Friday May 7, 2021
Article of the Month
Charitable Gifts of Real Estate – Part I
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 well equipped and informed about the benefits and pitfalls of gifts of real estate.
This series about gifting real estate will discuss the definition of real estate, charitable deductions for real estate gifts, charitable gift options and some best practices. This first article will touch on overarching considerations from a donor's and charity's point of view when gifting real estate.
There are a variety of categories of real estate, including residential property, commercial property and agriculture. Real property comes in many forms—homes, office buildings, undeveloped lots and timber land are a few examples. Generally, the best property for a donor to use as a charitable contribution is unencumbered real property that has been held for longer than one year.
Without any charitable gift, the sale of real estate will trigger income for the owner. Generally, the owner will owe taxes on the income gain resulting from the sale—the excess of the sale price over the cost basis of the property. Gifts of real estate to a charity satisfy the donor's charitable purposes, as well as offer a charitable deduction and bypass capital gains. The gift may include lifetime payouts and other benefits.
Considerations When Gifting Real Estate
i. Deduction Limitations
The donor's charitable deduction is based on two factors. First, the property must qualify as a capital asset. Real estate that is inventory or sold in the ordinary course of the donor's business is not a capital asset and is instead treated as an ordinary income asset. Personal residences generally qualify as capital assets. If the real estate does not qualify as a capital asset, the donor's charitable deduction is limited to the cost basis.
Second, the charitable deduction is dependent on whether the property is classified as a long-term capital gain asset or a short-term capital gain asset. A long-term asset is one that the donor holds for more than one-year, while a short-term asset is held for less than a year. If the gift is a long-term asset, the donor may be entitled to a charitable deduction equal to the fair market value (FMV) of the real estate. However, gifts of a short-term asset or an inventory-type asset are only deductible at cost basis.
Generally, the donor's charitable deduction for gifts of appreciated property (including real estate) is limited to 30% of the donor's adjusted gross income (AGI), with a potential carry forward up to five additional years. This limitation may disallow a donor from taking the entire charitable deduction amount in year one, but the five-year carry forward gives the donor the opportunity to take the entire amount spread out up to six years.
The donor may elect to deduct the cost basis of appreciated property at 50% of his or her AGI. This is a helpful option for a donor who desires to make a large gift of real estate that has a high basis. The higher 50% of AGI deduction limitation may allow the donor to take the entire deduction in the year of the gift, rather than needing to carry it forward. However, if the donor elects to deduct at cost basis, then all other appreciated property gifts and carry forwards must also be deducted at cost basis.
The CARES Act increased the deduction limitation for cash gifts in 2020 to 100% of the donor's AGI. However, there is not a change in the deduction limitation for gifts of appreciated property, which includes real estate.
ii. Partial Interest Gifts
In general, the donor is not eligible for a charitable deduction when gifting a partial interest. There is an exception for giving an undivided fractional interest in property. An undivided fractional interest in property is an undivided portion of a donor's entire interest in property, which qualifies for a charitable deduction when gifted to a charity. See the partial interest gift examples below.
Fred owns land with mineral deposits. He is considering a gift to his favorite charity. Fred asks his advisor about making a gift of the land, while retaining the mineral rights. His advisor explains that structuring the gift this way would be a gift of a partial interest and is not eligible for a charitable deduction. Furthermore, in order for Fred to receive a charitable deduction, he must give an undivided interest in the land and the mineral rights. His advisor asks him to consider an alternative arrangement, Fred can meet his philanthropic goals by making a gift of a 25% undivided interest in the land and the mineral rights. While it is only a portion of the property, it is a deductible interest. Fred is very pleased that his gift can make a lasting impact at his favorite charity.
Mary has a home that she is thinking about selling and she would like to donate some of the sale proceeds to charity. She considered a cash gift to charity out of the proceeds of the sale, but realized she would need to pay capital gains taxes on the sale. She asked her advisor for guidance on the best route. The advisor recommends Mary gift a 50% interest in the home to charity, retain the other 50% interest and sell the property in a gift and sale arrangement. She asks if she would be eligible for a charitable deduction on the 50% interest gifted. The advisor explains that the gifted 50% interest qualifies as an undivided fractional interest and she is eligible for a charitable deduction. Mary is also only taxed on the gain for her 50% portion of the home, rather than capital gains on the entire gain in the sale of the home. Mary is pleased with the advisor's plan and proceeds with the gift arrangement.Professional advisors should understand the difference between a partial interest gift and an undivided fractional share when helping donors with real estate gifts. The goals of the donor may vary and care should be taken when a donor intends to make a donation that will generate a charitable income tax deduction.
iii. Gift Acceptance Policies
The gift acceptance policy of an organization may dictate the parameters for acceptance of a charitable contribution from a donor. Generally, there are three categories of gift acceptance policies a charity may implement. Certain types of gifts, such as real estate, may fall under exceptions to the standard acceptance parameters and need to be approved on a case-by-case basis.
When a charity creates real estate gift acceptance policies, it must consider the Comprehensive Environmental Response, Compensation, and Liability Act of 1980 (CERCLA). Under CERCLA, the current property owner (i.e. a charity) or anyone in the chain of title can be held liable for cleanup costs, even if they are not responsible for any of the property contamination. When a charity accepts a gift of real estate, it will have taken title to the property and can be held liable under CERCLA. The potential for unlimited liability under CERCLA requires a charity's decision to accept gifts of real estate to be done carefully and with due diligence. It is highly recommended that the charity create a gift acceptance policy that best suits the charity's tolerance for risk and reward.
Some charities will adopt a "no acceptance" policy based upon the potential environmental liabilities under CERCLA. The policy is simple—all gifts of real estate will be rejected. Although the charity is ensured it will not inherit any liabilities associated with real estate ownership, the charity is limiting its charitable gifts. Accordingly, fewer charitable gifts mean less money for the charity. Considering that many donors' wealth is in real estate, a blanket "no acceptance" policy would deny these donors from achieving their philanthropic goals along with reducing the amount of gifts to the charity.
On the opposite end of the spectrum is the "accept everything" policy. This policy is not necessarily formally adopted, but is a result of a lack of careful planning. A charity in this position often will not have a formal gift acceptance policy or lacks a committee to review proposed gifts. The benefit of this policy is that the charity can receive more charitable gifts, but the downside is the charity might unknowingly accept gifts of real estate with environmental risk and liabilities that far exceed its value. The uniqueness of the benefits and liabilities of real estate makes an "accept everything" policy unsuitable for charities.
The middle ground is the "case-by-case" acceptance policy. This policy understands the uniqueness of real estate and the risks and rewards associated with each gift of real estate. A charity's gift acceptance policy should be designed to accept "good" gifts, while rejecting "bad" gifts. A flexible gift acceptance policy on a "case-by-case" basis is the ideal approach for many charities. It reduces liabilities, while enhancing donor contributions and gift options.
iv. Environmental Factors
Real estate gifts may come with heightened risk factors compared to other types of property. Although the charity will attempt to sell the real estate as soon as possible, once in the chain of title any environmental issues may subject the charity to liability.
Charities must carefully review each gift of real estate before acceptance, but may need to take additional steps if the real estate is commercial or industrial in nature. Commercial or industrial real estate is more likely to have issues with hazardous materials incurring CERCLA liability than a typical residential property.
As an additional step, charities can obtain an environmental impact survey (EIS) to assess the potential environmental risks associated with the property. There are three levels of testing: Phase 1, Phase 2 and Phase 3. With each higher phase the charity is provided with more assurances regarding the likelihood of the potential environmental issues, but the higher phases have increasing costs. There are no tax rules that regulate who pays for the EIS costs. The charity and donor are free to negotiate the costs.
As is true with all gifts of real estate, the charity must consider the risks and rewards of accepting the gift. A "good" gift of real estate with unknown environmental issues can create significant problems for a charity. Therefore, charities must ensure all steps are taken to identify and determine the environmental issues before acceptance.
v. Mortgaged Real Estate
Potential gifts of real estate may be encumbered by a mortgage. Encumbered real estate is not ideal for charitable contributions. When encumbered real estate is gifted, the debt remains on the property, unless it is paid off. If a donor wants to gift debt-encumbered property, the charity should consider several factors before accepting the gift.
The charity may choose to "step into the shoes" of the donor and make payments on the mortgage prior to the sale of the property. Because the charity acquires the property subject to a recorded mortgage, the gift is treated as a bargain sale. The donor's relief of indebtedness is treated as gain to the extent the debt exceeds the cost basis. The donor will only receive a charitable deduction for the equity portion of the gift. In short, the charitable deduction will be reduced by the value of the debt on the property. The charity does not assume the mortgage, but may make payments to protect its interest in the property.
One very important consideration is that mortgaged property may be categorized as "acquisition indebtedness" property under Sec. 514(c)(2)(A). When a charity acquires property subject to a mortgage or other similar lien, the amount of the indebtedness is considered to be the indebtedness of the organization incurred in acquiring such property. This designation occurs regardless of the organization assuming or agreeing to pay such indebtedness. If the charity is subject to acquisition indebtedness when encumbered property is acquired, the charity may owe unrelated business income tax (UBIT) upon the sale of the property.
However, there is one exception to the acquisition indebtedness rule under the "Five and Five" exception. This exception allows a safe harbor if the debt has been on the property for more than five years and the donor has owned the property for more than five years. Sec. 514(c)(2)(B). If the exception applies, the charity receives the property free of acquisition indebtedness for a period of ten years. Therefore, if the property passes the "Five and Five" test, then the charity may receive and sell the property within the ten-year period without payment of UBIT. This exception may not apply to many properties, especially in a low interest environment where many property owners will refinance debts.
