For many donors, the most significant part of their net worth is real estate. Thus, donors regularly make real estate charitable gifts. As a general rule, many charities prefer gifts of cash, stocks and bonds because these types of gifts are easy to transfer, value and liquidate. In contrast, gifts of real estate may bring legal and financial liability that gives rise to numerous issues the charity must navigate.
Real estate is a unique asset and each gift must be properly tailored to the property and the donor's expectations, while protecting the charity from any issues that may arise. Charities and donors must ensure they are informed about the benefits and pitfalls of gifts of real estate.
This series about gifting real estate will discuss the definition of real estate, charitable deductions for real estate gifts, charitable gift options and some best practices. This article will discuss the different ways to structure real estate gifts.
Structuring Real Estate Gifts
Gifts of real estate can be excellent assets to donate to charity. In general, a donor may experience heightened tax benefits by gifting real estate, rather than donating the cash proceeds from a sale of real estate. Gains may be bypassed or avoided if real estate is gifted to charity prior to a sale. If a donor donates the cash proceeds from a real estate sale, the donor will be taxed on the gain from the sale of appreciated real property. Part I of this series touched on the prearranged sale rules. If the IRS deems a transaction a prearranged sale, the donor will not bypass the gain.
There are several ways a donor can structure a charitable transfer of real estate to charity, each with differing benefits and risks for the charity and donor. The major gift vehicles for contributing real estate to charity are discussed below.
i. Outright Gift
In its most basic sense, an outright gift is a transfer of the donor's interest in property to the charity. An outright gift of real estate has two major benefits for the donor. Assuming the real property is a long-term capital asset, the most favorable tax benefits will be realized when the property is contributed to charity. The donor avoids capital gains tax on the portion of the property contributed to charity and generally receives a fair market value (FMV) charitable deduction.
John owns a rental home valued at $1 million that he bought for $200,000 many years ago. John's income tax rate is 37% and his capital gains tax rate is 23.8%. He asks his financial advisor what the tax benefits would be if he gifted the rental home outright to a charity. His financial advisor informs him the capital gains will be bypassed and he will receive an income tax deduction equal to the value determined by a qualified appraisal of the property.
If John were to sell the rental home at its FMV, he would realize $800,000 in capital gains. At his 23.8% tax rate, he would owe $190,400 in capital gains tax. By contributing the rental home outright to charity rather than selling and donating the cash proceeds, John bypasses $190,400 in capital gains tax. John also will receive an income tax deduction of $1 million. At his 37% income tax rate, the charitable contribution will generate an income tax savings of $370,000. John is pleased with the combined tax savings of $560,400 and moves forward with donating his rental home to his favorite charity.
In general, for a charitable gift of real estate that has been held for longer than one-year, the charitable deduction will be the fair market value as determined by a qualified appraiser. If the property has been held for less than one-year or the property is an inventory-type asset, the donor's deduction will be limited to the lesser of cost basis or fair market value. In practice, the lesser of these two is most often the cost basis.
When a real estate (held for over one year) gift is made to charity, the deduction may be applied up to 30% of the donor's adjusted gross income. Any unused deduction exceeding the deduction limit may be carried forward for an additional five years. Including the year of the gift, that gives the donor up to six total years to take the deduction, if it must be carried forward.
Donors should be aware that with a gift of a partial interest in property, the appraised fair market value may be discounted to reflect a minority interest lacking marketability. If this is the case, a qualified appraiser will determine the discount to the value to charity, thus reducing the charitable deduction.
Another form of an outright gift is a combination of a gift and subsequent sale of the property. The donor transfers a portion of the real estate to a charity and retains the remaining portion. After the gift, the donor and charity sell the property with the proceeds apportioned appropriately. If structured carefully, the transfer may result in a zero-tax sale for the donor.
Martha owns real estate valued at $1 million that she purchased for $500,000 over a year ago. Her income tax rate is 32% and her capital gains tax rate is 18.8%. She would like to sell her home and make a gift to a charity, but would like to minimize any income and capital gains tax related to the sale. Martha's tax advisor informs her that if the portion contributed to charity is properly apportioned, the income tax deduction can offset her capital gains tax. The tax advisor recommends Martha follow his plan set below to generate a zero-tax sale.
