Real estate has been the fastest appreciating investment for many people during the past several years. With interest rates rising, however, recently there has been a softening of the real estate market in many parts of the country. Some economists feel that this may be the beginning of a long-term decline in real estate values. For those clients who believe that it's time to lock in some of their
Real estate has been the fastest appreciating investment for many people during the past several years. With interest rates rising, however, recently there has been a softening of the real estate market in many parts of the country. Some economists feel that this may be the beginning of a long-term decline in real estate values. For those clients who believe that it's time to lock in some of their profits now, advisors need to be aware of the tax-efficient alternatives available for diversifying out of real estate. One is charitable planning. Structured properly, a charitable transfer of real estate can not only serve a client's philanthropic goals, but also provide significant tax benefits and, under the right circumstances, increased cash flow. Unfortunately, real estate transfers to charity raise a number of tax traps. So let's identify those tax traps and examine the best ways to structure charitable gifts of real estate.
Thetraps tax traps associated with charitable gifts of real estate are numerous and running afoul of one or more of them can result in significant negative tax consequences to the donor and, under certain circumstances, to the recipient charity as well. The most common traps are valuation and substantiation issues; prearranged sale; unrelated business taxable income; mortgaged property and the excise tax on self-dealing:
Valuation and Substantiation — The general rule for federal income, gift and estate tax purposes is that property is to be valued at its fair market value (FMV) at the time of contribution. FMV is the price at which the property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or to sell and both having reasonable knowledge of the relevant facts.1 If a donor places a restriction on the use of the contributed property, the FMV must reflect that restriction.
Because Congress and the Internal Revenue Service are extremely concerned that donors will overvalue contributed real property for charitable deduction purposes, certain protections have been built into the law to ensure valuation will be fair. These protections are known as the charitable substantiation requirements. No charitable deduction is allowed for a contribution of real estate worth more than $5,000 unless the donor obtains a qualified appraisal of the property from a qualified appraiser in accordance with the requirements of Internal Revenue Code Section 170(f)(11)(c). Treasury Regulations Section 1.170A-13(c)(3 sets forth the requirements for the content of the qualified appraisal. In addition to the appraisal requirements, the donor must attach a Form 8283 (Non-cash Charitable Contributions) to the return on which the deduction is taken, including with the form an appraisal summary (and for gifts valued at more than $500,000 the actual appraisal) or no deduction is allowed. To help the IRS determine whether the donor took an inflated deduction, if the recipient charitable organization disposes of the contributed real estate within three years (extended from two to three years under the Pension Protection Act of 2006), the charity is required to file Form 8282 with the IRS showing the amount received on the sale of the real estate. The Pension Reform Act of 2006 also tightened the accuracy-related penalties for overvalued non-cash contributions and imposes for the first time, penalties against appraisers for substantial or gross valuation misstatements.
Prearranged Sale — In contrast to sales of publicly traded securities, sales of real estate are privately negotiated. If a donor has entered into a binding contract to sell a parcel of real estate prior to the transfer to the charitable entity or vehicle, the donor will not avoid the capital gain on the sale of the real estate by the charitable recipient. The donor will be personally responsible for the gain under the “assignment of income” theory and will not be able to receive funds back from the recipient charity to pay the tax, but will have to reach into his own pockets instead. This is an all too common experience with charitable gifts of real estate. If, however, there is no legally binding contract in place prior to the transfer to charity, the donor will not be responsible for the capital gain that will be exempt from tax upon the sale by the recipient charity.
Unrelated Business Income Tax — Although charitable entities generally are not subject to income tax, an exception applies if the charitable entity has income subject to the unrelated business income tax (UBIT). Income is subject to UBIT if the income is from a trade or business that is regularly carried on and the activity is substantially related to the charitable entity's exempt purposes. Most passive income, such as rents from real estate, is not subject to UBIT. Passive income is, however, subject to UBIT to the extent it is derived from “debt-financed property.” Debt-financed property generally means any property held to produce income (including gain from the sale of such property) for which there is “acquisition indebtedness” at any time during the year (or during the 12 month period before the date of the property's disposal, if it was disposed of during the year).2
If a public charity or private foundation has unrelated business taxable income (UBTI), it's subject to UBIT at regular corporate or trust income tax rates, depending on how the entity is organized. UBIT is a particularly significant problem for charitable remainder trusts (CRTs) because, in any year that the trust has unrelated business income, it loses its status as a tax-exempt trust and all of its income is taxed under the UBIT rules. For charitable lead trusts (CLTs), UBIT presents much less of a problem because lead trusts are not tax-exempt. A non-grantor lead trust is taxed as a complex trust, with the trust generally receiving an unlimited income tax deduction under IRC Section 642(c) for the income distributed to charity each year. If the lead trust has unrelated business income, its income tax deduction for distributing unrelated business income to charity is subject to the same percentage limitation rules that restrict the amount of income an individual can shelter from income tax each year with a charitable deduction.
