Wednesday February 1, 2023
Real Estate Gifts
Donors own many trillions of dollars in real estate value. Major real estate gifts can be beneficial for both the donor and the charity. The donor usually benefits from a bypass of capital gain and a fair market value charitable deduction. The charity conducts due diligence and receives a valuable asset that is often sold and the proceeds reinvested. The preferred real property is a home, land or building with no debt. Moderately challenging real estate gifts are agricultural or development assets. Finally, difficult real property gifts include multiple owners, partial interests, buildings with active business interests or land with environmental issues.
Transfer of Real Estate
Under state law, a gift of real estate is generally accomplished by transferring a properly executed and notarized deed to charity. While it is important that the charity record the deed as soon as possible, the gift date is usually the date the deed is delivered to an agent for the charity. The best practice is for the delivery and recording of the deed to be in the same tax year. This ensures clarity for both the title transfer and federal tax reporting.
Avoid a Prearranged Sale
Because the donor desires to bypass the capital gain, it is important that the donor contribute the property without making any sales commitment to a third party, since this could create a prearranged sale. The safest strategy is for the donor to transfer the property to the charity outright or in trust prior to any negotiations with prospective buyers. Even if there have been offers without acceptance, under Rev. Rul. 78-197 there clearly is "no binding agreement" and the charity or trustee may then list the property for sale. After a period of negotiation with various buyers, the property may be sold. This arrangement is clearly within the bounds contemplated by Rev. Rul. 78-197, since there is no "binding agreement" as of the date of the gift.
Buyer Waiting in the Wings
What if the property has been listed and one or more buyers have made offers near the listing price? Does the ability of the charity to receive the property and quickly sell to an available buyer cause a ripening of the capital gain? Fortunately, it is permissible to have buyers waiting in the wings. It is helpful to show that two or more prospective buyers were waiting in the wings when the property was transferred. An excellent strategy with a buyer waiting the wings is to transfer the property to the charity on day one. On day two, the charity or trustee lists the property for sale in a public newspaper. On day three, there is no activity. On day four or later, the charity or trustee contacts the prospective buyer and both parties sign a sale agreement. The purpose of the four-day process is to establish a clear record that there is no binding agreement under Rev. Rul. 78-197.
Contingent Escrow Agreement
A more aggressive strategy is a contingent escrow. The charity creates a contingent listing for the property and a buyer enters into a contingent escrow with full knowledge the charity does not yet have title. Both the charity and the prospective buyer complete the customary escrow processes, with disclosure that any actions taken are explicitly contingent upon the charity receiving the property. A few days before the anticipated closing, the donor deeds the property to charity and the escrow process is completed.
At present, this contingent escrow strategy has not been tested in Tax Court. Because the donor has no contact with the buyer, he or she may reasonably maintain there is "no binding obligation" between the donor and prospective buyer. With obligation for the donor to make the gift to the charity, this transaction should pass the test of Rev. Rul. 78-197.
The existence of a prearranged sale is highly dependent upon the facts and circumstances of the situation. A binding agreement may exist if there is a signed contract of sale, transfer of earnest money or an enforceable oral contract. Examples of permissible conduct (where there is no prearranged sale) may include a listing of the property, letter of intent, right of first refusal and oral negotiations.
Gift Substantiation and Appraisal
In addition, because a gift of real estate will exceed $5,000 in nearly every case, the donor should request a contemporaneous written acknowledgment from the charity at the time of the contribution, obtain a qualified appraisal and file IRS Form 8283. For further information on gift acknowledgments, appraisals and Form 8283, see GiftLaw Pro Ch. 1.6.1 and Ch. 1.5.2.
Long-term Capital Asset
As a general rule, a donor will receive a charitable deduction equal to the fair market value of contributed real estate. However, it is important that the real estate qualify as a capital asset. Real estate is generally not a capital asset if it is inventory or property sold in the ordinary course of a donor's business. Sec. 1221. For example, donors who are real estate developers would fall into this category for sales of lots held as inventory. For most donors, investment real estate will qualify as a capital asset.
