Article of the Month

Introduction

There are many advantages to owning a home. Homes often appreciate over the years, providing stable growth and equity ownership. Over time, however, family and financial circumstances change and the benefits of owning a home may no longer be needed. In such cases, homes can be excellent assets to donate to nonprofits. By gifting a home to a nonprofit, donors may bypass or avoid capital gains taxes. Additionally, gifts of interests in homes can also be structured to allow donors to continue living on the property or to provide income.

In this series, we will explain the rules surrounding gifts of homes to nonprofits for charitably minded homeowners. The first installment will review charitable deductions for gifts of homes as well as charitable gifts involving outright gifts and life estates. The second installment will discuss the benefits and common issues of using homes for charitable gift annuities and charitable remainder trusts.

Determining the Deduction

An outright gift of a home provides an income tax deduction equal to the fair market value if the home has been owned for more than one year. Generally, the donor’s charitable deduction for gifts of appreciated property (including real estate) is limited to 30% of the donor’s adjusted gross income (AGI), with a potential carry forward up to five additional years. Sec. 170(b)(1)(C). This AGI limitation may prevent a donor from taking the entire charitable deduction amount in the first year, but the five-year carry forward gives the donor the opportunity to spread the deduction over a total of six years.

The donor may elect to deduct the cost basis of the appreciated property at 50% of his or her AGI. This is a helpful option for a donor who desires to make a large gift of real estate that has a high basis. The 50% AGI deduction limitation may also allow the donor to take the entire deduction in the year of the gift, rather than carrying it forward, which is useful if the donor does not expect to have significant income in the following years.

Gifts of appreciated property to private foundations are regulated more stringently than gifts to public charities. If the donor chooses to donate a home to a private foundation, the deduction is limited to cost basis. Sec. 170(e)(1)(B)(ii). The gift to a private foundation of appreciated property is also limited to 20% of AGI. Sec. 170(b)(1)(D). If the gift exceeds the 20% limit, the excess may be carried forward for up to five years. Sec. 170(b)(1)(B)(ii).

Substantiation

As with any charitable deduction, the substantiation rules must be strictly followed. Because a gift of real estate will likely exceed $5,000, the donor should request a contemporaneous written acknowledgment from the charity at the time of the contribution, obtain a qualified appraisal and file IRS Form 8283. Reg. 1.170A-16(d)(1).

Advisors should also keep in mind that, if a nonprofit sells a home within three years of the date of the gift, then the nonprofit is required to complete and file IRS Form 8282 which reports the sale price of the property. A failure to file Form 8282 or provide a copy to the donor may subject the nonprofit to a penalty. If the sale price of the property is substantially less than the amount of the claimed deduction, then the donor may risk triggering a tax audit.

Outright Gift

An outright gift is a transfer of the donor’s entire interest in the property to a nonprofit. An outright gift of a home has major benefits for the donor, including a fair market value charitable deduction and removing the property from the donor’s estate for estate tax purposes. There are also valuable capital gains tax benefits. Assuming the real property is a long-term capital asset, the donor avoids capital gains tax on the portion of the property contributed to the nonprofit. While donors who have lived in their home for at least two years out of the prior five years may exclude $250,000 in capital gains ($500,000 for married couples filing jointly), owners may still encounter significant capital gains taxes on homes they have held for an extended period.

A vacation home or vacation rental can also be a good fit for an outright gift. If the property was otherwise sold, the entire gain would be subject to capital gains tax since no exclusions apply. By donating the property outright, the donor avoids capital gains taxes at either the maximum rate of 23.8% (20% plus the 3.8% surcharge for net investment income) or the portion attributable to straight-line depreciation that is recaptured and taxed at a maximum rate of 28.8% (25% plus 3.8%). Since accelerated depreciation is recaptured as ordinary income and an ordinary income asset gift is not deductible, the deduction would be reduced by the difference between the amount of depreciation and accelerated depreciation, if any, claimed by the donor. Sec. 1250.

An outright gift of a home is generally accomplished by transferring a properly executed and notarized deed to the nonprofit. While it is important that the nonprofit records the deed as soon as possible, the gift date is usually the date the deed is delivered to the nonprofit. To avoid confusion as to the timing of the charitable deduction, it is best if the delivery and recording of the deed occur in the same tax year.

If the nonprofit plans to sell the property after it is donated, it is important that the donor contributes the property without making any sales commitment to a third party since this could create a prearranged sale. A prearranged sale occurs when there is a binding obligation of the nonprofit to sell the home to a buyer prior to the transfer of the asset to them. Rev. Rul. 78-197, 1978-1 C.B. 83. The safest strategy is for the donor to transfer the property to the nonprofit outright or in trust prior to any negotiations with prospective buyers. If the nonprofit has complete control over picking the buyer and setting the sales price, the donor can safely proceed. If the IRS finds that a prearranged sale has occurred, the donor forfeits any bypass of capital gain and must realize the income gained in the transfer to the nonprofit.