IRC Section 4941 Self-Dealing Prohibitions — The IRC Section 4941 self-dealing rules apply to private foundations, CRTs and CLTs, but not to outright transfers to public charities. The basic principle underlying IRC Section 4941 is that all financial transactions of a private foundation, CRT or CLT with a disqualified person should be prohibited, whether or not the transaction benefits the charitable entity. For example, if a donor contributes a personal residence to a CRT, CLT or private foundation and continues to reside — even for one second — in the residence after the transfer, the charitable entity is deemed to have conferred a direct benefit on the donor, resulting in an excise tax for self-dealing. The self-dealing tax cannot be avoided by having the donor lease the property from the charitable vehicle after the contribution. To avoid self-dealing, the donor must move out of the property before making the charitable contribution. IRC Section 4941(d)(2) provides limited exceptions to the self-dealing rules.
Mortgaged Property — Mortgaged property is perhaps the most common and worrisome tax trap for charitable contributions of real estate. Mortgaged property is almost always problematic and the solution is virtually always to get rid of the mortgage before transferring the property to charity. Transferring mortgaged property to any charitable entity raises two key issues. First, transferring mortgaged property to charity creates a UBIT problem for the recipient charity or charitable vehicle, because mortgaged property is considered to be debt-financed for purposes of UBIT (unless something known as the “5/5/10” exception applies,3 which is rare.) Thus, any gain or income attributable to the mortgaged percentage of the property will be taxable to the charity, which would otherwise not be the case. Second, whenever a donor transfers mortgaged property to charity, the donor is considered to have recognized taxable income on some portion or all of outstanding mortgage value under IRC Section 1011(b). This is true regardless of whether the mortgage is recourse or non-recourse and regardless of whether the donor continues to pay the mortgage after the charitable transfer. In addition, private foundations, CRTs and CLTs also have to be concerned about self-dealing if the mortgage was placed on the property within 10 years of the charitable transfer. For CRTs, if the donor remains personally liable on the mortgage after the transfer to the CRT, the CRT is treated as a grantor trust for income tax purposes. A qualified CRT can never be a grantor trust, thus the donor would lose the income and gift tax charitable deductions, plus the trust loses its tax-exempt status. In addition, the donor will be liable for any capital gains taxes generated when any appreciated trust asset is sold.4
Structuring charitable gifts of real estate is challenging not only because of the various tax traps, but also because it requires an understanding of the various charitable vehicles and which are appropriate for the particular donor and the particular piece of real estate. Charitable alternatives for transfers of real estate run the gamut from outright gifts to public charities and private foundations; bargain sales of real estate to a public charity; and permissible partial interest gifts in which the donor gifts a portion or all of the real property to a charitable vehicle but retains an ongoing right to use the property or to income from the sale of the property by the charitable entity (such as a remainder interest in a personal residence or farm or a charitable remainder trust).
Outright Gifts of Real Estate — A donor who wants to structure an outright gift of real estate to charity will need to be aware of a couple of issues in addition to the tax traps. An outright gift to a public charity should be deductible at FMV — as long as the donor is not considered a dealer in property. A gift of the same property to the donor's private foundation will be deductible only in an amount equal to the donor's tax basis, because the general rule for contributions of appreciated property to a private foundation is that the deduction is limited to basis unless the contributed property consists of marketable securities (known as “qualified appreciated stock”) that are deductible at FMV.
A second concern is whether the donor receives some form of benefit in return for transferring the property. The most common example of this involves a transfer of a parcel of real estate to a local government or land trust in order to get favorable zoning on an adjacent parcel in connection with the development of the property. Typically, there will be no charitable deduction for the contributed property, because the transfer was a quid pro quo for the favorable zoning result on the adjacent parcel.