There are two benefits for a gift of real estate held for more than one year and a day. The donor bypasses the long-term capital gain and is entitled to a fair market value charitable deduction. In the case of gifts of appreciated property, the 30% adjusted gross income (AGI) limitation will generally apply. See Sec. 170(b)(1)(C). In contrast, gifts of short-term capital gain assets are deductible at cost basis. Sec. 170(e)(1)(B)(ii).
Long Term Gain for Lisa Landowner
Lisa Landowner purchased an investment property five years ago for $100,000. Since that time, the property has grown in value to $200,000. Because Lisa owned the property for more than one year and does not hold the real estate as inventory or as property sold in the ordinary course of her business, it qualifies as a capital asset. If the property were sold, Lisa would have $100,000 of long-term capital gain income ($200,000 FMV - $100,000 basis). With a federal capital gains tax rate of 18.8%, Lisa would owe tax of $18,800. If Lisa contributes the property to charity, she receives a $200,000 charitable income tax deduction and bypasses the $18,800 in capital gains tax. This appreciated property charitable deduction is subject to the 30% AGI limit, with a carry forward of the excess deduction for up to five years.
A donor may own real estate that he or she has depreciated, e.g., rental property. As a result, there may be depreciation recapture issues. Straight line depreciation is recaptured at a 25% tax rate but is classified as capital gain and therefore does not reduce the charitable deduction.
If a donor has taken accelerated depreciation and sells the asset, depreciation recapture requires a donor to realize ordinary income upon sale in an amount equal to the excess of accelerated depreciation over straight-line depreciation. See Sec. 1250. In the event deprecation recapture applies to a donor, a gift of the depreciated property will be subject to the income tax reduction rules. Basically, the initial fair market value charitable deduction will be reduced by the ordinary income component of the real estate. See Sec. 170(e)(1)(A). Because most real estate gifts are deducted over several years and the ordinary recapture amount is typically 3% to 8% of the asset value, donors will generally proceed with the real estate gift. However, the donor’s CPA will need to reduce the deduction by the amount of potential ordinary income.
Lisa Landowner Takes Accelerated Depreciation
Lisa Landowner purchased an investment property 10 years ago for $100,000. It is now valued at $200,000. During the past 10 years, Lisa has taken $50,000 of accelerated depreciation on the property and her adjusted cost basis is $50,000. After speaking with her CPA, she discovers she would have $20,000 of ordinary income to report if she sold the property. The $20,000 figure represents the excess of $50,000 of accelerated depreciation over $30,000 of permitted straight-line depreciation.
Under the normal charitable deduction rules, Lisa would receive a $200,000 charitable deduction for a gift of the property. However, since there is $20,000 of depreciation recapture, Lisa's charitable deduction is $180,000 ($200,000 - $20,000).
If Lisa were to sell the property for $200,000, there are four tax rates. The $50,000 basis is taxed at 0%. The $20,000 of excess depreciation is taxed as ordinary income at 37%. The $30,000 of straight-line depreciation recapture is taxed at 25%. Finally, the $100,000 of long-term capital gain is taxed at 18.8% (23.8% if Lisa is in the top income tax bracket). In summary, with a sale Lisa would report no tax on the adjusted basis, $100,000 of long-term capital gain, $30,000 of 25% depreciation gain and $20,000 of ordinary gain.
Conservation Easement Deductions
Conservation easement deductions are permitted under Sec. 170(f)(3)(B) if several tests are met. First, the conservation easement must be a real property interest, usually a restriction granted in perpetuity concerning the use of the property. Second, the recipient must be a "qualified organization." Third, the gift must be made "exclusively for conservation purposes." Fourth, for a historic area home easement deduction, the entire exterior must be preserved and any changes in the front, sides or rear "inconsistent with the historical character" are prohibited.
Normally, appreciated property deductions are limited to 30% of AGI, with a carry forward deduction available for up to five years. However, Sec. 170(b)(1)(E) permits deductions for qualified conservation easements to qualify for the more generous 50% of AGI contribution level, with a potential carry forward of up to 15 years.
The deduction must be supported by a qualified appraisal. An independent professional appraiser with appropriate credentials and experience in conservation easements must value the gift. Sec. 170(f)(11)(E).
