Wednesday March 29, 2023
Article of the Month
Real Estate Transfers to a Gift Annuity, Lead Trust or PIF
A charitable gift annuity (CGA) is an excellent option for donors with appreciated real estate. A CGA provides a charitable tax deduction and a fixed income stream for life. In addition, a CGA gives a donor two capital gain benefits: 1) partial bypass of the donor's unrealized capital gain and 2) deferral of capital gain taxes on the remaining portion of the donor's unrealized capital gain. Most CGA donors are age 75 or above because the fixed rates and tax benefits are attractive for those seniors.
Strategies to Minimize Risk With a Real Estate CGA
Many major donors hold substantial real estate assets. For donors over age 75, a transfer of real property for a gift annuity has several benefits. The donor avoids the time and trouble involved with the sale of real property and receives a contractual promise of fixed payments for one or two lives from the charity. The charity receives the real property, sells the assets and contributes the proceeds to its gift annuity reserve fund to provide lifetime payments to the donor.
However, there are risks for the charity with real estate gift annuities. Typically, a donor with appreciated real property is able to bypass the capital gain on the gift portion and recognize pro rata the capital gain on the annuity contract portion. For a single person or a married couple, the capital gain may be reported over the life expectancy of the donor or the couple. Reg. 1.1011-2(a)(4).
When a donor deeds real property to charity for a gift annuity contract with fixed payments, there is some risk to the charity. If the property sells for an amount substantially less than the negotiated value of the gift annuity contract, the ultimate charitable gift to the charity may be greatly reduced. Because the charity and all of its assets stand behind the gift annuity agreement, even if the value received by the charity from sale of the property is ultimately exhausted, the charity will be required to continue payments to the donor out of endowment assets. Because of these risks, real estate gift annuities are generally limited to nonprofits with substantial annuity reserve funds and endowments. Even these nonprofits will be interested in "risk reduction" strategies.
Discounted Charitable Gift Annuities With Real Estate
There are two ways to establish a discounted gift annuity. Some organizations discount the appraised fair market value by 15% and issue a gift annuity at the normal organizational rate for 85% of the value. Other nonprofits reduce the gift annuity payout rates by 15% and issue the gift annuity on the full appraisal value.
The results are ultimately similar. An 8% gift annuity on a $100,000 property discounted to $85,000 produces 8% multiplied by $85,000, or a gift annuity of $6,800 per year. The donor receives a $15,000 charitable deduction for the gift of the balance of the property.
Alternatively, the 8% gift annuity payout percentage may be reduced 15% from 8% to a 6.8% payout. A 6.8% payout on a $100,000 property produces an annual annuity of $6,800. With the reduced payout, there will be a larger charitable deduction. The choice of which method to use is primarily a marketing decision by the charity.
Deferred Payment Gift Annuities
A second strategy for risk reduction for a real estate charitable gift annuity is a deferred payment gift annuity. By deferring the payout for 18-24 months, the charity has an opportunity to sell the property and transfer the proceeds to its gift annuity reserve account. The charity then can invest the proceeds and make payments on the deferred gift annuity.
While the charity may incur costs of sale and may not be able to deposit the full proceeds in the gift annuity reserve account, there is a period of deferral for the charity to earn income before starting payments on the gift annuity. In addition, deferred payment gift annuities generally produce substantial gifts to charities. The charity may decide that the risk involved is sufficiently modest that it is willing to move forward with the gift plan.
Gift Annuity "Unprearranged" Prearranged Sale
Another risk-reduction strategy for real estate charitable gift annuities is to use an "unprearranged" prearranged sale. The charity accepts real property only if there are buyers waiting in the wings, a contingent purchase agreement or even a contingent escrow. The charity will have a fairly clear understanding of the probable sales price, sales costs and net proceeds. Therefore, the charity may have a higher level of confidence that the gift annuity will be written for the correct price.
Under Rev. Rul. 78-197 the donor must not enter into a binding agreement to sell to a prospective buyer prior to a charitable gift. If there is no binding agreement, the prorated gain allocable to the gift will be bypassed. This strategy also permits pro rata recognition of capital gain allocated to the annuity over the lifetime of the donor.
While the chief financial officer of the charity will undoubtedly want to have the greatest certainty and least risk, the charity must disclose potential risks to the donor's professional advisors. The greater the certainty for the charity, the potentially higher the risk to the donor that the transaction will conflict with the "no binding agreement" provision of Rev. Rul. 78-197.
Anna Transfers Real Estate for a Reduced Value CGA
Anna Annuity owns debt-free real estate valued at $100,000. She wants to sell the property and reinvest for retirement income, but does not want to pay capital gain tax. Therefore, she approaches her favorite charity about a CGA. The charity is very interested in the real estate but has several reservations. First, it is possible the real estate may sell for less than $100,000. Second, the charity would be responsible for property taxes, insurance and maintenance until the property is sold. Finally, the charity knows it will pay closing costs and broker's fees of 5% to 8%.
As a result, the charity asks Anna if she will accept an $85,000 CGA in exchange for her real estate. The charity explains that this 15% reduction takes into account the uncertainty of sales price, ongoing holding costs and sales costs. Anna understands the charity's concerns and believes the reduction is fair. Therefore, she agrees to the $85,000 CGA. Pursuant to the CGA agreement, Anna will receive a 5.8% annuity, or $4,930 each year. Based upon the $85,000 contract value, she will receive a $41,214 charitable deduction. In addition, Anna will receive another charitable deduction for $15,000, representing the difference between the $100,000 appraised value and $85,000 CGA contract value.
