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Section 1031 Exchanges and Charitable Giving, Part Two
Many professional advisors have clients who are real estate investors. Over the years, these investors have purchased and sold properties under Sec. 1031 to defer recognition of capital gains. Over time, the burden of property maintenance and management may no longer be desirable. Selling the property, paying taxes and investing the money elsewhere may work for some individuals. Other clients, however, are looking for a way out of the property that fulfills their charitable goals without incurring significant tax burdens.
This article will discuss the benefits of more complex charitable giving models. The first part of this series explained Sec. 1031 exchanges and discussed a few simple charitable giving methods to dispose of these holdings. The information will help advisors and donors understand how these properties can be used to fulfill their charitable goals.
Potential Charitable Giving Vehicles
When Sec. 1031 assets are held as long-term capital assets, they may be a good fit for a variety of charitable gifts. The appropriate gift type will depend on the value of the asset being transferred and the donor's philanthropic goals. Another important consideration is the organization's ability and willingness to manage the asset. Any nonprofit organization planning to accept gifts of real estate must perform due diligence to determine whether it can handle the risks involved. The nonprofit should have a thorough gift acceptance policy that covers all types of gifts involving real estate.
Charitable Gift Annuity
A charitable gift annuity (CGA) is a contract between the charity and the donor. In a CGA funded with Sec. 1031 property, a donor gives the appreciated asset to the nonprofit in exchange for a promise to pay a set percentage of the initial funding amount to one or two annuitants for life. The charitable deduction for a CGA is based on the present value of the charitable remainder at the time of the gift. The donor also bypasses the portion of the capital gain attributed to the charitable gift. If the donor is the annuitant, the remaining portion of the capital gain is taxed over the donor's life expectancy. The advantages of bypassing capital gain, receiving fixed payments and generating a charitable deduction make this a favorable gift planning strategy.
Because of real estate's unpredictable nature and carrying costs, some charities are reluctant to accept real estate in exchange for a CGA. When accepting real estate to fund a CGA, the nonprofit must always take several factors into consideration. These considerations include: 1) marketability of the property, 2) potential to sell below the qualified appraisal amount, 3) ongoing expenses such as maintenance, insurance, property taxes and utility bills, 4) hazardous conditions on the property and 5) nonpayment of rent. To minimize risk, a nonprofit should thoroughly evaluate the risks involved. After careful analysis, it is often best to fund the CGA for 80% to 90% of the appraised value or include a deferral period.
Andrew, 77, has been asked by his alma mater to make a donation. He owns development land on the outskirts of town that he obtained in a Sec. 1031 exchange. There is no debt on the property, and it is valued at $320,000. Andrew thinks it would be nice to transfer it to a charitable gift annuity so he can bypass part of his capital gains and receive a monthly payment. The university was interested but had concerns related to the property's marketability. In addition, the university would have to pay for insurance, taxes and selling costs that could reach 8%. As a result, the university offered a CGA funding amount of $272,000, 85% of the appraised value. Pursuant to the CGA agreement, Andrew will receive a 7% annuity, or $19,040 each year. Andrew receives a charitable deduction for the CGA of $123,490. He also receives an additional $48,000 deduction for the outright gift, which is the difference between the qualified appraisal value and CGA funding value. The charity sold the property several months later for $310,000, net of costs. Andrew is very pleased that he received a large charitable deduction, bypassed capital gains and receives income while making a gift to his alma mater.
Charitable Remainder Unitrust
A charitable remainder unitrust (CRUT) is a tax-exempt irrevocable trust that is funded by a donor and makes income payments to the donor or other beneficiaries for life, lives or a term of years. The donor also receives a charitable income tax deduction in the year the trust is funded, based on the present value of the charitable remainder. After all payments have been made, the remaining trust assets are transferred to one or more designated charities. There are many benefits to transferring appreciated real estate to a charitable remainder unitrust, including income tax deductions, bypass of capital gain and an income stream. Once property is sold inside the CRUT, the proceeds are then invested in stocks and bonds, which was something a Sec. 1031 exchange would not allow.
For donors who are not ready to part with their property in full, a transfer of a partial interest of Sec. 1031 property to a CRUT would fit their needs. Rev. Rul. 79-44, PLR 199926045. For example, prior to any binding sale agreement, a donor could transfer a 55% undivided interest in their property into a FLIP CRUT. When real property is transferred to a FLIP unitrust, the trust will only pay the lesser of the net income generated by the property or the unitrust percentage until the property is sold. On January 1 following the sale date, the trust flips to a standard unitrust and will begin making the regular unitrust payments. Once the undivided interest in the property is transferred into the FLIP CRUT, the donor and CRUT trustee jointly sell the property.
