Many landowners continue to hold on to and pay taxes on property that have appreciated in value. One way to unburden yourself of such real estate is to donate real estate to charity. Here are several traps for the unwary.
Understanding the benefits
If you are charitably inclined, donating appreciated real estate offers many great advantages. A real estate donation to a public charity, such as Giving Center, will allow you to deduct the property’s fair market value (FMV) while also avoiding capital gains taxes. But keep in mind that, if you decide to donate real estate property to a private foundation, your deduction will be limited to your cost basis.
Several charitable planning techniques allow you to both receive income from the property and generate an immediate tax benefit. A charitable remainder trust (CRT), for one example, can be an effective plan for converting appreciated real estate into an income stream.
A CRT is an irrevocable trust that generates income to you or another income beneficiary for life or a specified amount of time and then distributes the remaining assets to a qualified charity. When you transfer real estate to a CRT, you receive an immediate tax deduction for the present value of the charity’s remainder interest.
A CRT is a tax-exempt entity and, therefore, you can sell the property income-tax-free and reinvest the proceeds in income-producing assets. The trust income given to the income beneficiary is taxable. Keep in mind that each payment may include a combination of ordinary income, capital gain and tax-free return of principal.
One other option is to utilize a real estate donation to fund a charitable gift annuity. This means that in exchange for the property, the charity will pay you a fixed percentage of your gift’s value annually for the rest of your life.
In the year you make the gift, you are entitled to an income tax deduction based on an actuarial estimate of the portion of the property’s value the charity will keep. Each annuity payment you are given is treated as one part ordinary income, one part capital gain and one part tax-free return of principal — that is, until all of your principal has been returned to you. After that, the entire payment will be viewed as ordinary income.
Some other alternatives for donating real estate to charity include charitable lead trusts, bargain sales, and conservation easements. Ask your estate planning advisor to help you determine which approach is right for you.
Sidestepping the tax traps
Donating real estate to charity can seem like a simple proposition, but you need to plan very carefully to navigate a field of tax traps. Here are just some tips for avoiding them:
Substantiate the value. Whichever avenue you choose, it is critical to obtain an accurate valuation of the real estate property and substantiate that value. It can result in loss of deductions as well as penalties for overvaluation if you fail to do so.
For a property worth more than $5,000, you usually must have it appraised by a qualified appraiser, file IRS Form 8283 with your federal tax return and have your appraiser sign the form. If you are claiming a charitable deduction of more than $500,000, you have to attach the appraisal report to your return in the majority of instances.
If the charity sells the property within three years, the IRS requires it to report the sale price on Form 8282. If the selling price is significantly less than the value you reported on your income tax return, the IRS can challenge your deduction.
Avoid mortgaged property. Donating real estate that is subject to a mortgage can cause a hand full of problems. For one thing, you will likely recognize taxable income for some or all of the outstanding mortgage’s value. The charity may also have to pay unrelated business income tax on income generated by some debt-financed property.
As a rule, it is best to avoid this by limiting donations to debt-free properties. If you are able to, pay off the mortgage before you make the real estate donation, you can also ask the lender to accept other property as security for the loan.
Put bargain sales in writing. If you are not prepared to part with a property’s full value, a bargain sale might be a good compromise. You will have to sell the property to a charity at a discounted price and then claim a charitable deduction for the transaction’s “gift element” — this is the difference between the property’s FMV and the sale price.
Remember to document bargain sales in writing. If you do not clearly express your intent to treat the discounted sale price as a donation and the IRS views the transaction as a “bad deal” rather than a bargain sale, you might lose the charitable deduction.
Watch out for prearranged sales. One of the many benefits of donating appreciated real estate to charity is that you avoid capital gains taxes. To preserve this benefit, make sure you do not donate property to charity after you have entered into a binding agreement to sell.
This sometimes can happen when a property owner with philanthropic intentions gets close to closing a sale and then figures out a better tax result could be achieved by donating the property and then having the charity sell it to the buyer.
The IRS might view this as a prearranged sale and subsequently require the donor to pay the capital gains taxes anyway. Even worse, the donor will not be able to pay the tax out of the sale proceeds paid to the charity. The tax dollars will have to come out of the donor's pocket.
Avoid self-dealing
If you donate real estate to a charitable entity or vehicle that you established, make sure you watch out for the self-dealing rules. These rules impose harsh excise taxes on some arrangements between a tax-exempt entity and a “disqualified person.”
When you are ready to donate real estate to charity please think of donating with the Giving Center. Some of the types of real estate accept are:
