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Ever been forced to sell a stock in a sinking market or pressured to trade a car for less than it’s worth? Anyone who has experienced these disappointing financial transactions has felt the sting of sacrificing an asset for less than its true value. No one wants to sell at a loss; indeed, everyone expects to gain from a sale. Yet “selling for less than full value” is the very essence of a charitable bargain sale of real estate. What makes a charitable bargain sale more attractive than selling property on the open market? How does the arrangement work, and how do both sides benefit?
The elements of the transaction are straightforward:
- The owner sells the property to the charity at a discount.
- The owner receives ready cash and enjoys a charitable tax deduction in the amount of the discount.
- The charity sells the property for a tax-exempt gain.
While the idea is simple, there are inevitable technical details that, if not carefully considered, can sink the transaction and lead to IRS penalties.
Historically, donors have avoided the charitable bargain sale, perhaps because of the complex rules that govern this planned giving technique.
Today’s environment, however, includes both widespread property ownership and the likelihood of a continued recovery. It should come as no surprise, then, that many believe charitable bargain sales of real estate will increase in popularity in the coming years.
In this issue of Options, we’ll review the many benefits to the donor/seller and discuss the potential traps to avoid when making a bargain sale.
Bargain Sale Basics
A bargain sale occurs when a donor sells property to a qualified charity for less than the property’s fair market value. The difference between the “fair market value” and the “bargain sale price” is considered a charitable contribution. If the property has appreciated in value, the donor realizes a capital gain only on the sale portion of the transaction. The gift portion of the transaction escapes taxation. Because the cost basis cannot be used in full to offset the gain on the sale, basis must be allocated between the sale and gift portions of the transaction.
There are many kinds of bargain sales. The most common is an actual sale to a charity in return for an installment note or cash. Bargain sales can also involve a “like-kind exchange,” where a donor trades the charity for a similar property of lesser value or sells property that is subject to debt.
A bargain sale to charity provides significant donor benefits:
- A timely sale without the expense or delay involved in marketing the property
- Cash from the sale portion of the transaction
- A charitable income tax deduction for the gift portion of the transaction
- Partial capital gains tax avoidance for the gift portion
Before we get into any potential complications, let’s look at a bargain sale under ideal circumstances. Todd and Martha bought a house 35 years ago for $250,000 that is now worth $950,000. They’re getting ready to retire, and they want to downsize. They have no children so they decide to sell their home, buy a condominium, and donate the remainder to their college.
When they approach their attorney for assistance, she suggests selling the property directly to the college in a bargain sale. The sale price would coincide roughly with the amount they need to buy a condominium. The difference between the bargain sale price and the home’s fair market value would be a gift, and would provide them with a substantial charitable tax deduction. Moreover, Todd and Martha would owe no capital gains tax on the gift portion of the transaction.
Before Todd and Martha agree to the bargain sale, their attorney considers several key issues:
- Is there a mortgage or other indebtedness against the property? If so, this may complicate the transaction.
- Do IRC §170 reduction rules apply? Depending on the type of charitable organization, contributions may be limited to 50% or 30% of the donor’s adjusted gross income, which may reduce the amount of the contribution for the gift portion of a bargain sale.
- Does the income-based Pease limitation apply? If so, itemized deductions may be reduced[i].
Donor Intent—A Gift, or Not a Gift?
What is obvious to the donor is not always obvious to the IRS. After deciding on a bargain sale to charity, the donor must clearly establish charitable donative intent—in this case, the intention to make a charitable gift of the excess of the property’s fair market value over the bargain sale price. A letter from the donor to the charity prior to the execution of the arrangement should unambiguously document intent.
The case of Stubbs v. United States[ii] illustrates a situation where a “donation” of property was found to lack charitable intent. In Stubbs, a developer dedicated a strip of land for use as a public road to further his pursuit of building a trailer park on the surrounding property. The appeals court upheld the lower court’s ruling that the developer’s primary incentive in dedicating the strip of land was not to make a charitable donation, but rather to increase the value of the property he wanted to develop. Without evidence of charitable intent, the IRS denied the taxpayer’s deduction.
The moral of the story for attorneys and other financial professionals is twofold:
- Do not suggest a bargain sale without compelling indications that the donor/seller has charitable intentions, and
- Always memorialize the donor’s charitable state of mind.
