Donating Real Property to Charity

• Publication year: 2007
• Author: By Chris Nicholson, Esq., Bruce H. Coblentz, CPA, and Edward Faircloth, CPA

DONATING REAL PROPERTY TO CHARITY

By Chris Nicholson, Esq.^*, Bruce H. Coblentz, CPA^**, and Edward Faircloth, CPA^***

Recently, significant attention has been focused on the Pension Protection Act of 2006,¹ which enables individuals age 70 ½ and older to make distributions of up to $100,000 exempt from federal income tax from their Individual Retirement Accounts (IRAs) to public charities in 2006 and 2007. Although Americans hold approximately $3.5 trillion in IRAs, that amount pales in comparison to the amount of wealth held in the form of real property.² Recent studies suggest that 50 percent of American wealth is held in the form of real property.³ Further, it is estimated that real property will constitute 40 percent of the $12 to $15 trillion which is expected to be transferred by 2025.⁴ However, real property accounted for less than 2 percent of the $248.52 billion contributed to charity in 2004, according to a report by Giving USA.⁵

Real property riches are especially abundant in California. With a median home price of $567,360 and approximately seven million single-family homes, the Golden State alone has real property assets of $3.9 trillion, and this does not include multi-family homes, commercial property and raw land, all forms of real property and therefore all potentially suitable for charitable giving.⁶

This article outlines both the process and the charitable tools which can be used to transfer real property to charitable organizations, ranging from an outright gift, bargain sale and retained life estate to split-interest strategies involving trusts and gift annuities. The article focuses on the impact real property gifts have on charities, highlighting the challenges charities face when considering these gifts and outlining the steps charities take in the review and approval process. Examining the gifting process from the charity's perspective will provide advisors with new insights into gifts of this nature.

An advisor who is planning to talk with a client about gifting real property should consider framing the conversation around four issues: (1) ownership interest, (2) non-financial benefits, (3) financial benefits, (4) gifting options. This article addresses those topics in turn, then looks at gifts of real property from the donee's perspective.

I. ASSESSING THE FORM OF OWNERSHIP

An easy starting point to a discussion of gifting real property is clarifying the form of ownership. Real property ownership interests fall into three general categories: fee simple, partial interests and indirect interests. Fee simple interests are the easiest to deal with in a gifting context because they are the simplest to transfer. They also provide the largest income tax deductions because they are not subject to discounting (other than certain blockage discounts).

Partial interests occur when a property owner shares ownership of a property with another person or entity. Common forms of partial interests are tenancies in common, joint tenancies, community property, tenancy by the entirety, condominiums, leaseholds, life estates and remainders. When talking with clients with a partial interest, it is important to clarify exactly what their partial ownership interest is and what sort of restrictions exist, if any, which would prevent them from transferring their ownership interest to charity.

Finally, indirect ownership occurs when an individual does not own title to the property itself but owns an interest in the entity that holds title to the property. Partnerships, corporations, limited liability companies ("LLCs"), revocable living trusts and real estate investment trusts are common forms of indirect ownership. Advisors should note that many charities have gift acceptance policies applying to the receipt of assets of this nature which outline a review and approval process different from the process for fee simple or partial interest gifts.

II. NON-FINANCIAL BENEFITS

The primary reason people make charitable gifts is because they want to support a specific charitable organization—not because they want a tax deduction. For many, real property comprises the majority of their net worth and provides a great opportunity to make a significant charitable contribution. Those leaving a house and nothing more to a favorite charity in their estate plan can have a substantial impact on the lives of others.

Sometimes people gift real property because they are interested in escaping the burdens associated with property ownership and management. This is common for older individuals who own investment property and/or second homes and don't care to participate in the property's upkeep. In addition, individuals who want to make charitable testamentary gifts and bequests to heirs find that leaving real property to charity and more liquid assets to their heirs can make life easier for their heirs, especially when they live in another state or country.