With respect to the FLIP CRUT, because the trust would be exempt from income taxes, the trust would owe no taxes following the sale of the property. Therefore, the donor would defer the capital gain attributable to the undivided interest in the CRUT.
Example 6To prevent self-dealing with split interest transactions, it is suggested that certain "safety steps" be taken. For example, it would be advisable for the FLIP CRUT trustee or an independent trustee to be trustee of a revocable trust holding the interest retained by the donor and handle the sale of both portions of the property. The donor also should not prearrange a sale on behalf of the trustee. Additionally, the CRT assets must not be sold or leased back to a disqualified person.
Rebecca has owned and operated a successful restaurant for many years. She would like to scale back her involvement in the business. Rebecca purchased the restaurant building many years ago through a Sec. 1031 exchange. Because property values are skyrocketing in the area, she would like to use the property to support her favorite charitable organizations. Her advisor explains that the best strategy is to donate 55% of the restaurant building to a FLIP unitrust. By selling part of the building inside the unitrust, Rebecca will save the capital gains tax that would otherwise be payable on the gain. She will also receive a charitable income tax deduction and trust income for her lifetime. Once the real estate is sold, the capital gains will be invested primarily in stocks. Thus, most of the trust's payouts will be dividends or long-term capital gain taxable at Rebecca's capital gains rate of 18.8%. Rebecca sells her 45% of the building when the charity sells the 55%.
A bargain sale occurs when a charity purchases property from a donor for less than fair market value. IRC Sec. 1011. With a bargain sale, the gift amount is the fair market value of the property less the sale price. The basis is allocated between the taxable sale portion and the gift portion. With respect to the taxable sale portion, the difference between the sale price and the allocated basis will be, in most cases, long-term capital gain. Reg. 1.1011-2(a)(1). The donor's sale proceeds will result in a taxable event, which may be offset in full or in part by the bypass of capital gains and the charitable deduction on the portion that is contributed to the charity.
With Sec. 1031 property, sale proceeds attributable to straight-line depreciation will be recaptured and taxed at a maximum rate of 25%. The excess of accelerated depreciation over straight-line depreciation may also be recaptured at the donor's ordinary income rate. IRC Sec. 1250. The remaining profit is taxed as long-term capital gain. With careful planning, a donor can achieve a zero-tax outcome if the tax savings from the charitable deduction equals or exceeds the taxes owed on the portion sold by the donor.
It is important to note that the donor's charitable deduction for the transfer of real estate is subject to a deduction limitation of 30% of the donor's adjusted gross income (AGI) in the year of the gift. However, the charitable deduction may be carried forward for up to an additional five years, giving the donor a total of six years to claim the charitable deduction.
There are many benefits to a bargain sale that make it an attractive option. Bargain sales to charities are very convenient and easy to arrange. If the property has not been listed before, the charity and the donor may also deal directly and avoid the real estate agent fees completely. If it is long-term appreciated property, the donor receives the benefit of a deduction based on the full fair market value, less the ordinary income component of the real estate. IRC Sec. 170(e)(1)(A). Additionally, if the donor is not concerned with owing tax on the sale and prefers more cash proceeds from the sale, the apportionment of the real estate retained and transferred to the charity can be adjusted to meet the donor's goals.
Mary, age 77, plans to donate her Sec. 1031 property to charity. She purchased the property several years ago for $600,000 and has taken $200,000 in straight-line depreciation. The property is now valued at $1 million with an adjusted basis of $400,000. Mary would like to get cash from the property while minimizing her tax liability. If Mary sells the property to a charity at 50% of the fair market value, she receives a charitable deduction of $500,000 based on the fair market value of the 50%. At her 37% tax rate, she will have income tax savings of $185,000, and bypass capital gain with her gift.
Mary would also receive $500,000 in proceeds from the sale portion. Mary will owe long-term capital gain tax based on the $200,000 difference between the pro-rata original cost basis and the sales price ($200,000 x 23.8% = $47,600). The $100,000 gain attributed to straight-line depreciation is subject to tax at a maximum rate of 25% plus the 3.8% Medicare tax ($100,000 x 28.8% = $28,800). Thus, she will have a total tax bill of $76,400 ($47,600 + $28,800). Mary's charitable income tax savings of $185,000 will more than offset the tax owed. In total, Mary can sell her property tax-free and retain $500,000 in cash proceeds from the sale.
The prevalence of Sec. 1031 exchanges has led to innumerable questions regarding tax consequences, especially for donors ready to exit their Sec. 1031 properties. It is important for taxpayers who are interested in disposing of these properties to understand the tax implications. While there are many rules to follow when it comes to Sec. 1031 exchanges, a donation of Sec. 1031 property can offer donors a great opportunity to fulfill philanthropic goals and take advantage of important tax benefits.
Published September 1, 2023