If the gift is a home in a historic district, all four sides of the building must be preserved. Sec. 170(h)(4)(B)(i). In that case, the appraisal must include photos of the four sides of the home, a $500 fee and an agreement with a qualified conservation charity. The appraisal must be submitted with the tax return. The agreement states under oath that the conservation charity is qualified to receive the easement and has the resources and commitment to enforce the agreement. Sec. 170(h)(4)(B)(ii).
Most gifts of appreciated property qualify for a charitable deduction with a 30% of AGI limit and a five-year carry-forward. However, a qualified conservation contribution to an organization described in Sec. 170(b)(1)(A) is deductible to the extent of the excess of 50% of the contribution base over the amount of all other allowable charitable contributions. Therefore, the other charitable contributions are first deducted under Sec. 170 provisions. Then, to the extent that other contributions do not exceed 50% of adjusted gross income, qualified public charity conservation gifts are deducted. If there is a carry forward for qualified conservation gifts, it may be used over the next 15 years. Sec. 170(b)(1)(E).
Joe Landowner Protects the Purple Warbler
Joe Landowner has a contribution base of $100,000 and makes a qualified conservation easement contribution of land with habitat for the rare and endangered purple warbler. The appraised “before and after” value of the land is $80,000. He also gives cash of $30,000 to public charities. Joe may deduct the $30,000 cash gift and $20,000 of the conservation easement gift (50% total deduction). He will carry forward $70,000 of the conservation gift and may deduct that over the next 15 years.
Conservation Easement Deduction for Farmers and Ranchers
For qualified farmers and ranchers, the deduction is increased to 100% of the excess of the taxpayer's contribution base over the amount of all other allowable charitable contributions. The excess may also be carried forward for 15 years. Sec. 170(b)(1)(E)(iv)(I). The qualified farmer or rancher must receive more than 50% of his or her gross income (as defined in Sec. 2032A(e)(5)) from ranching or farming activity and the land must remain available for agricultural or livestock production. Sec. 170(b)(1)(E)(iv)(II).
Ronda Rancher’s Home on the Range
Ronda Rancher has a contribution base of $100,000 and makes a qualified ranch conservation easement gift of $400,000 this year. She also gives cash of $60,000 to public charities. Ronda may deduct 50% or $50,000 of the cash gift and will carry forward $10,000 of the cash gift for up to five years. Because over 50% of her income is from her ranch, the $400,000 conservation gift qualifies for a $50,000 gift this year (the difference between the 50% deducted and 100% of her contribution base). The $350,000 balance of the conservation gift may be carried forward for up to 15 years.
In the case of a corporation (other than a publicly traded corporation) that is a qualified farmer or rancher, for the taxable year in which the contribution is made, a qualified conservation contribution is allowable up to 100% of the excess of the corporation's taxable income (as computed under Sec. 170(b)(2)) over the amount of all other allowable charitable contributions. Any excess may be carried forward for up to 15 years as a contribution subject to the 100% limitation.
Ronda Rancher’s Poem
Ronda Rancher was also a poet and wrote a poem to express her appreciation for the 100% conservation easement deduction.
“My Home on the Range”
O give me a home where the buffalo roam,
Where the deer and the antelope play,
Where seldom is heard a discouraging word,
And no tax will I ever pay,
Oh, no tax will I ever pay!
Adjusting Charitable Easement Deductions to Consider Previous Rehabilitation Credits
For qualified rehabilitation expenditures for certified historic structures, there is a rehabilitation credit. The rehabilitation credit could be as much as 20% of qualified rehabilitation expenditures for a certified historic structure, reported ratably over five years. If a charitable easement in a certified historic structure is created, then the deduction calculation must consider the rehabilitation credits taken during the preceding five years. The amount of the deduction is reduced by an amount that bears the same ratio to the gift fair market value as the sum of the rehabilitation credits under Sec. 47 for the preceding five taxable years bears to the fair market value on the gift date. For example, a $1 million building with credits during the previous five years of $100,000 will be valued at $900,000 for purposes of determining the conservation contribution. Sec. 170(f)(14).
Published February 1, 2022
IRAs in 2022: New RMD Tables