A donor can get income and estate tax benefits from this transfer, even if he keeps the right to life enjoyment
There was an old woman who lived in a shoe
Had she planned on giving that shoe (her personal residence) to a charitable remainder unitrust (CRUT) or charitable remainder annuity trust (CRAT) — and didn't vacate before funding the trust — no income tax deduction would have been allowable. Her use of the shoe would have been a prohibited act of self-dealing.1
So what should that old woman do?
She wants to live in her shoe (or other personal residence) — and get tax benefits now. Read on.
The Basic Rules
A donor can get income and estate tax benefits by making a charitable gift of his personal residence or farm, even though the donor keeps the right to life enjoyment. A life estate may be retained for one or more lives. Or an estate may be retained for a term of years.
The charitable deduction isn't allowed for future interests in furnishings or other tangible personal property.2 However, the Internal Revenue Service has privately ruled that property that qualifies as a “fixture” under local law can be included in the value of the real property.3 This favorable ruling hinged upon an air conditioning and heating system being considered “real property” under local law. Had the system been deemed “tangible personal property,” the IRS would have denied the income and gift tax charitable deductions. And the property wouldn't have qualified for the annual gift tax exclusion because it was a gift of a future interest.
Practice point: A donor who contributes a remainder interest in a personal residence or farm during lifetime and who also wants the charity to have the furniture, farm machinery or other tangible personal property, should give the tangible personal property by will, rather than give a remainder in the personal property during lifetime.
What's a Personal Residence?
Under Treasury Regulations Section 1.170A 7(b)(3), any property used by a donor as his personal residence qualifies as a personal residence. And it needn't be the donor's principal residence. So, a donor's vacation home is also a personal residence.
If the donor rents his vacation home
Internal Revenue Code Section 280A(d)(1), which pertains to disallowance of certain business expense deductions, defines “personal residence” as a dwelling used for personal purposes for more than: (1) 14 days; or (2) 10 percent of the days during the year for which the unit is rented at fair rental. In one case, donors asked the IRS to rule that a gift of the remainder interest in their vacation home would qualify for the deduction. They had used the house 14 days each year and held it out for rental during the remaining 50 weeks. However, the house was actually rented only two weeks each year. They donors requested a ruling that the IRS would apply the actual rental time, as opposed to the availability for rental, in determining whether the house qualified as a “personal residence” for purposes of deducting a gift of the remainder interest.
But the IRS said that because of the particular facts of the case, it couldn't rule on the issue. It noted, however, that unfortunately neither IRC Section 170 nor the Treasury regulations provided that the test in IRC Section 280A, with respect to the charitable contribution deduction, is the only test to use to decide whether a specific dwelling is a taxpayer's “personal” residence.
What about a cooperative?
The term “personal residence” also includes stock owned by a donor as a tenant stockholder in a cooperative housing corporation, if he uses the dwelling that he's entitled to occupy as a stockholder as his personal residence.
What's a Farm?
You know one when you see one! But here's what the law says: A farm is any land used by a donor (or his tenant) for the production of crops, fruits or other agricultural products or for the sustenance of livestock. The term “livestock” includes cattle, hogs, horses, mules, donkeys, sheep, goats, captive fur-bearing animals, chickens, turkeys, pigeons and other poultry. A farm includes the improvements thereon.4
Gift Can't be in Trust
The remainder interest must be given outright.5 As noted earlier, the personal residence can't be in a charitable remainder trust (CRT). A personal residence can be used to fund a CRT, but the beneficiary must vacate before the trust is funded.6
Caution: Make sure that there isn't a mortgage on the property. Otherwise, the CRT will be disqualified.7
Income Tax Charitable Deduction
For income tax purposes, the amount deemed contributed isn't necessarily the amount that may be deducted. The remainder interest in an appreciated personal residence or farm held long-term (more than one year) is deductible up to 30 percent of the donor's adjusted gross income (AGI) (with a five-year carryover for any “excess”) when the remainder organization is a church, school, hospital or other public charity.
