Real estate, both residential and investment, represents a significant portion of the country’s wealth. As such, it should be considered as an asset class for a potential charitable gift. 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.
Tax Traps
The 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; minority interest discounts; prearranged sale; unrelated business taxable income (UBTI); excise tax on self-dealing; mortgaged property; and tax impact of depreciating the real estate.
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 a fair valuation. 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) appraisal summary to the return on which the deduction is taken (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, the charity is required to file Form 8282 with the IRS showing the amount received on the sale of the real estate. The Pension Protection Act of 2006 also tightened the accuracy-related penalties for overvalued non-cash contributions and imposed, for the first time, penalties against appraisers for substantial or gross valuation misstatements.
Minority Interest Discounts
The minority interest discounts often found in the real estate context may endanger charitable deductions. Suppose an owner’s estate includes his 100 percent
interest in the family business, valued at $10 million, and the owner’s will bequeaths 25 percent of the stock to a local community foundation (CF) and 75 percent to the owner’s children. The estate includes the 100 percent interest in the business, but the CF receives a minority interest in the business. In a similar context, the Tax Court has ruled that when a decedent’s estate includes a controlling interest in a company, but only a minority passes to charity, a minority interest discount should be applied in determining the amount of the charitable deduction.2 Accordingly, in the example above, it’s likely that the amount of the charitable deduction would be less than $2.5 million (25 percent of the value of the business).3
This approach is followed in the recently proposed IRC Section 2704 regulations,4 which generally limit discounts in the family entity context. The preamble specifically states that when an interest passes to family members as well as to charity, the interest passing to the family may be valued without reference to minority interest discounts, while the interest to the charity will be treated separately and subject to discounting.
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 won’t avoid the capital gains on the sale of the real estate by the charitable recipient. The donor will be personally responsible for the gains under the “assignment of income” theory and won’t be able to receive funds back from the recipient charity to pay the tax, but will have to reach into his own pocket instead. This experience is all too common with charitable gifts of real estate. If, however, there’s no legally binding contract in place prior to the transfer to charity, the donor won’t be responsible for the capital gains that will be exempt from tax on the sale by the recipient charity.
Unrelated Business Income Tax (UBIT)
Although charitable entities generally aren’t subject to income tax, an exception applies if the charitable entity has income subject to the UBIT. Income is subject to UBIT if it’s from a trade or business that’s regularly carried on, and the activity isn’t substantially related to the charitable entity’s exempt purposes. Most passive income, such as (generally) rent from real estate, isn’t subject to UBIT. Passive income is, however, subject to UBIT to the extent it’s derived from debt-financed property. “Debt-financed property” generally means any property held to produce income (including gains from the sale on the debt-financed portion of such property) for which there’s “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).5
If a public charity or private foundation (PF) has UBTI, it’s subject to UBIT at regular corporate or trust income tax rates, depending on how the entity is organized. UBIT is especially problematic for charitable remainder trusts (CRTs) because a 100 percent excise tax applies to the income.6 For charitable lead trusts (CLTs), UBIT presents much less of a problem because lead trusts aren’t 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 UBTI, its income tax deduction for distributing UBTI 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.
Self-Dealing Prohibitions
The IRC Section 4941 self-dealing rules apply to PFs, CRTs and CLTs, but not to outright transfers to public charities. The basic principle underlying Section 4941 is that all financial transactions of a PF, 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 PF 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 can’t 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. 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, it 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,7 which is rare). Thus, any gain or income attributable to the mortgaged percentage of the property will be taxable to the charity, which otherwise wouldn’t 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 the 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, PFs, CRTs and CLTs have to be concerned about self-dealing if the mortgage is assumed by the charity or if it 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; the donor would lose the income and gift tax charitable deductions, plus the trust would lose its tax-exempt status. In addition, the donor will be liable for any capital gains taxes generated when any appreciated trust asset is sold.
Depreciation
It’s typical for buildings held for investment to be depreciated for tax purposes over time. Generally, such depreciation is done using the straight-line method. But, certain buildings are depreciated using an accelerated depreciation schedule. It’s important to note that the charitable deduction will be reduced when accelerated depreciation has been taken. Under IRC Section 170(e), the amount of the charitable deduction is reduced by the amount the accelerated depreciation taken exceeds what would have been permitted under the straight-line method.
Structures
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 ones 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 (including donor-advised funds) and PFs; 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 CRT).
Outright Gifts of Real Estate
A donor who wants to structure an outright gift of real estate to charity needs 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 (subject to discounts for minority interest gifts)—as long as the donor isn’t considered a dealer in property (if so, the deduction will be limited to the tax basis). A gift of the same property to the donor’s PF 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 PF is that the deduction is limited to the lesser of FMV or cost 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 involves a transfer of a parcel of real estate to a local government or land trust to get favorable zoning on an adjacent parcel in connection with the development of the property. Typically, there’ll 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’s very common for a charitable organization to purchase a parcel of real estate for less than its FMV. In this situation, 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 sales price and FMV. The donor will incur capital gains on the difference between the sales price and the cost basis allocated to the sale element. No capital gains tax will be paid on the gains allocated to the charitable gift element. It’s very important that the donor intend and clearly express in writing the intention to make a charitable gift of the difference between the sales price and FMV. A taxpayer who merely negotiates a bad deal with the charity purchasing the property can’t 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 isn’t 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.8 Certain partial interest gifts, however, are deductible. Deductible partial interest gifts fall into two basic categories: (1) deductible partial interest gifts in trust, and (2) deductible partial interest gifts not in trust:
In trust—In this category we have: (1) charitable remainder unitrusts (CRUTs), and (2) CLTs.
(1) CRUTs—A CRUT can be an excellent vehicle for highly appreciated unmortgaged real estate. Because it’s 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 grows or decrease if the value declines. Although the CRUT itself doesn’t pay income taxes, the beneficiary will pay income tax on some or all of the distributions received from the trust (under a system of taxation unique to CRTs known as the “four-tier system”). In addition, the donor will receive an income tax charitable deduction for the present value of the charitable remainder interest. 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 flip CRUT, which allows the trustee to refrain from making unitrust payments until the property becomes income-producing.
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.
(2) 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 UBTI is largely irrelevant as all of the trust’s income is taxed to the grantor in all events. Even for a non-grantor CLT, UBTI isn’t as big a problem as it is for a CRT (100 percent excise tax discussed above). A non-grantor lead trust 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 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 self-dealing rules can present problems for a CLT funded with real estate, particularly commercial real estate because there may be transactions, such as rental of the real estate to the grantor, or individuals 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 PF 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 won’t be possible, because that disposition would constitute a prohibited act of self-dealing. In the case of testamentary CLTs, planning steps 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.9 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,10 and the CLT will be denied a Section 642(c) deduction for distributions of lead payments to charity each year.11
Not in trust—What about deductible partial interest gifts that aren’t in trust? In this category, we have:
(1) undivided interest gifts; (2) contributions of a remainder interest in a personal residence or farm; (3) qualified conservation contributions; and (4) charitable gift annuities (CGAs).
(1) 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. 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.12
(2) 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 needn’t 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) to be deductible. Donating property subject to a mortgage isn’t advisable, because it results in the donor recognizing income to the extent of mortgage under the bargain sale rules.
(3) Qualified conservation contributions—A contribution of a “qualified real property interest” donated to a “qualified organization” exclusively for “conservation purposes” is deductible.13 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 on a “before and after” analysis; comparing the property’s FMV 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 Protecting Americans from Tax Hikes Act of 2015 permanently increased the deductibility percentages allowed for such a contribution to 50 percent (100 percent for qualified farmers and ranchers).
(4) CGAs—A CGA is considered a bargain sale—part outright charitable gift and part purchase of an annuity—and therefore isn’t subject to the partial interest rules. A CGA usually results in similar tax and financial consequences to a charitable remainder annuity trust. However, because a CGA is a contract, rather than a trust, it isn’t subject to the self-dealing rules of Section 4941. CGAs 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 CGA may be an attractive option.
—The views expressed herein are those of the authors and may not necessarily reflect the views of UBS Financial Services Inc. UBS Financial Services Inc., its affiliates and its employees do not provide tax or legal advice. You should consult with your legal or tax advisor regarding your particular circumstances.
Endnotes
1. Treasury Regulations Section 1.170A-1(c)(1)-(2).
2. Ahmansan Foundation v. United States, 764 F.2d 761 (9th Cir. 1981). See Technical Advice Memorandum 9403005; Chenoweth v. Commissioner, 88 T.C. 1577 (1987).
3. See, e.g., Private Letter Ruling 9050004 (Aug. 31, 1990) (49 percent interest in closely held corporate stock allocated to marital deduction trust with resulting reduction in marital deduction); PLR 9147065 (July 12, 1991) (marital deduction reduced when decedent’s will bequeathed voting stock to decedent’s son and nonvoting stock to marital trust); Disanto v. Comm’r, T.C. Memo. 1999-421 (marital deduction reduced when surviving spouse disclaimed a portion of closely held stock bequeathed to her, resulting in her receiving only a minority interest). The decedent held a controlling interest in the stock. By reason of the surviving spouse’s disclaimer, the surviving spouse received a minority interest in the stock; compare Chenoweth, supra note 2 (when 51 percent of a closely held corporation was bequeathed to the surviving spouse and 49 percent to the children, control premium accorded to marital share and minority discount accorded to nonmarital share).
4. www.gpo.gov/fdsys/pkg/FR-2016-08-04/pdf/2016-18370.pdf.
5. 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 wouldn’t have been incurred except for the acquisition or improvement of the property; or (3) after acquiring or improving the property if the debt wouldn’t have been incurred except for the acquisition or improvement of the property, and the debt was reasonably foreseeable when the property was acquired or improved. Internal Revenue Code Section 514(b) and (c).
6. IRC Section 664(c)(2)(A). This is actually a relaxing of the prior rule, which treated a charitable remainder trust as not tax-exempt (subject to regular trust income tax rates) if it had even a de minimus amount of unrelated business taxable income for the year.
7. IRC Section 514(c)(2)(B)
8. IRC Section 170(f)(3)(A).
9. IRC Section 1361(c)(2).
10. IRC Section 641(c)(2)(A).
11. Ibid., flush language; Treas. Regs. Sections 1.641(c)-1(g)(4); 1.641(c)-1(l), Ex. 4; Section 170(f)(3)(B)(ii).
12. Treas. Regs. Section 1.170A-7(b)(1)(i).
13. Section 170(h).
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