Real estate can make a wonderful gift to charity. The tax treatment for gifts of real property often depends on the type of property and the length of property ownership. This article will provide an ;overview of gifts of real property and some of the unique challenges associated with these gifts.
What is the Holding Period? Long-Term or Short-Term?
The length of property ownership, or what is sometimes termed the holding period, determines tax treatment under the Internal Revenue Code. Accordingly, a donor's tax treatment of real property gifts will differ depending upon whether the asset is considered a long-term or short-term capital asset.
Long-Term Capital Asset
An asset held for more than one year is considered a long-term capital asset. The gift of a long-term capital asset qualifies for a charitable tax deduction at fair market value. However, the deduction for a gift of a long-term capital asset is limited to 30% of a donor's adjusted gross income (AGI). See Sec. 170(b)(1)(B)(i). Any remaining deduction may be carried forward for an additional five years.
Short-Term Capital Asset
Assets held for less than one year and one day are considered short-term capital assets. The deduction for the gift of a short-term capital asset is limited to the lesser of (1) the asset's fair market value or (2) the donor's cost basis in the asset. If a donor elects a cost basis deduction, the deduction is usable up to 50% of the donor's AGI. Sec. 170(b)(1)(C)(iii).
Election for Appreciated Property
When making a gift of long-term capital gain property, a donor may elect to deduct the gift at cost basis instead of fair market value. This is a helpful option for a donor who wants to make a large gift of appreciated property that has a reasonably high basis. If a donor makes this election, the donor: (1) takes a deduction at cost basis, (2) is allowed to apply the gift limit of 50% of AGI and (3) but must deduct any carry-forwards from previous years at cost basis.
Regardless of the nature of the asset gifted, a donor must take a deduction for a gift of real property in the year the gift was made. Any unused deduction may be carried forward for an additional five years.
Larry and Mary Berry are in their early 70s and retired several years ago. Their home in Illinois and their winter home in Florida are both paid for; they have few monthly expenses and enjoy a combined adjusted gross income of $100,000. Larry and Mary are avid supporters of their alma mater and wish to make a sizeable gift to the college. Larry and Mary want to give a piece of land with a fair market value of $70,000 and a basis of $20,000 to the college. They bought the land 10 years ago. What will their deduction be?
First, it is important to determine Larry and Mary's AGI. In this case, it is $100,000. Second, what is the holding period? The land is considered a long-term capital asset because they have owned the land for more than one year. Third, the property has appreciated during the time that Larry and Mary owned the land. Based on the fact that the land is an appreciated long-term capital asset, Larry and Mary qualify for a fair market value deduction subject to the 30% of AGI deduction limit.
At the time that Larry and Mary give the land to the college, they will be able to take a charitable deduction for up to 30% of their $100,000 AGI. The $70,000 gift permits a deduction of $30,000 and carry forward of $40,000 that they may use in any of the next five years (provided that their gifts that year do not exceed the limits allowed by the deduction rules). If Larry and Mary's income remains the same next year and they do not make any charitable contributions, they could take another $30,000 deduction next year and $10,000 the following year.
Assume the same fact pattern as Example 1 but Larry and Mary acquired the land five months ago for $55,000. How much can they deduct?
First, we determine that Larry and Mary's AGI is unchanged. Second, the land is now considered a short-term capital asset. Third, the land is still an appreciated asset. Because the asset is a short-term capital asset, Larry and Mary are allowed to take a deduction only for the cost basis. However, this cost basis deduction qualifies for the 50% limit, so they deduct $50,000 this year. With a total deduction limited to $55,000, they would only be allowed to carry-forward an unused deduction of $5,000.
Assume the same fact pattern as Example 1 (long-term capital gain), but Larry and Mary's cost basis in the property is $60,000 and its fair market value is $100,000. Also, assume that their tax advisor told them to maximize their charitable giving this year. Larry and Mary could make a 50% election for the gift of the property and deduct the cost basis rather than the fair market value. Because they elect to deduct the cost basis, they are permitted to use the 50% of AGI limit. They could take a deduction this year for $50,000 (50% of their AGI), but could then only carry forward $10,000 for future years. If the 50% election is made, it must apply to all appreciated gifts.
Is This Personal or Business Property?
Commercial property can make an excellent gift to charity, however, there are some tax issues a donor and their tax advisor must consider. If a donor has claimed depreciation deductions on the property, a portion of the depreciation may be subject to "recapture."
In general, there are two methods of depreciation available for commercial properties: (1) the straight-line method of depreciation, or (2) the accelerated depreciation method. If a donor depreciates property according to the straight-line method and sells the property, he or she reports a capital gain on the straight-line deprecation with a 25% tax rate on that gain. However, if the donor uses the accelerated depreciation method, any depreciation deduction taken in excess of the straight-line method will be potential ordinary income. Because under Sec. 170(e) there is no deduction for a gift of an ordinary income asset, a gift of commercial property with accelerated depreciation will result in a deduction reduced by the ordinary income portion. Section 1250.