Also, some older homeowners who are considering moving into a smaller home or a care facility might find gifting their home to be a more attractive option than selling, because the gifting process can be less stressful than the sales process.

III. FINANCIAL BENEFITS

Although it is almost impossible for clients to generate more for themselves financially through a charitable gift than through an outright sale, there are a number of financial benefits associated with gifts of real property. Yield is the first consideration. Clients who have property generating little or no income might be attracted to gifting the property to a split-interest vehicle like a charitable remainder trust ("CRT") or charitable gift annuity which will provide them with a higher income stream. Diversification is another possible benefit of gifting real property. Individuals who have a significant percentage of their net worth in

[Page 6]

real property holdings are exposed to greater risk of market fluctuation than those whose holdings are more diversified.

The income tax benefits associated with a gift of real property will vary based on a number of factors, especially the type of gift vehicle used. The general rules of deductibility for federal income tax purposes are those which apply to the most common type of real property gift—a transfer of a fee-simple interest to a public charity. These are:

1. The donor's contribution deduction is based on the fair market value of the property.⁷
2. The donor's deduction is limited to his/her equity in the property.⁸
3. The donor's deduction for the year of the gift is limited to 30 percent of his/her adjusted gross income ("AGI"), and any unused deduction may be carried forward for five years.⁹

In most situations, individuals contribute property that they have held for more than a year. In that circumstance, the charitable income tax deduction is as described above. However, if the property would produce any ordinary income when sold on the contribution date, the amount of the deduction must be reduced by the ordinary income amount.¹⁰ Ordinary income is generated when: (1) the property has been held for less than one year,¹¹ (2) the property has been held by the donor as a real-estate dealer,¹² or (3) the property may be subject to depreciation recapture.¹³

For example, Don subdivided and improved land, then donated a parcel of land from the development. Since Don is a dealer, he can only deduct the remaining basis in the donated parcel.¹⁴ The value of the parcel, less the amount that would be reported as ordinary income had the parcel been sold, is equal to the basis in the land.¹⁵

Individuals who contribute real property to charity can also benefit by avoiding the recognition of capital gain. Single individuals and married couples may exempt $250,000 and $500,000 worth of capital gain, respectively, from taxation when they sell a home they have owned as a personal residence for more than two years.¹⁶ However, real property prices have increased so dramatically in California that many homeowners still face a significant capital gain when they sell. As such, charitable strategies provide an opportunity to avoid paying capital gains tax.

Assets given to charity are removed from the donor's estate for transfer tax purposes. The size of the transfer tax deduction varies according to the type of gift vehicle used, which is discussed more fully below.

IV. GIFTING OPTIONS

A. Outright Gift

The simplest and most common option for gifts of real property is an outright gift of a fee simple interest to a public charity. When contemplating a gift of this nature, the first thing a client—or an advisor—should examine is the charity's gift acceptance policy. Attached as Exhibit Ais a standard checklist for gifts of real property which most major charities in California possess in some form and will provide to potential donors.¹⁷ If the charity doesn't have a policy for accepting gifts of real property, this raises the question of whether it has the capacity to receive a gift of this nature.

B. Bargain Sale

A bargain sale occurs when property is sold to a charity for less than fair market value. It is essentially part sale, part gift, and is attractive to someone who is interested in making a gift and receiving some cash from the sale. In this instance, the charitable contribution deduction is equal to the difference between the property's fair market value and the purchase price.¹⁸

Example. A partnership owns an apartment building financed by the U.S. Department of Housing and Urban Development (HUD) and subject to the Section 8 Housing Assistance Program. The partners sell the apartment building to HUD for the amount of the mortgage. The apartment building has a value of $2.5 million, with an adjusted cost basis of $1 million and outstanding debt of $1.5 million.

Bargain Sale to Charity (amounts x 1,000)
Sale	Contribution	Total
Sale price	$1,500	$1,000	$2,500
Basis	(600)	(400)	(1,000)
Gain	$900	$600	$1,500

Each partner reports as income his or her share of the $900,000 gain and takes...