Article of the Month

Introduction

There are many advantages to owning a home. Homes often appreciate over the years, providing stable growth and equity ownership. Over time, however, family and financial circumstances change, and the benefits of owning a home may no longer be needed. In such cases, homes can be excellent assets to donate to nonprofits. By gifting a home to a nonprofit, donors may bypass or avoid capital gains taxes. Additionally, gifts of interests in homes can also be structured to allow donors to continue living on the property or to provide them income.

In this series, we will explain the rules surrounding gifts of homes to nonprofits for charitably minded homeowners. The first part discussed charitable deductions for gifts of homes as well as charitable gifts involving outright gifts and life estates. The current installment will discuss the benefits and common issues of using homes for charitable gift annuities and charitable remainder trusts.

Charitable Gift Annuity

A charitable gift annuity (CGA) is a contract between the nonprofit and the donor whereby the donor transfers property or cash to the charity in exchange for income payments for one or two lives. Sec. 514(c)(5). Although many CGAs are funded with cash, a home may also be used to fund a CGA. A CGA provides a donor with important benefits including a tax deduction and fixed payments for life. When a donor funds the CGA with appreciated property, such as a residence, the donor will not incur any immediate capital gains tax. Instead, the donor will bypass the capital gain on the gift portion and recognize a pro rata share of the capital gain on the annuity contract portion. The capital gain on the annuity portion will then be reported over the life expectancy of the donor. Reg. 1.1011-2(a)(4).

When a donor creates a CGA, the funding asset is irrevocably transferred to the issuing charity. The donor does not retain the right to live in the residence or the right to use the property. Unlike a retained life estate where the donor retains the right to live in their residence, an outright gift of a home for a charitable gift annuity reserves no such right.

Due to potential market risks and carrying costs associated with real estate, some nonprofits are reluctant to accept real estate in exchange for a CGA. If the CGA funding amount is equal to the appraised value but the property sells for less, the nonprofit will receive less funding than what was expected. However, the nonprofit will still be required to make payments based on the appraised value. To mitigate the risks, nonprofits may defer the payment of the annuity for a period that allows for the sale of the property. If using this method, it is important to agree on who is responsible for holding period costs on the property until its sale. A more popular option to limit risk is to reduce the amount of the CGA by “discounting” the funding value up to 15% or, if allowed by state law, reducing the CGA rate. This creates a safeguard for the nonprofit against the risks of a reduced sale price and paying for holding or selling costs.

Example – Gift and Gift Annuity

Jason just made the final mortgage payment on his home which is valued at $500,000. Jason wants to sell the property and reinvest the proceeds for retirement income while he travels the country. Jason has heard that a CGA would provide him with reliable income while bypassing part of his capital gains. His favorite nonprofit, however, has some concerns. First, the home may sell for less than $500,000. Second, the nonprofit would be responsible for property taxes, insurance and maintenance until the home is sold. Finally, the nonprofit knows it will pay closing costs and broker's fees of 5% to 8% upon sale.

After weighing the risks, the nonprofit offers Jason a CGA with a funding amount of $425,000, which is equal to 85% of the appraised value. Under the CGA agreement, Jason will receive a 6.4% annuity, or $27,200 each year. Jason receives a charitable deduction of approximately $163,000. He also receives an additional deduction of $75,000 for the outright gift to the nonprofit, which is the difference between $500,000 (appraisal value) and $425,000 (CGA funding value). Jason is pleased with his total deduction of $238,000 and his steady stream of payments as he travels in retirement.

Gift Annuity for Home

As was discussed in the first part of this series, a donor can remain in his or her home for life with a retained life estate. For donors who want to continue to live in their home but also need an income stream, a charitable gift annuity can be combined with a retained life estate to achieve their goals. Under this gift scenario, the donor retains the life estate interest, and the remainder interest is vested to the nonprofit. The CGA contract is then funded based on the present value of the remainder interest irrevocably transferred to the nonprofit.

This type of gift may be particularly attractive to a donor who is able to provide for family with other assets. Donors will be pleased with the ability to live in the home and convert the home into a fixed payment stream. The home will be fully vested to the nonprofit when the payment stream ends. It is important for donors to understand that using this method will allow the nonprofit to receive the home in exchange for the charitable gift annuity payments during life.

Example

Georgia, 85, would like to make a generous donation to her favorite charity. She owns a home valued at $850,000 with a cost basis of $300,000. She is considering using the home for a charitable gift, but she would prefer to remain in the home and, if possible, receive annual income. The planned giving associate at her favorite nonprofit recommends funding a charitable gift annuity using a retained life estate. Excited about the possibilities, Georgia asks her how this would work.