The contribution can be deductible up to 50 percent of the donor's AGI (with a five-year carryover for any “excess”) if the donor makes this election regarding all contributions of long-term appreciated property during the year, and long-term appreciated property gifts are carried over from earlier years. The donor makes the same contribution but, for tax purposes, reduces the amount deemed contributed by 100 percent of the appreciation. If the election is made, any carryover from earlier years is reduced as just described. When the election is made for a remainder interest gift, the amount deemed contributed is reduced by 100 percent of the appreciation attributable to the remainder interest.
Private foundations (PFs)
The ceiling on deductibility is limited to 20 percent (with a five-year carryover for any “excess”) when the remainder organization is a PF.
Avoiding Capital Gain
Capital gain is generally not taxable on a transfer of appreciated property to charity. A donation of mortgaged property is, however, considered a bargain sale, with the donor “receiving” an amount equal to the outstanding debt on the property. That's true even if the donor remains liable for the mortgage.8 If a donor bargain sells a remainder interest in an appreciated personal residence or farm to charity, he will have gain as determined under IRC Section 1011(b) and Treas. Regs. Section 1.1011-2.9
Watch Your Step
Gift of proceeds from sale of residence or farm
The IRS maintains that no deduction is allowable for a gift of a remainder interest in a residence or farm when the donor's will directs that the property be sold and all or part of the sale proceeds be distributed to charity.10
The IRS allowed a deduction, however, when the second beneficiary's interest terminated (he died) before the due date of the donor's estate tax return. Thus, the remainder interest passed directly to charity and was deductible under a special exception in IRC Section 2055(e)(3).11
The IRS will also allow a deduction if state law recognizes the doctrine of “equitable conversion” (that is, it permits the charitable remainder organization to take the residence or farm itself, despite the terms of the donor's will).12
The IRS allowed a deduction on these facts: The donor gave his personal residence to charity, retained a life estate and directed that on his death, the charity sell the residence and add the sales proceeds to a trust that the donor had previously established for the charity's benefit. Here, the IRS said, the charity's remainder interest was in the residence itself, not just the proceeds of a future sale.13
In Estate of Blackford v. Commissioner, the Tax Court allowed a deduction even though the interest received by a charity wasn't a remainder interest in a personal residence, but rather a remainder interest in the proceeds from the residence's sale.14 The IRS acquiesced in the result of Blackford, but still disagreed with the Tax Court's reasoning.15 The IRS intends to continue challenging Blackford-type bequests when local law doesn't allow for equitable conversion of remainder interests.16
If a remainder interest is split between a charity and noncharity
A number of years ago, a deduction wasn't allowed when the remainder interest in a personal residence (or its sales proceeds) was split between a charity and a noncharity.17
Reversing itself (sort of), the IRS allowed a charitable deduction when a remainder interest in a home was split between a charity and an individual. As stated earlier, the IRS had denied an estate tax charitable deduction when a remainder in a personal residence passed to a charity and an individual as equal tenants in common at the donor's death. Although the law and regulations were silent on the point, the IRS said that the entire remainder must pass to charity to qualify.18
But another donor willed his sister a life estate in his personal residence. On her death, the remainder interest would pass under his will's residuary clause, which devised 90 percent of the residue to charity and 10 percent to individuals. In Technical Advice Memorandum 8341009, the IRS denied an estate tax charitable deduction, citing Revenue Ruling 76-544.
But here's yet another word from the IRS
Alphonse conveyed the remainder in his home to a charity and Sarah as tenants in common. Sarah has a 90 percent interest; the remaining 10 percent goes to the charity. Alphonse filed a gift tax return, but subtracted the charity's undivided 10 percent interest from the value of his gift to Sarah. The IRS allowed Alphonse to deduct the charity's 10 percent interest as a charitable contribution.19
A house divided — valuation
In the above ruling, the IRS said that the amount of the charitable deduction must be reduced “to reflect appropriate valuation discount for the cotenancy arrangement.”20
Note that this ruling deals only with the gift tax charitable deduction. Arguably, the reasoning should apply for income tax purposes, but what's deductible for estate and gift tax purposes isn't always deductible for income tax purposes. For example, artwork donated without the underlying copyright can be deductible for estate and gift tax purposes,21 but remains a nondeductible “partial interest” for income tax purposes.