In effect, Anna is making an outright gift of the excess $15,000. Thus, Anna's total deduction equals $56,214. Fortunately, a charity's cost to sell property generally does not reduce a donor's charitable deduction. Therefore, broker's fees associated with selling donated stocks do not affect a donor's charitable deduction. Alternatively, if agreeable to Anna and permissible under state law, the charity may suggest a lower annuity rate. For instance, the charity may suggest a $100,000 CGA but with a 4.93% annuity payout. The annuity payout is still $4,930.
Withholding Tax on Real Estate for a Gift Annuity in California
Will accepting real estate for a California gift annuity require 3.33% withholding by the charity? Charity ABC has a potential donor who wishes to transfer land in exchange for a charitable gift annuity (CGA). This is a "bargain sale" transaction and the question is whether California's 3.33% withholding requirement on sales of real property (AB 2962) will apply to the portion of the land "sold" to Charity ABC in exchange for the CGA.
There are several exceptions to the 3.33% withholding requirement. A tax-exempt seller or CRT is exempt. This exception does not apply with a real estate gift annuity because the seller is an individual and the buyer is the tax-exempt entity. A second exception is for the sale of a principal residence that qualifies under IRC Sec. 121. With a gift annuity for home or gift annuity for life estate, there is no withholding requirement.
Another exemption from the 3.33% withholding requirement exists where the total sales price of the property is less than $100,000. If the annuity contract value of the land transferred to Charity ABC is less than $100,000, this exception should apply. If the seller completes and files Form 593-C and an exception applies, no withholding is required. If the annuity contract value is greater than $100,000 for property other than a principal residence, then the 3.33% withholding would seem to apply. The question then becomes whether the full 3.33% must be withheld at the time of the creation of the gift annuity or if Charity ABC can defer the withholding to coincide with each yearly annuity payment.
There is specific provision in the 3.33% withholding requirement rules for traditional installment sales. Specifically, if the seller in an installment sale files Form 593-I and the buyer agrees to withhold 3.33% of each installment payment, the 3.33% need not be withheld up front. For a brief discussion of this installment sale provision, click here. While transfer of land to Charity ABC in exchange for a CGA is similar to an installment sale because the seller/donor receives an annual annuity payment, there are ways in which an installment sale differs from an annuity arrangement. There are good arguments to make in favor of treating the annuity transaction like an installment sale and withholding the 3.33% as each annuity payment is made, but at this point it is prudent to withhold the entire 3.33% at the time of the transfer of land in exchange for a CGA.
A logical solution for this withholding requirement is to set up a 5% sale and 95% gift. The 3.33% of the annuity contract value could be withheld from the sale portion. Because the donor will be able to reduce California withholding for other income, there will be minimal impact on the donor. When the seller/donor files a personal income tax return in the year following the CGA transaction, he or she will receive a refund of any amount withheld that is not offset by taxable income.
Gift Annuity for California Development Land
Donor has development land valued at $520,000 with basis of $52,000 and transfers the land for a payment of $20,000 and a $500,000 charitable gift annuity. The charitable deduction is $200,000 and the annuity contract value is $300,000. Donor has a gain of $18,000 on the sale and $270,000 gain ($300,000 FMV - $30,000 basis) on the gift annuity. Total gain is $288,000 and the 3.33% withholding amount is $9,600. The net payment to the donor is $20,000 - $9,600 or $10,400. The donor may then either reduce other withholding or receive a refund on the $9,600 after filing the California tax return. The withholding does not change the taxable amount for a real estate transaction.
Gift Annuity for Home
Donor has a principal residence valued at $800,000 with basis of $160,000 and transfers the home for a charitable gift annuity. The charitable deduction is $300,000 and the annuity contract value is $500,000. The prorated basis of $100,000 on the contract value is increased by the $250,000 principal home sale exclusion. Donor has gain of $150,000 ($500,000 less $350,000 adjusted basis) on the annuity contract value, but there is no California withholding for the sale of a principal residence.
Gift Annuity for Remainder in Home
Donor owns a home valued at $1,000,000 with basis of $200,000 and transfers the remainder interest in the home for a charitable gift annuity. The remainder value of $600,000 is exchanged for a gift annuity. The CGA deduction is $250,000 and the annuity contract value is $350,000. The $70,000 prorated basis on the contract value is increased by $250,000 to $320,000. Donor will report $30,000 of capital gain over his or her life expectancy. There is no California withholding for the sale of this remainder in a principal residence.
Charitable Lead Trust
Real estate can work very well with a charitable lead trust (CLT). The best real estate scenarios for CLTs include the following characteristics:
1) income-producing real estate,
2) passive income such as rental or lease income (no unrelated business income),
3) no debt, and
4) desire to hold the real estate long term (no sale inside the CLT).
If the above conditions are met, then real estate and CLTs can produce wonderful results. For a full discussion of the benefits and limitations of CLTs, see GiftLaw Pro 3.5 and 3.6.
Pooled Income Fund
Real estate is not generally recommended for a PIF, because of the illiquid nature of real estate. In addition, many PIFs may not accept real estate. With gifts of real estate, it may take months or even years for a PIF to dispose of the property. In addition, if the real estate does not produce any income, the overall return of the PIF will likely diminish since this PIF investment asset is unproductive. This can cause unhappiness and unrest among other PIF beneficiaries.
In the event the real estate is income producing and the PIF is willing to accept real estate, then it may be a worthwhile planned giving option. At this point, a donor would usually review the benefits and drawbacks of a PIF in comparison to a CRT and CGA, e.g., setup costs, payout options and tax deductions. Afterwards, a donor should select the gift plan that best accomplishes his or her goals.
Many senior donors who hold real estate are interested in gift annuities. While real estate for a gift annuity is best suited for larger nonprofits with experienced staff and substantial endowments, it can be an attractive gift.
Published May 1, 2022
Real Estate Unitrusts and Life Estates
Real Estate Gifts - Debt and Environmental Issues