The associate explains that Georgia would retain the right to live in her home for her life, while also receiving annuity payments based on the present value of the remainder interest transferred to the charity. She will receive a charitable deduction of $312,281 that may save her approximately $75,000 based on her 24% tax bracket. Her annuity rate based on her age is 9.1% and would produce annual annuity payments of over $53,000. Because Georgia can increase her basis in the gift annuity contract by $250,000 due to the principal residence capital gain exclusion, she receives tax-free payments of $40,700. The balance of the $53,000 annuity is taxable. Over her life, Georgia retains the right to live in her home, while also receiving her annuity payments. Even though Georgia is required to pay the property taxes and insurance, Georgia is satisfied that all her goals will be met and decides to proceed with the gift.

Gift Annuity for Rental Property

In some cases, donors move out of their home and rent it for several years. Because the IRS assumes that a rental property will lose value each year, these donors may have depreciated the property to maximize their tax benefits. Such donors may later decide that they no longer need to keep the property and will want options for disposing of the property without incurring a large capital gains tax. Although a gift of depreciated property may have some tax consequences, it is still possible to use this home to fund a charitable gift annuity.

For depreciation of residential properties, the IRS allows a taxpayer to claim a “straight-line” depreciation deduction every year for 27.5 years. However, a donor may also choose to accelerate depreciation more rapidly, meaning the asset has greater deductions in its value in the earlier years as opposed to deductions that spread evenly across its life. In doing so, any gain in the property due to the accelerated depreciation will be considered ordinary income. If property with accelerated depreciation is donated, the charitable deduction will be reduced proportionately by the short-term gain or ordinary income element. Sec. 170(e). If a donor has taken only straight-line depreciation on the property, the donor's charitable contribution is typically not diminished, as straight-line depreciation is usually recaptured as capital gain under Sec. 1250, rather than being classified as ordinary income. However, for donors who took accelerated depreciation, it is important to remind them that they will receive a reduced charitable deduction. In addition, depreciation recapture requires a donor to realize ordinary income upon sale of the depreciated property in an amount equal to the excess of accelerated depreciation over straight-line depreciation. Sec. 1250. If deprecation recapture applies to a donor, the initial fair market value charitable deduction will be reduced by the ordinary income component of the real estate. Sec. 170(e)(1)(A).

Example

Angela and her first husband purchased a home years ago for $600,000. It is now valued at $1,000,000. Unfortunately, Angela’s husband died, and she later remarried and moved out of the home. For the past 10 years, Angela has rented the property and taken $100,000 of accelerated depreciation, leaving her an adjusted cost basis of $500,000. Angela would now like to sell the home. After speaking with her advisor, she discovers she would have $60,000 of depreciation recapture or ordinary income to report if she sold the property. The $60,000 figure represents the excess of accelerated depreciation ($100,000) over straight-line depreciation ($40,000).

Angela is ready to sell the property and is interested in a charitable gift annuity. Under the normal charitable deduction rules, her charitable deduction is based on the fair market value of the property. However, since there is $60,000 of accelerated depreciation recapture, Angela’s charitable deduction will be reduced by the portion of ordinary gain.

Angela’s advisor points out that payments attributed to the $400,000 difference between the original cost basis ($600,000) and the appraised value ($1,000,000) are subject to the long-term capital gain tax rate. The $60,000 excess of accelerated depreciation ($100,000) over straight-line depreciation ($40,000) is subject to ordinary income tax rates. Finally, the capital gain attributable to straight-line depreciation is subject to a capital gain tax rate at a maximum of 25%.

In addition to a tax-free return of principal, each payment has a pro rata share of $500,000 of income to report ($1,000,000 minus $500,000). Of the $500,000, $400,000 is long term capital gain, $40,000 is 25% depreciation gain (or less depending on Angela’s income tax bracket), and $60,000 is ordinary gain.

To accomplish the deduction calculation in Crescendo’s CresPro software, there are a couple of adjustments. First, the property value and cost basis will be $1,000,000 and $500,000, respectively. Second, on the "options" screen, one must enter 88% for "long-term capital gain" and 12% for “ordinary income” (since $60,000 of $500,000 is ordinary income). As a result, Crescendo’s CresPro software will produce the appropriate deduction calculation.

Charitable Remainder Unitrusts

A charitable remainder unitrust (CRUT) may be a good option for a donor who desires to move out of his or her residence but would incur significant capital gains taxes if the house were sold outright. This tax-free sale of the home inside the trust allows the trustee to reinvest all the sale proceeds, providing investment diversification without immediate payment of any capital gains tax. In addition to a tax-free sale of the home, a CRUT provides a charitable income tax deduction and an income stream.