Bargain Sale — It'svery common for a charitable organization to purchase a parcel of real estate for less than its FMV. When a sale is made to a public charity for less than the real estate's FMV, the donor must allocate the cost basis between the gift element and the sale element based on the FMV of each part. The donor is entitled to an income tax charitable deduction for the difference between the sale price and FMV. The donor will incur capital gain on the difference between the sale price and the cost basis allocated to the sale element. No capital gains tax will be paid on the gain allocated to the gift element. It is very important that the donor intend and clearly express in writing the intention to make a charitable gift of the difference between the sale price and FMV. A taxpayer who merely negotiates a bad deal with the charity purchasing the property cannot come back later and claim a charitable deduction for the difference between the price paid by the charity and the property's actual FMV.
Partial Interest Gifts — The general rule is that an income tax charitable deduction is not allowed for a contribution of a partial interest in property, that is, a gift of less than the donor's entire interest in the property.5 Certain partial interest gifts are deductible. Deductible partial interest gifts fall into two basic categories: deductible partial interest gifts in trust, and deductible partial interest gifts not in trust:
In trust — In this category we have (a) charitable remainder unitrusts (CRUTs) and (b) charitable lead trusts (CLTs).
(a) CRUTs — A CRUT can be an excellent vehicle for highly appreciated unmortgaged real estate. Because it is a tax-exempt entity, a CRUT allows for sale of the real estate by the trustee without any capital gains tax at the time of the sale. This means that the full proceeds are available to reinvest. Each year the beneficiary receives a fixed percentage (which must not be less than 5 percent) of the value of the trust assets. The value of the trust assets are redetermined annually so the annual distribution will increase if the value of the trust assets grow or decrease if the value of the trust assets decline. Although the CRUT itself does not pay income taxes, the beneficiary will pay income tax on some or all of the distributions received from the trust. In addition, the donor will receive an income tax charitable deduction for the present value of the charitable remainder interest. In order to have a qualified CRUT, the income tax charitable deduction must be at least 10 percent of the amount contributed. The preferred type of CRUT for real estate is the FLIPCRUT.
There are numerous issues to consider when a donor funds a CRUT with real estate. Mortgaged property should never be used to fund a CRUT for reasons already discussed. Depending on the particular facts, there are also concerns with prearranged sale, UBIT and self-dealing:
(b) CLTs — Funding a CLT with real estate generally presents problems similar to those presented with other charitable vehicles, including UBIT, self-dealing, excess business holdings and special S corporation problems. UBIT is of limited or no concern. If the CLT is created during the grantor's lifetime and is structured as a grantor trust for income taxes, the existence of unrelated business taxable income (UBTI) is largely irrelevant as all of the trust's income is taxed to grantor in all events. Even for a non-grantor CLT, UBTI is not the tax disaster that it is for a CRT. As noted, in a CRT, the presence of even $1 of UBTI causes the trust to lose its income tax-exempt status for that year. A non-grantor lead trust is not tax-exempt in any event. Rather, it is taxed as a complex trust with a deduction against its income under IRC Section 642(c) for required distributions to charity. UBTI does dilute the tax efficiency of the trust, however, in that the trust's income tax deduction for distributions to charity attributable to UBTI is subject to the deductibility percentage limitations applied to individuals. The deduction for distributions attributable to UBTI applies only with respect to distributions to domestic charities.
The self-dealing rules can present problems for a CLT funded with real estate, particularly commercial real estate since there may be transactions, such as rental of the real estate to the grantor or persons related to the grantor, that would give rise to a self-dealing tax. In limited circumstances, it should be possible to plan around the self-dealing rules, particularly in the case of testamentary CLTs. In addition to the self-dealing rules, CLTs are subject to the private foundation excise tax on excess business holdings. Excess business holdings exist if the CLT and its disqualified persons own more than 20 percent of the voting interest in a business entity. Thus, for example, if the real estate contributed to the CLT is owned through a limited liability company (LLC), the CLT will have excess business holdings if it and its disqualified persons own more than 20 percent of the voting interests in the LLC. The CLT must dispose of the excess business holdings within five years to avoid an excise tax. Note that a disposition of the excess business holdings back to the grantor or a related party will not be possible, because that disposition would constitute a prohibited act of self-dealing. In the case of testamentary CLTs, there are planning steps that can be taken to avoid the excess business holdings rules.