Prior to the sale, Martha donates 22.71% or $227,060 of the property to charity. The remaining $772,940 is retained and sold. The property is then listed for sale jointly by the charity and Martha and transferred to a third-party buyer. The outright contribution valued at $227,060 results in an income tax deduction, creating a tax savings of $72,659 based on Martha's 32% income tax bracket. The capital gains bypass on the charity's portion will save $21,344 based on Martha's 18.8% capital gains rate. The sale of the retained portion of the property valued at $772,940 results in a taxable gain of $386,470. Martha's 18.8% capital gains tax rate generates $72,656 in capital gain taxes. However, the tax on the gain is offset by the income tax savings of $72,659, leaving a net benefit to Martha of $3.
Therefore, the net to Martha is the $772,940 cash from the sale, minus the tax on the gain of $72,656, offset by the $72,659 from the tax savings, for a total of $772,943. Compared with the sale of the entire asset, Martha reduces her taxes and makes a gift of $227,060. The advisor explains that the $227,060 charitable deduction may only be taken up to 30% of her AGI for the year, but any unused charitable deduction can be carried forward for an additional five years. She may not realize a zero-tax sale in the year of the sale, but it likely will be realized within six years.
Despite the benefits for donors, as with all gifts of real estate, charities must be aware of the risks associated with accepting real property outright. The charity is added to the chain of title which can raise environmental risk liability under CERCLA. Charities must ensure the risks are outweighed by the financial benefits.
ii. Bargain Sale
A bargain sale occurs when a donor transfers property to a charity and receives less than the fair market value in return. The donor's charitable gift is the fair market value less the cash value received by the donor. The donor receives a charitable deduction and avoids capital gain taxes on the amount of the donated portion, but must recognize taxable gain on the cash payments to him or her. The donor's basis will be allocated between the donated portion and the sale portion.
Alex owns property that he has agreed to sell to a charity. He purchased the property two years ago for $50,000 and it was recently appraised at $250,000. Alex is in the 32% income tax bracket and the 18.8% capital gains tax bracket. The charity has agreed to purchase the property for $100,000. Alex asks his financial advisor how the sale will be taxed. The advisor informs Alex that this is a bargain sale. The charitable deduction is the difference between the FMV and the sale price. Thus, Alex will have an income tax deduction of $150,000. At the 32% bracket, Alex will save $48,000 in income tax.
However, the advisor informs Alex that capital gains will be due on the sale portion of the transfer. Alex has a gain of $80,000 based on the allocated basis amount of $20,000 and the $100,000 purchase price. At Alex's 18.8% capital gains rate, he will owe $15,040. The income tax savings of $48,000 will offset the capital gains tax owed of $15,040, resulting in a net benefit of $32,960. In total, Alex receives $100,000 from the sale, donates $150,000 to the charity and has a net tax savings of $32,960.
iii. Installment Bargain Sale
An installment bargain sale occurs when the charity pays the donor in a series of payments covering more than one-year, rather than a lump sum. Structuring a bargain sale with a series of installment payments is beneficial for both the donor and the charity. The donor is able to receive an income stream for the term of the agreement, while also spreading out the capital gains. An installment structure allows the charity to spread out the payments rather than owing a lump sum.
Eric is a longtime supporter of his favorite charity. He owns land near the charity's main office that the charity is interested in purchasing from Eric to expand its operations. The land is valued at $1.6 million, Eric is interested in receiving cash out from the property. The land was purchased years ago at a value of $400,000. When Eric heard of his favorite charity's plans to expand its footprint, Eric reached out in the hopes he may be of help. He intended to make a major gift to charity of $1 million in support of his favorite charity's mission. Eric and the charity agreed to enter into a bargain sale for the land for $600,000. Charity's board requested the option of a bargain sale with a 10-year installment note. This structure was beneficial to Eric because his capital gain realization will occur over the course of the term of the note.
Eric receives an income tax deduction of $1 million, which is the difference between the fair market value of the land and the purchase price. Based on his allocated basis of $150,000, Eric has capital gains of $450,000 over the 10-year term on the sale portion of $600,000. Under the 10-year installment note, the charity will make annual payments of $60,000 plus interest over the term of the note. The structure of the installment bargain sale allows the charity to begin expansion on the newly acquired property. In total, Eric satisfied his desire to donate $1 million, received a partial bypass of capital gain and transferred his land to charity.
There are many different models to gift real estate, each with their own different benefits. Real estate gifts can be structured to satisfy the expectations of both the donor and the charity. This article discussed the major gift vehicles for real estate gifts. There are many gift models that may satisfy the goals and motivations of every donor wishing to contribute real estate. December's Article of the Month will discuss a few of the planned gift vehicles for transferring real estate to a charity or a charitable trust.