This does not mean the parties cannot negotiate on price. However, if the IRS decides to challenge a bargain sale, the taxpayer’s motivations and incentives will be at the heart of their fact-finding efforts regarding the charitable element of the sale.
Allocating Basis—Gift vs. Sale
There are two parts to a bargain sale. There is the sale (for which the seller typically receives cash) and there is the gift to the charity (representing the amount of the discount in the price of the property). Since donors usually select appreciated property for the transaction, the cost basis must be allocated between the “sold” and the “contributed” parts of the property.[iii] The donor/seller’s taxable gain may only be offset by the basis allocated to the sale portion.
Example: Donelle Shrump owns a small office condominium she purchased years ago for $80,000; it’s currently appraised for $200,000. When Donelle’s mother dies after a long and difficult battle with cancer, Donelle is moved to sell the property to a leukemia research charity for an amount equal to her basis in the property—$80,000. Her charitable contribution is $120,000. To determine her taxable gain, Donelle’s basis must be allocated between the gift and sale portions in the proportion that each bears to the current value of the property. This calculation may be summarized as follows:
| Type | Gift Portion (60%) | Sale Portion (40%) |
|---|---|---|
| Fair Market Value | $120,000 | $80,000 |
| Allocated Basis | -$48,000 | -$32,000 |
| Gain | $72,000 | $48,000 |
- Donelle must recognize the $48,000 of gain on the sale portion for federal income tax purposes. She does not have to recognize the $72,000 of gain on the gift portion for tax purposes, even though it generates an economic benefit for her when she takes the charitable deduction.
- If Donelle is in the 33% marginal tax bracket (and her deduction is not limited by the 30%-of-AGI ceiling),[iv] the $120,000 charitable deduction will produce tax savings of $39,600.
- If Donelle had sold the property for its fair market value, the $120,000 of gain on the gift portion would have been taxed at the 15% capital gains tax rate (assuming the 3.8% Medicare surtax does not apply).[v] By making the bargain sale, Donelle reduces her capital gains tax from $18,000 to $7,200, thus saving $10,800.
- For her generous gift to the charity, Donelle enjoys combined tax savings of $50,400 ($39,600 deduction + $10,800 in avoided capital gains tax).
Let’s take a look at how sales expenses will affect the transaction if Donelle sells the property for its $200,000 fair market value and uses the net proceeds to make a $120,000 gift:
| Type | Sell Property and Donate to Charity | Bargain Sale to Charity |
|---|---|---|
| Asset Value | $200,000 | $200,000 |
| Capital Gains (100% Long-Term) | $120,000 | $120,000 |
| Sale Price | $200,000 | $80,000 |
| Sales Expenses (Fees, Maintenance, etc.) |
$22,000 | $0 |
| Gift to Charity | $120,000 | $120,000 |
| Charitable Deduction | $120,000 | $120,000 |
| Capital Gains Tax | $14,700* | $7,200** |
| Donor Tax Savings | $39,600 | $39,600 |
| Donor’s Balance | $82,900 | $112,400 |
* taking sales expenses into account ** paid on sale portion only
In addition to the economic benefit, Donelle has the satisfaction of knowing she has made a significant gift to the charity in her mother’s name.
Throwing a Mortgage into the Mix
Real estate gifts often fall within the definition of a bargain sale even when the transaction appears to be a straight gift with no cash changing hands. Why? Because real property is often mortgaged, and the IRS treats the mortgage as an amount realized by the donor/seller.[vi] The donor’s basis in the property is again allocated between the gift portion (fair market value less the mortgage) and the sale portion.
But here is the real surprise: the mortgage debt is treated as an amount realized by the donor even when the charity does not assume or agree to pay the debt.[vii] According to IRS Private Letter Ruling (PLR) 9329017, if the donor/seller continues to be liable for the debt, the continuing mortgage payments will result in additional charitable contributions to the extent that they consist of principal.
Example: Harris Milton makes a gift of commercial real estate to a charitable organization. On the date of the transfer, the property has a fair market value of $300,000.