There is one important pitfall within the "Five and Five" exception for the charity to avoid. The charity must receive the property subject to the debt, but may not assume the debt obligation. That is, the charity may receive title and make payments on the debt to defend its position and title, but it must not contractually obligate itself with the lender to pay the indebtedness secured by the mortgage.
There are several steps that may be undertaken prior to accepting the gift of real estate. If the "Five and Five" exception does not apply, the donor should be encouraged to pay the debt on the property prior to making the donation. There are multiple strategies to enable the donor to pay off the debt, which may include a bridge loan or working with a lender to release the debt. If the donor gifts indebted property, the charity may avoid UBIT by paying off the debt and then holding the real estate for 12-months before selling it. However, some nonprofits may lack the financial resources for this strategy.
If the donor gifts debt-encumbered property to charity, the donor's equity in the property will generate a charitable deduction, but the amount of the mortgage will be treated as a "release of indebtedness" to the donor. This release of indebtedness is a taxable event. The amount of debt the donor is relieved from paying must be reported by the donor as capital gain in the year of the gift. The donor's charitable deduction may offset some or all of the taxes due. The offset of capital gains tax is an important consideration to note when speaking to donors about gifts of debt-encumbered property.
When gifting real estate, the charity must ensure the donor is aware of any encumbrances on the property and the potential associated issues. Additionally, the donor needs to be informed of the effect of transferring encumbered real estate to charity.
vi. Charitable Deduction Substantiation
Donors who make real estate gifts must file IRS Form 8283 with their tax return, which applies to all non-cash charitable contributions greater than $500. Under Reg. 1.170A-16(d)(1)(ii), donors must also obtain a contemporaneous written acknowledgment from the charity for the charitable contribution. Additional requirements may apply based on the value of the property.
In general, the IRS requires a qualified appraisal for gifts of non-cash assets to charity that exceed a value of $5,000. This requirement applies to gifts of real estate. To be considered a qualified appraisal, it must not be performed earlier than 60 days prior to the date of the transfer and must be obtained prior to the due date, including any extensions, of the tax return on which the charitable deduction is claimed. If the property is valued in excess of $500,000, the donor is required to attach the qualified appraisal to the tax return for the year of the gift, in addition to Form 8283. Reg. 1.170A-16(e)(1)(iv).
Although required by the IRS, a qualified appraisal is also used to determine the fair market value (FMV) of the gifted real estate. If the gift is a long-term capital asset, the FMV determined from the qualified appraisal should be used to calculate the donor's charitable deduction.
The majority of real estate gifts are in excess of $5,000. Acquiring a qualified appraisal is an absolutely essential aspect of gifts of real estate to charity. Without a qualified appraisal, the IRS may deny the donor's charitable deduction.
In many cases, a donor may wish to gift real estate that he or she has depreciated over time, such as rental property. Donors must be aware of the impact depreciation can have when gifting real estate to charity. Accelerated depreciation recapture on improvements can decrease the charitable deduction.
If the donor gifts property that was depreciated using the accelerated depreciation method, the donor may need to reduce the charitable deduction by the ordinary income portion of the asset value. The excess of the accelerated depreciation over the straight-line method would be ordinary income if the asset were sold. Because the ordinary income portion of value is not deductible under Sec. 170(e)(1)(A), a gift of property that has been subject to accelerated depreciation to a charity will lead to a reduced deduction.
viii. Prearranged Sale
A prearranged sale occurs when there is an identified purchaser, an identified price and a legally enforceable agreement to sell the property before the real estate is gifted to charity. If a prearranged sale occurs, the donor forfeits any bypass of capital gain and must realize the income gained in the transfer to charity.
In Rev. Rul. 78-197, the IRS established a bright line test to determine a prearranged sale. When a charitable gift is followed by a "prearranged redemption" or "pursuant to a prearranged plan" the IRS will "treat the proceeds as income to the donor." The rule on prearranged sales is rooted in contract law. If the contract has proceeded to a point when performance can be compelled, then a binding agreement exists.
A major benefit of gifting real estate to charity is the bypass of capital gain. The charity and donor must be cognizant that a prearranged sale will forfeit the donor's bypass of capital gain.
There are many issues to consider when gifting real estate to charities. These issues can limit or disqualify a donor from receiving a charitable deduction or can seriously impact a charity that accepts the wrong types of real estate gifts. Despite the risks and intricacies of real estate gifts, donors and charities can effectively navigate real estate gifts with careful planning and thoughtfulness. These gifts can be structured to maximize the benefits for both the donor and the charity. November's Article of the Month will discuss different ways to structure real estate gifts to charity.