Gift and Sale

Another form of an outright gift is a combination of a gift and sale of the property. With this gifting method, the donor transfers a portion of the real estate to a nonprofit and retains the remaining portion. After the gift, the donor and nonprofit then jointly sell the property with the proceeds apportioned according to the ownership interests. If structured carefully, the transfer may result in a zero-tax sale for the donor.

While a donor is generally not eligible for a charitable deduction when gifting a partial interest, there is an exception for giving an undivided fractional interest in property. An undivided fractional interest in property is an undivided portion of a donor’s entire interest in property. Sec. 170A-7(b)(1). Thus, a gift and sale combination qualifies for a charitable deduction on the portion gifted to the nonprofit. If a donor wants to gift a home but retain other rights to the property, such as mineral rights, this would be considered a gift of only a partial interest and would not be eligible for a charitable deduction.

Example

Nancy owns her home valued at $1 million that she purchased for $300,000 many years ago. With her $250,000 homeowners’ exclusion, her adjusted basis is $550,000. She would like to sell her home and make a gift to her favorite nonprofit but would like to minimize any income and capital gains tax related to the sale. Nancy’s advisor informs her that, if the portion contributed to the nonprofit is properly apportioned, then the income tax deduction can offset her capital gains tax.

Nancy donates 22.45% or $224,490 of the property to the nonprofit. The remaining 77.55% or $775,510 is retained. The property is then jointly listed for sale by the nonprofit and Nancy and eventually sold to a third-party buyer. The outright contribution of $224,490 results in income tax savings of $83,061. The sale of the retained portion of the property valued at $775,510 results in a taxable gain of $348,979, resulting in a capital gains tax of $83,057. The tax on the gain, however, is offset by the income tax savings of $83,061, leaving a net benefit to Nancy of $4.

Compared with the sale of the entire asset, Nancy reduces her taxes and makes a gift of $224,490. The advisor explains that she can claim the $224,490 charitable deduction 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 will likely be realized within the allowed six years.

When considering a gift of a partial interest in property, donors should be aware that the appraised fair market value may be discounted to reflect a minority interest for lack of marketability. If this is the case, a qualified appraiser will determine the discount, thus reducing the charitable deduction. Rev. Rul. 87-37.

Bargain Sale

A bargain sale occurs when a donor transfers property to a nonprofit 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. This is an effective strategy for a donor who wants to donate property but would like to receive some cash back. 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 received. The donor’s basis will be allocated between the donated portion and the sale portion.

When there is a mortgage on the property, the transfer is treated as a bargain sale. If the donor gifts property encumbered by debt to a nonprofit, only the donor’s equity in the property will qualify for a charitable deduction. A donor may not claim a deduction for the debt-encumbered portion of the property. From the nonprofit’s perspective, a gift of property with a mortgage may cause it to have debt-financed income and the charity will have to pay unrelated business income tax (UBIT) if sold. This can be avoided, however, if the nonprofit’s use of the land is substantially related to its exempt purpose. Sec. 514(b)(1)(A). For instance, a university may intend to use the acquired property for teaching facilities. This rule will also not apply for the first ten years if the debt is non-recourse (in other words, the creditor can only satisfy the debt against the property), the donor owned the real estate for more than five years and the debt was placed on the property more than five years prior to the gift. Sec. 514(c)(2)(B).

It is important for a donor to understand that the transfer of debt-encumbered property to a nonprofit will be considered as a “release of indebtedness” to the donor. Reg. §1.1011-2(a)(3). This relief of indebtedness triggers gain to the extent that the debt exceeds the allocated cost basis. This taxable event will occur even if the nonprofit does not agree to assume or pay the indebtedness or if the donor agrees to pay off the debt after the gift. The amount of debt the donor is relieved from paying must be reported by the donor as capital gain in the year the gift is made. While the donor’s charitable deduction may offset some or all the taxes due, the possible taxation is an important consideration to note when speaking to donors about gifts of debt-encumbered property.

Example

Max inherited a home from his parents many years ago that is currently worth $600,000, but which still has a mortgage of $200,000. When Max received the home, it was valued at $300,000, thus he has a cost basis of $300,000. Max no longer wants the upkeep and maintenance of the home, so he deeds it to his favorite nonprofit in exchange for payment of $200,000 (the sale or “debt-relieved” portion).

Since the excess of the fair market value over the price paid is $400,000, Max receives a charitable deduction of $400,000 which saves him income tax of $148,000. The gift portion has an allocated basis of $200,000 with a potential gain of $200,000. By giving a portion to charity, Max bypasses the capital gains of $200,000 which saves $47,600 in capital gains tax. The sale portion has an allocated basis of $100,000 with a gain of $100,000. The tax on this gain is $23,800. This amount, however, is offset by the tax savings on the gift portion. Thus, Max has made a gift to the nonprofit while enjoying net tax benefits.