Harris’ basis is $120,000. Harris intends to make a straight gift of the property. However, the property is encumbered by a $60,000 mortgage.[viii] Under the bargain-sale rules, instead of having made a $300,000 contribution, Harris is deemed to have:
- Received $60,000 (the amount of the mortgage debt) in exchange for the property, and
- Made a charitable contribution of $240,000.
Some of this contribution may not be deductible in the current year due to the 30% limitation,[ix] but can be carried over and deducted in future years. We can use our previous template to find Harris’ taxable gain on the transaction:
| Type | Gift Portion (80%) | Sale Portion (20%) |
|---|---|---|
| Fair Market Value | $240,000 | $60,000 |
| Allocated Basis | -$96,000 | -$24,000 |
| Gain | $144,000 | $36,000 |
Harris must recognize a $36,000 gain on the sale portion for income tax purposes. The $144,000 gain on the gift portion is not recognized.
Like-Kind Exchanges
A bargain sale to charity may take the form of an IRC §1031 like-kind exchange. For example, suppose a charity owns undeveloped land sought by a particular donor, and the donor owns undeveloped land that is attractive to the charity. The donor and the charity could arrange a swap, with a bargain element built into the transaction to generate a charitable deduction.
Under the IRC rules, the gain on the sale portion of the transaction that would normally be taxed is not recognized. The donor’s basis in the original property normally carries over to the new property under IRC §1031, but the bargain sale limits the carryover to that portion of the basis allocated to the sale portion of the property.[x]
Example: Leo Hemsley bought land near a university for $160,000 that is now appraised at $300,000 (giving Leo a basis of $160,000). The school wishes to acquire this land to build a new science and engineering building. Leo is interested in acquiring a parcel of land the university owns downtown that has been appraised at $250,000. Leo and the university make the swap. The $50,000 difference between the two appraised values is the amount of Leo’s charitable contribution.
Ignore for a moment the IRC §1031 provisions—a donor would normally realize a taxable gain of $116,667 on the sale portion as follows:
| Type | Gift Portion (16.67%) | Sale Portion (83.33%) |
|---|---|---|
| Fair Market Value | $50,000 | $250,000 |
| Allocated Basis | -$26,667 | -$133,333 |
| Gain | $23,333 | $116,667 |
But IRC §1031 exempts the gain on the sale portion from taxation, provided that the requirements for non-recognition are satisfied. (Land-for-land qualifies as a like-kind exchange, but donors should check other contemplated swaps for IRC §1031 qualification.)
Leo loses part of his basis, however. Under IRC §1031, the $160,000 basis would normally carry over to the new property. But because of the bargain sale, his adjusted basis for determining gain on a subsequent disposition of the downtown land would be $133,333.
The Appeal of Installment Sales
When a bargain sale is combined with an installment sale, the donor can fashion a viable alternative to a charitable gift annuity or charitable remainder trust. Here, the charity would pay the bargain price in installments, giving the donor a periodic cash flow. The donor can spread the gain over the payout period and still take an immediate deduction for the gift portion of the transaction.
An installment bargain sale is most attractive when a gift annuity or remainder trust is impossible or impractical. Consider some typical scenarios:
- A donor needs income for a term of years (not possible with a gift annuity), or for a term exceeding 20 years (impossible with a remainder trust).
- The charity will not issue a gift annuity in exchange for a gift of real estate.
- The charity wants to defer installment payments or the donor wants payments to vary from year to year based on the donor’s income needs (both impossible with a remainder trust or gift annuity).
- The donor wants to continue living in a donated house (which would be considered self-dealing in a remainder trust).
Example: Caldwell B. Anchor III holds 20 acres of unimproved real estate, appraised at $500,000. His basis is $100,000 and there is no debt on the property. The location is attractive to a charity as a possible future building site. Caldwell and the charity agree to an installment bargain sale of the property for $300,000, to be paid in equal annual installments over 10 years. Caldwell will also be making a deductible gift of the remaining $200,000 in value. In his 33% tax bracket, the charitable deduction will provide federal income tax savings of $66,000.[xi]
Caldwell’s $100,000 basis must be allocated between the gift and sale portions of the transaction, as in any bargain sale. Here, $60,000 is allocated to the sale portion and $40,000 to the gift portion. Caldwell’s taxable gain on the sale portion is $240,000 ($300,000 sale price minus $60,000 allocated basis). Recognition of this gain for tax purposes is spread over the installment period. Of each $30,000 annual installment payment, $24,000 will represent taxable gain.
