Saturday January 29, 2022
Article of the Month
Charitable Gifts of Real Estate - Part IV
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 donating 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 using real estate assets to fund charitable gift annuities.
Structuring Real Estate Gifts
Real estate can be an excellent asset to donate to charity. Usually, a donor will receive a greater tax benefit by gifting real estate, rather than donating the cash proceeds from a sale of the real estate. If a donor sells the real estate first and then donates the cash proceeds, the donor will be taxed on the gain from the sale. When the donor transfers the property to a charity before the sale, the capital gain may be bypassed. One exception to the bypass of gain is when there is a prearranged sale. 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. A charitable gift annuity is one option that can create an income stream for the donor using real estate.
i. Charitable Gift AnnuityA charitable gift annuity (CGA) is a contract between the charity and the donor whereby the donor transfers property or cash to the charity in exchange for income payments for one or two lives. Although many CGAs are funded with cash, appreciated property, such as real estate, may also be used to fund CGAs. One of the most attractive benefits of a charitable gift annuity is that the payment rate is fixed for the life of the annuitant(s).
When a donor creates a CGA, the funding asset is irrevocably transferred to the issuing charity. The donor does not retain the right to live in his or her residence or a right to use the property. Unlike a retained life estate where the donor retains the right to live in their residence, funding a charitable gift annuity with real estate reserves no such right. There are numerous benefits for the donor when funding a CGA with real estate. The donor receives a fixed payment stream, a charitable income tax deduction and a partial bypass of capital gains.
The annuity payments are determined by multiplying the applicable annuity rate by the funding amount. The annuity payments can be paid out monthly, quarterly, semi-annually or annually. About 97% of charities use the suggested maximum rates published by the American Council on Gift Annuities (ACGA) to determine the annuity payment rate. The ACGA suggested maximum rate schedule assigns a payment rate based on the annuitant's age. The ACGA rates are targeted to provide the charity, on average, a 50% residuum.
A charitable gift annuity is treated as a bargain sale because value will be returned to the donor in the form of annuity payments. Under the bargain sale rules, whether a CGA is funded with cash or appreciated property, only a portion of the transfer qualifies for a charitable deduction. There are two components to a CGA— the portion that is gifted to charity and the portion returned to the beneficiary in annuity payments. The donor will be entitled to a charitable deduction based on the difference of the funding value of the CGA and the present value of the annuity portion. The donor's charitable deduction is calculated by multiplying the applicable life factor from IRS Pub. 1457 Table S by the annuity amount. The life factor from IRS Pub. 1457 Table S is selected based on the donor's age and the AFR.
Charities should exercise caution when accepting real estate to fund a charitable gift annuity. The charity is entering into a contract committing itself to payments for the life or lives of the annuitants, with significant uncertainty regarding the timing and selling price of the property. The charity will be required to start payments if the CGA is structured with immediate payments. These payments will need to come from other sources, such as the charities' general funds. The charity will also be expected to meet all state gift annuity reserve requirements, which may need to be funded from other sources while the real estate is pending an eventual sale.
Killian, a 75-year-old, who recently retired from his tailoring business, wishes to donate the property where he ran his business. He would like to make a gift that also includes fixed payments for his life. He purchased the building many years ago for $100,000 and it is now worth $500,000. He approaches his favorite charity hoping to donate the building. The gift planner recommends a charitable gift annuity funded with the building, which would satisfy Killian's goals of gifting the building and receiving payments for his life.The major difference between CGAs funded with cash versus appreciated property, such as real estate, is the partial bypass of capital gains. If the donor were to first sell the building and donate the proceeds of the sale to charity the donor would owe tax on all capital gains in the year of the sale. In the alternative, when a donor funds a CGA with appreciated property, the donor bypasses a portion of the capital gain on the gift portion and the capital gains attributed to the annuity portion are prorated in the annuity payments.
The creation of this gift will generate a charitable deduction of $213,092 in the year of the gift, which may save $46,880 based on Killian's 22% income tax bracket. His partial bypass of capital gain may save him $37,504. Based on his age, he will receive $27,000 per year in annuity payments based on a 5.4% payment with about $4,628 of that being tax-free. Killian is happy with the gift to charity, his tax savings and the payments from the charitable gift annuity. Of course, the charity is excited to acquire a property they could later sell. The charity will start making payments immediately, regardless of the timing on the sale of the property.
Mary, who is 80 years old, owns a rental property that she would like to donate to her favorite charity in exchange for lifetime payments through a charitable gift annuity. The property has a fair market value of $750,000 and a cost basis of $250,000. She asks her financial advisor whether it would be more beneficial to sell the property first and then fund the CGA with cash or to fund the CGA with the rental property. Mary's financial advisor informs her the major difference between the two options is the realization of capital gain. If Mary were to sell the property first and then donate the cash proceeds, the capital gain will be recognized in the year of the sale. If, instead, she was to transfer the property to fund the CGA, she would bypass a portion of the capital gain. The remaining capital gain would be spread out over the donor-annuitant's life expectancy.The bypass of capital gain benefit may not be applicable in all situations. If the annuity is created for the life of the donor or lives of the donor and spouse, the capital gain tax allocated to the annuity payments is prorated over the term of the contract. Because the capital gain recovery is only applicable to the annuity portion of the CGA, the capital gain allocated to the charitable gift portion will be bypassed.
Regardless of Mary's choice to sell or donate the property, she would receive an income tax charitable deduction of $354,057, which based on her 22% tax bracket may save her $77,893. Her one-life annual annuity payments will be $48,750.
If Mary sold the property first, the $500,000 in capital gain will be realized in the year of the sale. She would be using the cash proceeds to fund her annuity. Her annual annuity payments would be $42,120, comprised of tax-free and ordinary income. If Mary funded the CGA with the rental property, the partial bypass of capital gain may save her $51,928. Her annuity payments would be apportioned as $14,038 tax-free, $6,630 as ordinary income and the remaining $28,081 would be treated as capital gain. If she reaches her IRS life expectancy of 12.8 years, her subsequent annuity payments will be treated entirely as ordinary income under both scenarios. After sitting down with her financial advisor, Mary understands the benefit of funding the charitable gift annuity with the property before selling it and selects that option.
If neither the donor nor the spouse is an annuitant, the donor will benefit from the bypass of the capital gain attributed to the charitable gift. However, when the only annuitant is a child, nephew, niece or friend, the capital gain that would have been prorated over the donor's life expectancy must be recognized and reported in the year of the gift. If a parent were to create a charitable gift annuity with appreciated property that pays first for the life of the parent with successive payments for the life of a child, the capital gain on the annuity portion will be reported in the annuity payments during the life expectancy of the parent.
Tom, a 95-year-old donor, plans to donate one of his real estate properties to his favorite charity to fund a one-life charitable gift annuity for his eldest daughter Margaret, who is 70 years old. The property has a fair market value of $750,000 and a cost basis of $700,000. He desires favorable tax benefits, but his primary goal is to provide an income stream for his daughter. He asks his professional advisor how a one-life CGA for his daughter will be treated.
The advisor cautions Tom that because he is funding a CGA for another person, the capital gain on the annuity portion must be recognized in the year of the gift. Tom does not mind because the property has not appreciated much, and the primary goal is to provide an income stream to his daughter. He asks the advisor to continue with the one-life CGA. Tom will recognize $31,670 as taxable capital gain when he creates the CGA. He will receive a charitable income tax deduction of $274,943. Based on his 32% tax bracket, that may save $87,982. The partial bypass of capital gain may save $5,865. Tom may be required to file a gift tax return, Form 709, for the present value of the annuity to Margaret, valued at $475,027. Over her life, Margaret will receive annual annuity payments of $35,250. Of that amount, the tax-free portion is $30,632 and the rest is ordinary income, with no part treated as capital gain. Tom is happy with the tax benefits and the large amount of tax-free annual payments for his daughter and decides to proceed with the gift.
ii. Deferred Charitable Gift AnnuityDeferred charitable gift annuities follow the same structure as immediate gift annuities with one major difference. Deferred charitable gift annuities must have the first annuity payment occur more than one-year after the funding date of the CGA.
Because there is a deferral period between the funding date and the first annuity payment, a deferred charitable gift annuity will pay a higher payment rate than an immediate gift annuity for the same annuitants. The increased annuity rate results from a compound formula that considers the deferral period and the age of the annuitant at the time payments start. During this deferral period, the charity will invest the assets transferred to fund the deferred CGA. When the annuity payments commence, the charity will likely have a larger reserve to make annuity payments due to growth during the deferral period. The longer the period is deferred, the higher the rate rises.
The charitable deduction factor for a deferred charitable gift annuity is based on the period of deferral using Table H from IRS Pub 1457. The adjusted factor is multiplied by the annuity payment to determine the present value of the annuity payments over the donor's IRS life expectancy. The present value of the annuity is subtracted from the funding value, which produces the charitable deduction. In general, the charitable deduction may be larger when structured as a deferred CGA rather than an immediate CGA.
John, a 70-year-old retiree, owns property that he wishes to donate to his favorite charity in exchange for annuity payments. He is currently living comfortably off his retirement benefits. John is considering converting his property into an income stream of at least 5%, but is hesitant to do so because of the capital gain. The property is worth $400,000 with a cost basis of $100,000. He asks his financial advisor for advice and a comparison of an immediate and a deferred charitable gift annuity.