Installment Bargain Sale

In cases where the nonprofit is financially unable to make a large lump sum payment, an installment bargain sale may be a viable option. An installment bargain sale occurs when the nonprofit 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 can be beneficial for both the donor and the nonprofit. The donor receives an income stream for the term of the agreement while also spreading out the capital gains. The donor could also structure larger payments for later years under the contract and continue to live on the property.

Example

Juan purchased his home many years ago for $400,000 and it is now valued at $1.6 million. Juan would like to make a major gift of $1 million to the mission of his favorite nonprofit. Juan and the nonprofit agreed to a bargain sale for $600,000. The nonprofit’s board requested the option of a bargain sale with a 10-year installment note. This structure was beneficial to Juan because his capital gain realization will occur over the course of the term of the note.

Juan receives an income tax deduction of $1 million, which is the difference between the fair market value of the property and its purchase price. On the $600,000 sale portion, Juan’s basis of $400,000 ($150,000 of original allocated basis plus $250,000 homeowner exclusion) results in capital gains of $200,000 over the 10-year term on the sale portion of $600,000. Under the 10-year installment note, the nonprofit will make annual payments of $60,000 plus interest over the term of the note. The structure of the installment bargain sale allows the nonprofit to begin expansion on the newly acquired property. Juan is pleased that he has made a significant donation to his favorite nonprofit and received a partial bypass of capital gain.

As discussed above regarding mortgages, an installment bargain sale could cause a home to be treated as debt-financed property in the nonprofit’s hands. Consequently, the home could generate UBIT to the nonprofit if it is not used for the nonprofit’s tax-exempt purposes.

Life Estate

A retained life estate allows the donor to continue to live in his or her home while donating the remainder interest to a nonprofit. In this scenario, there is an irrevocable transfer to the nonprofit of the donor’s remainder interest in a personal residence while the donor retains the right to use the property for life, lives or a term of years. Sec. 170(f)(3)(B)(i). The donor is entitled to take an income tax deduction for the present value of the remainder interest. Because this is a non-cash property gift of over $5,000, a qualified appraisal is required to determine the value of the residence for income tax purposes. A life estate allows the donor the right to reside in and utilize the property for their lifetime, regardless of whether they decide to reside in a different location.

The property used to create the life estate must be either a personal residence or a farm. A personal residence includes any property used by the taxpayer as a personal residence even if it is not a principal residence. Reg. 1.170A-7(b)(3). Thus, a taxpayer’s vacation home may meet the definition of a personal residence. A yacht, houseboat or trailer may also be a personal residence provided it contains cooking, sleeping and sanitation facilities and the donor uses it as a residence.

Example

Kai has resided in his modest home on a four-acre lot for many years. He is now 80 and his IRA distributions continue to increase. To create a charitable deduction to offset his increased taxable income, Kai is contemplating transferring the remainder in his home to charity. With his IRA and other assets, he has substantial liquidity and will not need the value of the home for living expenses.

Kai decides to deed the remainder interest in the home to his favorite nonprofit. Based upon his age, he receives a charitable deduction of $312,580. This deduction is an appreciated-type deduction usable to 30% of AGI and can save Kai $115,655 in income taxes. The deduction is calculated based on the property’s total value of $500,000, of which $150,000 is for the home and $350,000 is for the land. While it is unusual for such a modest residence to be on expensive land, Kai has lived in his home for many years and the adjoining city has now developed all around his home, substantially increasing the value of the land.

Some donors may own vacation rental properties that they wish to donate. The IRS requirements on rental properties are not expressly related to retained life estates but can provide persuasive authority on how the IRS might treat life estates for rental property. For a home mortgage interest deduction, the IRS states a second home that is rented out part of the year may be a qualified home if used as a home more than 14 days or more than 10% of the number of days during the year that the home is rented at a fair rental, whichever is longer. If use requirements are not met, it may be considered rental property and not a second home.

In other instances, however, the IRS has ruled that a “personal residence” may include rental property even where a portion of the property is rented out. PLR 8711038. In its analysis, the IRS cited Rev. Rul. 78-303 which allowed a retired farmer to take a charitable deduction for the creation of a life estate. Since the IRS has ruled that a leased farm qualifies, the same logic could apply to a personal residence. A PLR, however, cannot be relied upon as precedent by other parties. Thus, the best practice for a home that is rented out is to refrain from having tenants for some period before the donation to the nonprofit.

Conclusion

There are several charitable strategies that can be used when gifting a personal residence. Using charitable gifts, homeowners can align their objectives for downsizing their home with their increasing philanthropic efforts, while realizing tax savings. By understanding the deduction rules and the tax advantages offered by charitable gift strategies, professional advisors will be well-equipped to guide and support homeowners through this process.