The IRS' copious citations to IRC Section 170 in this ruling don't assure parity for income tax deductions — the gift tax statute itself is cross-referenced to IRC Section 170. Note that if an income tax charitable deduction is allowable, the amount must be discounted twice: once for cotenancy and once for depreciation on the structures. For gift tax purposes, though, depreciation isn't taken into account.
How much discount for cotenancy?
Not much guidance is offered in Estate of Fawcett, cited by the IRS in this ruling, beyond telling why a discount may be appropriate. In that case, a decedent's executor sought a 25 percent discount on the estate tax value of his half interest in a ranch. The court said: “Although we believe that such a factor should be considered to reflect the possible legal and other problems that would arise when such an interest is sold, we believe in this instance its importance is overstated. The subject ranch was owned by a family unit, not total strangers; consequently, we believe that neither the likelihood nor the magnitude of such problems would be great.”22
Unfortunately, the court didn't say how much of a discount would be applied under the case's facts; it simply arrived at a valuation “after a careful review of the entire record.”23 Still, it indicated that, in determining the amount of the discount, both the likelihood and the magnitude of “problems” resulting from the cotenancy should be considered.
Another case shed more light on cotenancy discounts (although not involving a charitable gift). An estate wanted a discount for federal estate tax valuation purposes in a situation in which the decedent held a half interest in a farm (the other half interest was divided among eight heirs of the decedent's sister). The estate's expert testified that local appraisers often discount fractional interests in real property by 20 percent to 25 percent. Citing the difficulty of finding an arm's length buyer for a fractional interest in property and the considerable expense that might be encountered in any attempt to partition the land under local (Illinois) law, the Tax Court found a 12.5 percent discount appropriate.24
A donor can give charity a remainder interest and an undivided interest in the same property. In Rev. Rul. 76-473,25 a donor deeded real property (20 acres of land plus improvements) to a college. The improvements included the principal 25 room dwelling house, a caretaker's cottage, a barn, a swimming pool, a gymnasium and a tennis court. The donor used the property only for summer vacations.
The deed of gift, however, reserved a lifetime right for the donor: (1) to use the property for summer vacations (he would have exclusive use each year from Aug. 1 through Sept. 15); and (2) to store personal property at all times of the year in the principal dwelling house. The deed restricted the college from conveying the property until the donor's death or 10 years after the execution of the deed of gift, whichever was later. Further, the college was restricted from making structural or decorative changes to the property during the donor's life without his consent.
The IRS ruled that the donor's rights didn't substantially restrict the college's use of the property. Thus, he made two gifts: (1) a remainder interest in a personal residence; and (2) an undivided portion of his entire interest in the property by sharing the life estate with the college as tenants in common. Both gifts were deductible charitable contributions.
In Private Letter Ruling 8305075 (Nov. 3, 1982), a donor made a novel gift by combining a remainder interest in his farm with a deferred payment gift annuity. He gave a remainder interest in the property to a charity, to take effect in three years. At that time, his annuity payments would begin. The charity would make annuity payments based on the farm's fair market value (FMV) on the date of transfer. The IRS ruled that the donor was entitled to a charitable deduction for the difference between the value of the remainder interest and the value of the annuity. The transfer was treated as a bargain sale, so the donor was taxed on some of the appreciation, as determined under Treas. Regs. Section 1.1011-2(b).26
Smart tax planning
The donor could have waited three years and then transferred his farm for a charitable gift annuity. Instead, he made a current transfer, retaining an estate for himself for three years. Thus, he got a charitable deduction right away, rather than three years down the road. The donor had some taxable gain under the bargain sale rules. However, the gain was reported ratably over his life expectancy and might have been completely offset by the charitable deduction. Further, because this was a deferred payment annuity, he shouldn't have had to start reporting the gain until payments actually began.
Check state law on whether a charity can issue gift annuities in exchange for real property. Also, the charity must decide whether it wants to start paying an annuity in the future based on a current valuation, even though it won't receive the property until later (when the property's value might have dropped). And in any event, the charity will be involved in a sale of the property unless it can itself use the property.