A personal residence is different from a commercial property in that a homeowner may not claim depreciation deductions. Therefore, there is no risk of recapture. By making a gift of a single family home, condominium or interests in a cooperative housing agreement, a donor is able to bypass any capital gain associated with the property. If the donor has owned the property for long enough to qualify the asset as a long-term capital asset (at least one year and one day), the donor may take a deduction for the full fair market value of the property, subject to the 30% of AGI limit per year.
Farms include not only farmed land but also associated structures such as barns, grain silos and equipment buildings. Making a gift of farm land and associated buildings allows the donor to bypass capital gain on the sale of the property and entitles the donor to a charitable income tax deduction. It is worth noting that such a gift may involve many of the same depreciation and recapture rules associated with commercial real estate.
Where the farm gifted includes crops growing on the property, most cash-basis donors may add the cost of raising the crops to his/her basis in the property. In the event the crops are harvested prior to the transfer of the property, the crop becomes inventory in the donor's trade or business. Therefore, the severed crops are separate and distinct from the farm and not included in the fair market value of the real property.
Sam Miller owns a vacant warehouse that he bought several years ago for $1,000,000, but the warehouse has appreciated to a current fair market value of $2,000,000. Sam has taken $500,000 of accelerated depreciation against the warehouse property so that his adjusted cost basis is only $500,000. If Sam had chosen straight line depreciation, it would have been $300,000. Therefore, the excess of the accelerated depreciation over straight line depreciation is $200,000.
The warehouse sits adjacent to the local Boys & Girls Club. The Boys & Girls Club is in desperate need of additional space. With a little bit of renovation, the warehouse could be turned into a gymnasium where the Club could host many after-school activities for the neighborhood kids. Sam had originally thought of selling the warehouse but has recently decided he wants to make a gift of the warehouse to the Boys & Girls Club. What kind of deduction would Sam be able to take for his gift?
While Sam's gift would normally be deductible at the fair market value of the property ($2,000,000), that is not the case here. Instead, Sam must reduce the amount of his deduction by the amount of depreciation recapture that would have been realized had he sold the property. Had Sam sold the property, he would have four different tax portions and rates. The $500,000 adjusted basis is taxed at zero.
The $300,000 straight line depreciation component is a capital gain taxed at 25%. The $200,000 excess depreciation is recaptured as ordinary income at Sam's rate of 35%. Finally, the $1,000,000 appreciation is long-term gain taxed at 15%. Instead of selling, Sam gives the warehouse to the public charity. Sam must reduce his charitable deduction by the potential ordinary income amount of $200,000. In this case, Sam will take a deduction of $1.8 million. His appreciated-property deduction includes his basis, the straight line depreciation capital gain and the balance of the capital gain.
What if the Realty Has Debt?
Whether the gain is considered short-term or long term, the existence of debt on a piece of property complicates the gift. First, a donor must reduce his or her deduction by the amount of debt attributed to any given piece of real property. Second, a donor should also carefully read the terms of the debt instrument. It is not uncommon for an instrument to call for an acceleration of the amount due upon the sale or transfer of a property, even upon the gift to charity. Therefore, it is important for a donor to know that the transfer of an indebted property may give rise to immediate payment on the debt obligation.
If a donor transfers to charity property that is subject to debt, the transaction is considered a bargain sale. Under the bargain sale rules, the equity in the property will produce a charitable deduction, but the ensuing release of indebtedness will be treated as a taxable event. Reg. 1.1011-2(a)(3); Rev. Rul. 81-163, 1981-1 C.B. 433.
The cost basis is prorated between the equity portion and the debt. In most cases, the gift is an appreciated property gift and the donor will recognize gain on the difference between the face value of the debt and the prorated basis. If property has been held for more than one year, then the donor will receive an appreciated property charitable deduction for the value of the equity and recognize long-term capital gain on the debt relief. The gain for depreciation taken by the straight-line method is taxed at the 25% rate. If depreciation is taken at an accelerated rate, the gain on the excess depreciation element is taxed at ordinary income rates.
If property subject to debt is transferred to charity, the charity could be subject to unrelated business income tax upon the sale of that property. However, there is an exception for property that has been owned by the donor for more than five years and the property has been subject to debt for more than five years. Sec. 514(c)(2)(B). In this case, the charity may receive the property and there will be no acquisition indebtedness for a period of ten years. Therefore, if the donor passes the "five and five" test, the charity may receive and sell the property within the ten-year period without payment of any unrelated business income tax.
There is another important pitfall 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 may not contractually obligate itself with the lender to pay the indebtedness secured by the mortgage.
Does the Donor Need an Appraisal?
Gifts of real estate usually require the donor to obtain a qualified appraisal to substantiate the charitable deduction. The issues surrounding qualified appraisals for gifts of real property will be covered in a subsequent article. The appraisal requirement is triggered if the real property gift value exceeds $5,000. In addition, the gift of a noncash asset greater than $500 requires the filing of Form 8283 with the donor's income tax return. Visit GiftLaw Pro 1.5.2 for a full discussion on Form 8283 and qualified appraisal issues.
For more information, contact Chris Cole at email@example.com or (901) 758-3763.