As most of us know, charitable gift planning entails many moving pieces including the donor and his wishes; one or more of the donor’s professional advisors; the asset the donor wants to use to make the gift; state and federal laws applicable to the proposed gift arrangement; and
the charity the donor wishes to benefit and the charity representatives who deal with the donor.
In particular, a gift of real estate to charity raises unique considerations that a donor and his advisors must consider. Here are some examples of situations that may arise and steps to take to avoid common pitfalls.
Pre-Gift Dealings by the Donor
A classic example of pre-gift dealings by the donor is that of an individual who wants to contribute real estate that the donor offered to sell. Gift planners often express concern in this situation about “buyers in the wing.”
If there’s a legitimate concern, it’s based on the assignment-of-income doctrine. This doctrine essentially is that an individual who’s gone too far down the road toward realizing income can’t avoid recognizing the income by assigning the right to receive the income to a third party.
There’s much tax law on what constitutes “too far down the road.” A donor of real estate to charity has gone too far down the road by entering into a contract to sell the real estate before donating it (Private Letter Ruling 8411029 (Dec. 9, 1983) is on point in this regard). Mere anticipation that the donee organization will sell to a particular third party, however, has been ruled not to bring the assignment-of-income doctrine into play (Revenue Ruling 78-197). The key question in all such situations is whether the charity is free to sell or not sell. If it’s free to sell or not, the assignment-of-income doctrine is inapplicable.
Pre-Gift Dealings by the Charity
Pre-gift dealings by the charity bring to mind the case of Guest v. Commissioner, 77 T.C. 9 (1981). In Guest, an individual sent a letter to a charity stating that he thereby gave certain real estate to the charity and that he awaited the charity’s instructions on how to proceed. The charity wanted the gift but didn’t want to be in the chain of title, so it instructed the individual to deed the real estate to a third party (T). The charity had already made a deal with T that T would receive the real estate, would sell the real estate on behalf of the charity and would remit the proceeds of sale to the charity.
The Tax Court held that: (1) the letter from the individual to the charity was a gift for federal tax purposes; (2) the gift was complete for charitable deduction purposes when the individual deeded the real estate to T; and (3) the charity’s dealings with T didn’t adversely affect the individual, because T was the charity’s agent, not the individual’s agent.
Guest presents a way for a charity to reap the financial benefits of a real estate donation without ever taking title to the real estate for local law purposes.
Single-Member Limited Liability Company (LLC)
Another way for a charity to receive the financial benefit of a real estate gift without being in the chain of title is for the charity to set up an LLC of which it’s the single member. The real estate is then conveyed to the LLC. The IRS has said the transfer of an asset to such an LLC is, for federal tax purposes, the same as a transfer to the charity (Internal Revenue Service Notice 2012-52). Yet for local law purposes, the LLC is a separate entity, which keeps the charity out of the chain of title.
The single-member LLC idea is illustrated here with real estate because real estate can be problematic, but such an LLC can, in principle, be used to receive any kind of asset.
Problems Caused by Debt
The principal kind of debt that causes problems in charitable gift planning is mortgage debt on real estate. Other kinds of debt that can cause problems include tax liens and life insurance policy loans.
Here’s a mortgage debt example: A donor proposes giving Blackacre to charity. Blackacre has a fair market value (FMV) of $1 million. The donor’s basis (B) in Blackacre is $200,000. Two years ago, the donor borrowed $500,000 (M) from the bank in a transaction using Blackacre as security. Blackacre is now subject to a $500,000 mortgage debt.
If the donor makes this gift, the gift will be a bargain sale for federal income tax purposes. The donor will be deemed to sell Blackacre to the charity for a price equal to the mortgage debt, $500,000 (Treasury Regulations Section 1.1011-2(a)(3)). This will cause the donor to realize a gain, given that Blackacre is an appreciated asset having appreciation equal to FMV - B, or $1 million - $200,000, or $800,000. A bargain sale formula for calculating the realized gain is:
REALIZED GAIN = (M/FMV)(FMV - B)
REALIZED GAIN = 0.5 x $800,000
The donor’s charitable contribution (gift) for federal tax purposes will be FMV - M, or $1 million - $500,000, or $500,000.
From a tax perspective, will this be a good gift for the donor? The answer depends on the donor’s situation. If, for example, the donor has a passive loss to offset the realized gain, the gift may work well for the donor.
How well the gift will work for the charity depends on what the charity will do with Blackacre. If the charity’s game plan is to sell Blackacre as quickly as possible, the charity’s gain on the sale will be partly debt-financed income under IRC Section 514(c), which may cause the charity to incur unrelated business income tax (See IRC Section 514(c)(2)(A), dealing with property acquired subject to a mortgage).
*This article is an abbreviated version of “The Dos and Don’t of Charitable Planning,” which appeared in the October 2022 issue of Trusts & Estates.