Donating Remaining Life Interest
A donor who has given a remainder interest in his residence or farm to charity, reserving a life estate for himself, should be entitled to an income tax charitable deduction if he later contributes his remaining life interest to the charitable remainder organization, thereby accelerating the charitable remainder. The income tax charitable deduction for a gift to a public charity would be for the value of the remaining life interest, based on the property's value at that time, the donor's age and the applicable Section 7520 rate (See “Why Now?” p. 39.)
If the property was divided at the outset (into a life interest and a remainder interest) to create an interest that would avoid the “less than the entire interest” rule, no deduction is allowable. It's a factual question whether a donor created a partial interest for reasons other than the avoidance of IRC Section 170(f)(3)(a). If a donor, for example, can show that he retained a life interest because he wanted to keep living there, but later determined that he no longer wanted to, he should be entitled to a charitable deduction for the current value of his remaining life interest.27
Gift Tax Rules
Life estate reserved for donor's life
The value of the charitable remainder interest in a personal residence or farm isn't subject to federal gift tax.28 However, the donor must report the remainder gift (regardless of size because it's a future interest) on a federal gift tax return.29 The donor then takes an offsetting gift tax charitable deduction.
If a life estate is retained for an individual other than the donor, there can be gift tax implications. Those implications are beyond the scope of this article. To highlight some (but not all) issues, a qualified terminable interest property (QTIP) marital deduction is available for a U.S. spouse. For an alien spouse, there's the $136,000 gift tax annual exclusion in 2011 (indexed annually for inflation) and for alien non-spouses, there's the $13,000 annual exclusion for present interests in 2011 (indexed annually for inflation). If an individual has a survivorship interest, generally gift tax concerns can be avoided on the donor's retaining the right to revoke the survivor's interest.
Estate Tax Rules
Gift of remainder interest with life estate reserved for donor's life
The FMV of the personal residence or farm at the donor's death (or the alternate valuation date) is includible in his gross estate when the donor retains a life estate in the property.30 The estate then deducts as a charitable contribution the amount included in the gross estate — resulting in a wash.31
The estate tax implication for survivorship interests are beyond the scope of this article. Suffice it to say that the charity's remainder interest isn't subject to the estate tax. And the survivor's interest for a citizen spouse can qualify for the QTIP marital deduction.
Receiving a remainder interest in a toxic waste dump could be costly. Before accepting any land gift (whether outright, in trust or as a remainder interest), the charity should check out its potential liability under environmental impact laws.
Conditional and restricted gifts
When vesting of the remainder interest in the charity is wholly dependent on some voluntary act of the donor, the contribution is conditional and thus not deductible.32 If any condition exists that could defeat the charity's remainder interest, the deduction is allowable only if the possibility of the occurrence of the condition is so remote as to be negligible.33
In Rev. Rul. 85-23,34 a donor's will gave a farm to her son Henry for life, with the remainder to charity. The will provided, however, that if Henry died before his twin sister Henrietta, she would get the farm, and the charity would get nothing. Both children were 45 years old at the donor's death. The IRS disallowed the estate tax charitable deduction because the charity's contingent remainder interest flunked the “so remote as to be negligible” test.
How remote is “so remote”? The IRS looked to Rev. Rul. 77-37435 that says that “so remote as to be negligible” means the probability is less than 5 percent that the contingency will occur and divest the charity of its interest.
No deduction will be allowed if there are substantial restrictions on the charity's use of the property. However, a deduction is allowable if only incidental restrictions are placed on the charity's remainder interest.36 Restrictions on the donee's use of the property may also cause the IRS to lower the valuation (and thus the charitable deduction) for the gift.37
In Rev. Rul. 77-305,38 the IRS disallowed the charitable deduction in the situation in which a donor and the charity agreed that if the donor was unable to continue living in the house (due to illness or old age), the house would be sold and the proceeds divided pro rata between the parties.
CRUTs and CRATs must, according to Rev. Rul. 82-128, provide that if the donor doesn't provide for the payment of death taxes out of assets other than the remainder gift, the survivor beneficiary's life interest will become effective on the donor's death only if the survivor furnishes funds for payment of any death taxes for which the trust may be liable on the donor's death.
The rationale of Rev. Rul. 82-128, which is specifically directed at CRUTs and CRATs, could apply to charitable remainder interests in personal residences and farms. However, the IRS has issued several PLRs and a General Counsel's Memorandum stating that Rev. Rul. 82-128 doesn't apply to pooled income funds. Until an official ruling comes down regarding remainder interests in personal residences and farms, the donor should state in the deed that no death taxes are to come out of the charity's remainder interest and that the donor will provide in his will or otherwise for the payment of any death taxes. However, consider not imposing on the second life tenant the obligation to pay any death taxes (levied against the property) as a condition of receiving his life interest.
Payment for property improvements by life tenant and foundation isn't self-dealing
In PLR 200149040 (Dec. 7, 2001), a husband (deceased at the time of the ruling) had contributed his house to a PF, retaining a life interest for himself and his wife. The wife, as the life tenant, continuously used the property as her principal residence for many years. She was over 90 years old and a disqualified person under IRC Section 4946. The wife and PF wanted to make much needed improvements — replacement of the driveway, central air conditioner and water heater — each paying a proportional share of the costs.
The IRS ruled that the wife's and the PF's payments of a proportional share of the costs of the improvements (equal to the present value of each party's interest in the improvements at the time of the payments) wasn't an act of self-dealing under IRC Section 4941. If the PF were to pay the entire cost of the improvements, the IRS noted, it could be argued that the value of the life tenant's property interest would be increased and that the PF would be making a prohibited direct or indirect transfer to the life tenant. On the other hand, if the wife, as the life tenant, were to pay the total costs, the payment would constitute a gift to the PF equal to the PF's remainder interest in the improvements. The IRS emphasized that the proposed improvements were necessary to maintain the property's condition (a valuable foundation asset) and that the life tenant was over 90 years old; thus, any benefits that the wife (a disqualified person) receives would be incidental.39
Computing the Charitable Deduction
Depreciation (computed using the “straight line” method) and depletion over the property's useful life must be taken into account for the income tax charitable deduction. Depreciation applies only to the structure, not to the land. The salvage value of the structure at the end of its useful life is also taken into account.40
IRC Section 170(f)(4) specifically requires taking depreciation into account in computing the income tax deduction, but the estate and gift tax IRC sections and the Treasury regulations are silent on depreciation. Rev. Rul. 76-47341 says not to take depreciation into account for gift tax purposes; presumably, the same rule applies to the estate tax charitable deduction. So for estate and gift tax purposes, just discount the remainder interest at the rate prescribed by the Treasury tables in effect at the time.
Rev. Rul. 76-47342 holds that depreciation needn't be taken into account for the gift tax charitable deduction. The computation of the estate tax deduction wasn't ruled upon because the ruling request asked only about the gift tax implications. Because the estate tax code provision parallels the gift tax provision, the same rule should apply for estate tax purposes.
Since the Treasury's interest assumption changes every month, the amount of the discount depends on when the transfer is made. The factors to compute the charitable deduction for splitinterest gifts are based on two components: an interest assumption and a mortality assumption. The interest assumption affects the rate at which a home or farm is presumed to depreciate and that affects the value of the property when it finally passes to the charitable remainder organization. Treasury tables have interest assumptions ranging from 2.2 percent to 22 percent. If a donor is terminally ill, a special actuarial factor taking the illness into account is used.43
And that, boys and girls, is almost everything that the old woman who lived in a shoe needs to know about gifts of remainder interests in personal residences and farms. Pleasant dreams and don't let the bedbugs or taxes bite.
- Revenue Ruling 76-357, 1976-2 C.B. 285; see also Private Letter Ruling 7802016 (Oct. 12, 1977).
- Rev. Rul. 76-165, 1976-1 C.B. 279.
- See PLR 8529014 (April 16, 1985) (heating and air conditioning system).
- Treasury Regulations Section 1.170A-7(b)(4); Rev. Rul. 78-303, 1978-2 C.B. 122.
- Estate of Cassidy, TC Memo 1985-37; Rev. Rul. 76-357, 1976-2 C.B. 285.
- Rev. Rul. 76-357, 1976-2 C.B. 285; see also PLR 7802016 (Oct. 12, 1977).
- PLR 9015049 (Jan. 16, 1990).
