide for fair andreasonable sale price and rentals. 4 There are numerous cases inwhich courts have held that the payment of rents for property whichcould have been purchased for less than the rentals was merely a taxminimization device and that the rents were not deductible expensesof the property owner, but were dividend distributions to the extentof earnings.1"However, when the rent is reasonable, even if on a percentagebasis, and the sale price is at fair market value, the transaction willbe allowed.' This is true even if the transfer is to a trust for thebenefit of the wife or children of the grantor.'714. See note 3, p. 202.15. See, for example, Wade Motor Co. v. Commissioner, 241 F.2d 712 (6th Cir. 1957),affirming 26 T.C. 237 (1956); Kirschemann v. Westover, 225 F.2d 69 (9th Cir. 1955); W.H. Armston Co. v. Commissioner, 188 F.2d 531 (5th Cir. 1951); Riverpoint Lace Works,23 P-H Tax Ct. Mem. 465 (1954).16. Consolidated Apparel Co. v. Commissioner, 207 F.2d 580 (7th Cir. 1953); Estate ofFrederick W. Sullivan, Sr., 20 P-H Tax Ct. Mem. 692 (1951); Henry G. Bender, 16 P-HTax Ct. Me,. 365 (1947).17. A. A. Skemp v. Commissioner, 168 F.2d 598 (7th Cir. 1948); J. T. Potter, 27 T.C. 200(1956); Albert T. Felix, 21 T.C. 794 (1954); see also Stanley Imerman, 7 T.C. 1030 (1946).19603

Tax Problems Incident to Family Planning with Real Estate

https://scholarlycommons.law.case.edu/cgi/viewcontent.cgi?article=3846&amp;context=caselrev

Tax Problems Incident to Family Planning with Real Estate

Abstract

Similar works

Full text

Available Versions

Case Western Reserve University School of Law