Let’s take a look at what Caldwell accomplished:
- Converted an unproductive asset into a 10-year income stream of $30,000/year
- Secured income tax savings of $66,000 from the charitable deduction for the gift portion of the transaction
- Spread his $60,000 capital gains tax over 10 years instead of having to pay all of the tax in the year of the sale
- Removed expenses associated with owning the land (property taxes, insurance, maintenance, etc.)
- Avoided the time and expense of selling the land
- Sidestepped the expense of establishing and administering a charitable remainder trust
There are advantages for the charity as well:
- Immediate, free-and-clear ownership of the property without having to wait until a charitable remainder trust terminates or gift annuity payments stop
- A payout obligation that is limited to a specified number of installments (gift annuities require the charity to pay out as long as the annuitant lives, even when the annuitant exceeds actuarial life expectancy)
Bargain Sale Gone Bad
Fill Dirt Transaction Runs Aground
A recent ruling illustrates what can happen when the Tax Court determines that the parties to a bargain sale of real estate failed to follow all the rules. In Boone Operations Co. et al. v. Commissioner,[xii] a landfill operator agreed to discount the sale price of real estate—”fill dirt” in this case—provided to the city of Tucson in the process of settling a dispute over methane gas pollution issues at the site. While it seems as though this transaction might easily be structured and memorialized as a bargain sale, there were problems that led to disallowance of the charitable deductions taken by the landfill company:
- Insufficient acknowledgement of the charitable gift by the city of Tucson
- Failure by the city to adequately document how it benefited from the bargain and the value of any consideration paid for the fill dirt (the “quid pro quo”)
The Tax Court examined the appraisal of the real estate and the structure of the sale of fill dirt in some detail, eventually ruling in favor of the IRS, which had denied the charitable deduction taken by the landfill operator.
A bargain sale of real estate is not appropriate in every case; however, there are certainly times when it suits both the donor’s needs and the charity’s interests. When circumstances align properly, a bargain sale can help both parties accomplish important goals, making it an attractive form of philanthropy. Indeed, this planned giving technique may allow certain donors to make a gift that might otherwise not be possible.
Endnotes
[i]The Pease limitation reduces the amount of itemized deductions that certain taxpayers are allowed and it can limit the itemized deduction for charitable gifts. The limitation for 2015 applies when AGI exceeds $309,900 for joint filers and $258,250 for individuals. Income over the applicable amount limits itemized deductions to the lesser of (a) 3% of the adjusted gross income above the applicable amount, or (b) 80% of the amount of the itemized deductions otherwise allowable for the taxable year.[↵]
[ii]Stubbs v. United States, 428 F. 2d 885, 887 (9th Cir., 1970) [↵]
[iii]IRC §1011(b); Reg. § 1.1011-2(a)(1)(c); see also Reg. §1.170A-4(d) and 1.1011-2(c)[↵]
[v]Taxpayers pay an additional 3.8% Medicare surtax on the lesser of “net investment income” or the taxpayer’s modified adjusted gross income less the applicable income threshold of $250,000 for joint filers and $200,000 for individuals.[↵]
[vi]Reg. §1.1011-2(a)(3); Goodman v. U.S., 2000-1 USTC; see also Rev. Rul. 81-163, 1981-1 C.B. 433; Crane v. Comm’r, 331 U.S. 1 (1947)[↵]
[vii]Ebben v. Comm’r, 783 F.2d 906 (9th Cir. 1986)[↵]
[viii]Assume for purposes of the example that the IRC §1250 recapture rules do not apply to the property. The IRS uses §1250 to maximize tax revenue from depreciating assets by requiring the profit on the sale of a depreciating asset to be reported as ordinary income rather than capital gain.[↵]
[x]Rev. Rul. 78-163, 1978-1 C.B. 257[↵]
[xi]Note: All examples are based on income tax rates effective in 2015. The marginal tax rates for ordinary income and capital gain income that apply in 2015 may be different for some or all taxpayers in future tax years. [↵]