- Internal Revenue Code Section 1011(b); Treas. Regs. Section 1.1011-2(a)(3). See also Guest v. Commissioner, 77 T.C. 9 (1981).
- PLR 9329017 (July 23, 1993).
- Rev. Rul. 76-543, 1976-2 C.B. 287; Rev. Rul. 76-544, 1976-2 C.B. 288.
- Technical Advice Memorandum 7812005.
- TAM 8141037.
- TAM 7835010.
- Estate of Blackford v. Comm'r, 77 T.C. 1246 (1981).
- IRS Announcement, 1983-2 C.B. 1.
- Rev. Rul. 83-158, 1983-2 C.B. 159. See also TAM 9347002.
- TAM 8341009.
- Rev. Rul. 76-544, 1976-2 C.B. 288.
- Rev. Rul. 87-37, 1987-1 C.B. 295.
- Rev. Rul. 87-37; see Estate of Fawcett, 64 T.C. 889 (1975), acq., 1978-2 C.B. 1.
- IRC Sections 2055(e)(4) and 2522(c)(3).
- Estate of Fawcett, supra note 20.
- Ibid. at p. 901.
- Estate of Youle, 56 T.C.M. 1594 (1989). See also Zable v. Comm'r, 58 T.C.M. 1330 (1990) (10 percent discount on fractional interests in land donated outright to charities; a partition proceeding would have taken a year and cost each cotenant $5,000 in legal fees) and Estate of Wildman v. Comm'r, 58 T.C.M. 1006 (1989) (decedent's minority interest in land justified 15 percent discount in value).
- 1976-2 C.B. 306.
- Similarly, PLR 8806042 (Nov. 17, 1987).
- See, e.g., Rev. Rul. 76-523, 1976-2 C.B. 54.
- IRC Section 2522(c)(2); Treas. Regs. Section 25.2522(c)-3(c)(2)(ii), (iii).
- IRC Section 6019(b).
- IRC Section 2036.
- IRC Section 2055(e)(2); Treas. Regs. Section 20.2055-2(e)(2)(ii), (iii).
- Rev. Rul. 77-305, 1977-2 C.B. 72.
- Treas. Regs. Section 1.170A-1(e); PLR 9436039 (Sept. 9, 1994).
- 1985-1 C.B. 327.
- 1977-2 C.B. 329.
- See, e.g., PLR 7807101 (Nov. 22, 1977).
- Deukmejian v. Comm'r, TC Memo 1981-24; Klopp v. Comm'r, TC Memo 1960-185; Dresser v. Comm'r, TC Memo 1956-54; Rev. Rul. 85-99, 1985-1 C.B. 83.
- 1977-2 C.B. 72.
- Rev. Rul. 73-407, 1973-2 C.B. 383; Treas. Regs. Section 53.4941(d)-2(f)(4), examples 1 and 4.
- IRC Section 170(f)(3), (4); Treas. Regs. Sections 1.170A 7(c), 1.170A 12, 20.2055- 2(f) and 25.2522-3(d).
- 1976-2 C.B. 306.
- Treas. Regs. Sections 1.7520-3(b), 20.7520-3(b) and 25.7520-3(b).
Conrad Teitell is chairman of the national charitable planning group in the Stamford, Conn. office of Cummings & Lockwood, LLC. Heather J. Rhoades is a principal of the national charitable planning group in the West Hartford, Conn. office of Cummings & Lockwood, LLC
Gifts of remainders in personal residences and farms are especially attractive today because of the extremely low Section 7520 rates
The donor receives an income tax deduction for the actuarial value of the remainder interest passing to the charity. The Internal Revenue Code Section 7520 rate at the time of the gift is used to calculate the value of the remainder interest. The lower the Section 7520 rate, the greater the value of the remainder interest and the greater the donor's income tax charitable deduction.
For example, a 70 year old giving the remainder in his personal residence worth $1 million to charity and retaining a life estate for himself would receive a charitable deduction of approximately $422,000 when the Section 7520 rate is 6.0 percent, but would receive a much higher charitable deduction of $580,000 when the Section 7520 rate is 3.0 percent.
— Conrad Teitell & Heather J. Rhoades