If the real estate contributed to the CLT is owned through an S corporation, additional problems may result. A CLT structured as a grantor trust for income tax purposes is a permitted S corporation shareholder.6 A non-grantor CLT can also be a permitted S corporation shareholder provided that the trustee elects to treat the trust as an electing small business trust under IRC Section 1361(e). This produces highly undesirable income tax results, however, because the CLT will be taxed on S corporation income at the highest marginal rates for trusts,7 and the CLT will be denied a Section 642(c) deduction for distributions of lead payments to charity each year.8
Not in trust — So what about deductible partial interest gifts that are not in trust? In this category we have (a) undivided interest gifts; (b) contributions of a remainder interest in a personal residence or farm; (c) qualified conservation contributions; and (4) dharitable gift annuities.
(a) Undivided interest gifts — An income tax charitable deduction is allowed for a transfer of a partial interest if that interest is an undivided portion of the donor's entire interest in the property.9 A deductible undivided interest consists of a fraction or percentage of each and every substantial interest or right the donor owns in the property that extends over the entire term of the donor's interest.10
(b) Contribution of a remainder interest in a personal residence or farm — A donor can get an income tax charitable deduction for the present value of a gift of a remainder interest in his personal residence or farm, even though the donor or other individuals retain the right to life enjoyment. A “personal residence” is any property used by the donor as his personal residence, but it need not be the donor's principal residence. For example, a donor's vacation home may be a personal residence. A “farm” is any land used by a donor (or a tenant) for the production of crops, fruits, or other agricultural products or for the sustenance of livestock. A gift of a remainder interest in a personal residence or farm must be outright (not in trust) in order to be deductible. Donating property subject to a mortgage is not advisable, because it results in the donor recognizing income to the extent of mortgage under the bargain sale rules.
(c) Qualified conservation contributions — A contribution of a “qualified real property interest” donated to a “qualified organization” exclusively for “conservation purposes” is deductible.11 Conservation purposes include preserving land for outdoor recreation; protecting a natural habitat of fish, wildlife, or plants; preserving open space for the scenic enjoyment of the general public; and preserving an historically important land area or a certified historic structure. Qualified real property interests include the donor's entire interest (while allowing the donor to keep a qualified mineral interest), remainder interests, and conservation easements. Conservation easements are the most common type of qualified conservation contribution. An easement is a personal interest in, or the right to use, the land of another. By giving an easement, a landowner limits his ability to use the land as he pleases. For instance, the owner may place restrictions on the type or size of buildings that may be erected on the property. To qualify, the easement must be perpetual and the recipient charitable donee must be a specifically described qualified organization (not all charities qualify) and must have the right to enforce the easement no matter who owns the land. For deduction purposes, the value of the conservation easement is based upon a “before and after” analysis; comparing the property's fair market value based on the highest and best use of the property at the time of the gift (including development rights) with the value of the property subject to the easement. The reduction in the property's value is the FMV of the easement and the amount of the charitable deduction. The Pension Protection Act of 2006 has enhanced the deductibility limits for conservation easement in 2006 and 2007.
(d) Charitable gift annuities — A charitable gift annuity is considered a bargain sale — part outright charitable gift and part purchase of an annuity — and therefore is not subject to the partial interest rules. A charitable gift annuity usually results in similar tax and financial consequences to a charitable remainder annuity trust. However, because a charitable gift annuity is a contract, rather than a trust, it is not subject to the self-dealing rules of IRC Section 4941. Charitable gift annuities can be funded with real estate. If a donor wants a fixed payment in return for a gift of unmortgaged real estate to charity, a charitable gift annuity may be an attractive option.
PROCEED WITH CAUTION
Real estate can be a great asset to give to charity. Now may be the right time to consider this kind of donation. But donors and their advisors should be careful.
- Treasury Regulations Section 1.170A-1(c)(1).
- Acquisition indebtedness is the unpaid amount of debt incurred under the following circumstances: (1) when acquiring or improving the property; (2) before acquiring or improving the property if the debt would not have been incurred except for the acquisition or improving the property if: (a) the debt would not have been incurred except for the acquisition or improvement, and (b) incurring the debt was reasonably foreseeable when the property was acquired or improved. Internal Revenue Code Section 514(b) and (c).
- IRC Section 514(c)(2)(B)
- IRC Section 170(f)(3)(A).
- IRC Section 1361(c)(2).
- IRC Section 641(c)(2)(A).
- IRC Section 641(c)(2)(A), flush language; Treas. Reg. Sections 1.641(c)-1(g)(4); 1.641(c)-1(l), Ex. 4; IRC Section 170(f)(3)(B)(ii).
- Treas. Regs. Section 1.170A-7(b)(1)(i).
- IRC Section 170(h).