If structured as an immediate charitable gift annuity, John would receive the following tax benefits. John would receive an income tax deduction of $146,080, which in his 22% tax bracket may save him $32,138. His annuity rate based on his age will be 4.7% and would produce annual payments of $18,800. Over his life expectancy, John may receive $370,360 in total.
If structured as a deferred charitable gift annuity with a deferral period of three years, his benefits would be altered. His income tax deduction would increase to $165,788, which may save him $36,473. The annuity payment rate increases to 5.5%, producing annual payments of $22,000 and meeting his goal of payments of at least 5%. Over his life expectancy, he may receive $367,325. Despite the fact he might receive less in total payments based on his IRS life expectancy, he likes the idea of receiving a larger income tax deduction in the year of the gift and a higher annual annuity rate. John decides to create the deferred charitable gift annuity because it meets all his goals.
iii. Charitable Gift Annuity and Life EstateAs was discussed in the December Article of the Month, a donor can remain in their home for life with a retained life estate. A charitable gift annuity and a retained life estate can be combined to allow the donor to retain the lifetime right to live in the home, while also receiving lifetime income payments. Under this complex gift, the donor retains the life estate interest, and the remainder interest is vested to the charity. The annual annuity payments are based on the present value of the remainder interest irrevocably transferred to the charity.
This type of gift may be particularly attractive to a donor who is able to provide for family with other assets. Donors will be pleased with the ability to live in the home and convert the home into a fixed payment stream. The home will be fully vested to the charity when the payment stream ends. It is important for donors to understand that using this method will allow the charity to receive the home in exchange for the charitable gift annuity payments during life. All the benefits of retained life estates and charitable gift annuities are blended together. While there are risks to this structure for the charity, it may be a beneficial gift model.
George, an 85-year-old donor, would like to make a generous donation to his favorite charity. He owns a home valued at $1 million with a cost basis of $500,000. He is considering using the home for a charitable gift, but he would prefer to remain in the home and, if possible, receive annual income. His financial advisor recommends funding a charitable gift annuity using a retained life estate. Excited about the possibilities, George asks him how this would work.
George would retain the right to live in his home for his life, while also receiving annual annuity payments based on the present value of the remainder interest transferred to the charity. He will receive a charitable deduction of $494,080 that may save him $182,809 based on his 37% tax bracket. His annuity rate based on his age is 7.6% and would produce annual annuity payments of $69,280. Over his life, George retains the right to live in his home, while also receiving annual annuity payments of $69,280. Satisfied that all his goals will be met, George decides to proceed with the gift.
iv. Compliance with State Charitable Gift Annuity RegulationsCharities must comply with CGA state regulations in the state where the charity is located and the state where the donor resides. Each state falls into one of four basic categories with regard to CGA regulation: (1) Registration States which have the highest level of regulation and require charities to meet statutory minimums, apply for a permit and submit annual reports; (2) Notification States require charities to meet statutory requirements and give notification prior to their first issuance of a CGA once the statutory requirements are met; (3) Conditional Exemption States require charities to meet statutory regulations before issuing a CGA and (4) Silent States do not address CGAs or exempt them from regulation as insurance under state law.
The charity will need to abide by the regulations in the state the organization is located and where the donor resides if the charity is administering a charitable gift annuity to a donor that resides in a different state than where the charity is located. As a general practice, if the regulations are varying levels, the charity can administer the CGA based on the state with the higher level of regulation. In some cases, it may be required for a charity to be registered to issue charitable gift annuities in the state where they are located and the state where the donor resides. Because of these regulations, charities must exercise due diligence when issuing charitable gift annuities.
Some states also require charities to hold a certain amount in reserve for the duration of each gift annuity contract. If the charity is required to hold an amount in reserve and the property has not yet sold, the charity will need other funds to generate the required reserve. Because of these reserve requirements, a deferred charitable gift annuity may be appropriate. The deferral period can be helpful to give the charity time to sell the property before the payments commence. Charities should review and update gift acceptance policies regarding accepting donated real estate, especially in relation to charitable gift annuities.
Charitable gift annuities are a great option for a donor who plans to donate real estate. A charitable gift annuity can be structured to produce immediate lifetime payments for the donor, or the payments can be deferred. The deferred charitable gift annuity may be preferred by the donor due to a larger charitable deduction and higher annual payments, and by the charity because it allows time for the charity to sell the property and have the required funds to make the annuity payments. This flexibility allows charitable gift annuities to be properly tailored to fit the preferences of the charity and the donor. The next article in this series will discuss funding charitable remainder trusts with real estate.