One of the risks, however, of funding a CRUT with real estate is that the home cannot always be sold immediately. Thus, there may be no liquidity to make a unitrust payment. For this reason, a standard payout CRUT or a charitable remainder annuity trust (CRAT) generally is not recommended when a home is the only trust asset, because both types of trusts require trust distributions irrespective of actual trust income. To alleviate this concern, a net income plus makeup charitable remainder unitrust (NIMCRUT) or FLIP CRUT is usually recommended. With either type of CRUT, the trustee is not forced to make a trust distribution unless there is actual trust income.

Example

Brent and Suzanne have lived in their large four-bedroom home for many years. It has a cost basis of $200,000 and is valued at approximately $1,000,000. They are interested in obtaining cash to move to a retirement condo. Although they qualify for the $500,000 home exclusion of capital gain, they would still owe some capital gain tax if they sold the property. They are also worried that, with interest rates so high, the home may not sell right away.

After meeting with their advisor, Brent and Suzanne learn about the benefits of a FLIP unitrust. If they transfer their home into a 6% FLIP unitrust, the trustee will not have to make immediate payments. Once the property is sold tax-free, the trust will flip to a straight unitrust payout. Since they can use their $500,000 exclusion to offset the gain, they will bypass $300,000 of gain on the unitrust. In addition, they receive an income tax deduction of $288,920 with the charitable remainder unitrust. This saves additional taxes on their other income.

For their two lives, the unitrust is expected to earn 7% and make payments of 6%. Over the course of the trust, their payments will start at approximately $60,000 per year and increase each year, reaching $75,000 as they approach life expectancy. Over the anticipated 28.3 years, the trust will pay almost $1.9 million to Brent and Suzanne. Brent and Suzanne use their savings to purchase their retirement condominium, and they use the unitrust income for their living expenses.

Unitrust and Sale

Another strategy for donors who would like to receive cash back or pay off debt on the property is a Unitrust and Sale gift. With this plan, a donor transfers an undivided percentage of the property into a CRUT and retains the remaining undivided percentage. For example, a donor may transfer 60% of a home into the CRUT and retain the remaining 40%. After the trust is funded, the home is sold, and the sale proceeds are divided between the CRUT and the donor in proportion to the ownership interests. This plan is an effective way for a donor to fund a CRUT and receive some cash back. Furthermore, if apportioned carefully, this plan can potentially provide a zero-tax solution by offsetting the tax on the cash portion with the charitable deduction.

As discussed in Part One of this article series, gifts of homes encumbered with debt may cause undesirable results including UBIT to the nonprofit and income tax to the donor on the amount of the debt. This rule will not apply for the first ten years if the debt is non-recourse (in other words, the creditor can only satisfy the debt against the property), if the donor owned the real estate for more than five years and the debt was placed on the property more than five years prior to the gift. Sec. 514(c)(2)(B). Even if the debt meets these requirements and is transferred to a CRUT, the trustee should not assume the debt. The trustee is allowed, however, to receive the property subject to the debt and make payments on the debt.

If the debt does not meet the “five and five” requirements, there are some solutions to the debt problem including paying off the loan with cash or a bridge loan. Another viable option is a Unitrust and Sale gift. Once the joint sale occurs, the donor then has funds to pay off the debt and the real property in the CRT is liquidated and debt-free.

Example

Carl purchased his home many years ago for $200,000. It is now worth $800,000. Carl paid off the original mortgage several years ago but recently took out a $150,000 loan secured by the home to help pay for his grandchildren to attend a prestigious university. Carl is considering retiring next year because his employer is offering a generous financial package. If he takes the package, Carl would like to get a deduction to offset the income from the buyout package.

After meeting with his advisor, Carl learns that the loan on the property is an obstacle to a CRUT. Carl’s advisor reviews the options for handling the debt. Carl decides to sell 19% of the property to his favorite nonprofit and uses the cash proceeds to pay off the debt. Carl then transfers the remainder of the property into a CRUT. With the removal of the debt, the UBIT issue disappears. Carl is happy knowing that he will receive a deduction and lifetime income from his CRUT while benefiting his favorite nonprofit.

Conclusion

There are several charitable strategies that can be used when gifting a personal residence. Using charitable gifts, homeowners can align their objectives for downsizing their home with increasing their philanthropic efforts while realizing tax savings. By understanding the deduction rules and the tax advantages offered by charitable gift strategies, professional advisors will be well-equipped to guide and support homeowners through this process.