CGNA: Chapter 1 - Real Estate | Advanced, Part 1 of 3

CGNA: Chapter 1 - Real Estate | Advanced, Part 1 of 3

Article posted in Assets, General on 6 September 2017| comments
audience: National Publication, Bryan K. Clontz, CFP®, CLU, ChFC, CAP, AEP | last updated: 11 September 2017


Gifts of non cash assets continues with a deeper and more advanced look at gifts of real estate.

This article is an excerpt from Charitable Gifts of Noncash Assets, a comprehensive guide to illiquid giving by Bryan Clontz, ed. Ryan Raffin. Published by the American College of Financial Services for the Chartered Advisor in Philanthropy Program (CAP), with generous funding from Leon L. Levy. For a free digital copy, click here, and to order a bound copy from Amazon, click here.

By Dennis Bidwell and Bryan Clontz1

Below is an in-depth examination on gifts of real estate. Real estate topics are based on the following paper I co-authored with Dennis Bidwell, “Converting Real Estate Wealth to Gifts – Opportunities and Challenges.” For quick take-aways on gifts of real estate, see Real Estate Quick Take-Aways. For a review based on that article, see Real Estate Intermediate. For an in-depth examination adapted and excerpted from the article, see Real Estate Advanced. For further details, see Real Estate Additional Resources or cross reference to the asset’s ownership entity (e.g., LLC, Limited Partnerships, etc).

This section looks more closely at the magnitude of the real estate gift opportunity, reviews the types of real estate assets and the various structures through which they are owned, examines key issues and challenges faced by organizations that seek and accept real estate gifts, and reviews various mechanisms for receiving real estate gifts.

Real Estate: The Opportunities

The nonprofit world is increasingly aware that most donors have more of their wealth in real estate than in any other asset type. In fact, about 30 percent of the nation’s private wealth is in real estate, compared to 16 percent for equities and mutual funds, 20 percent in pension funds and life insurance reserves, and just 11 percent in cash and equivalents.2 Other data points which show the potential of real estate gifts are as follows:

  • The total amount of U.S. privately-held real estate is approximately $26.9 trillion. Interestingly, nonprofit organizations own $3.3 trillion of real estate.3 World-wide, real estate represented 54 percent of total developed country wealth in 2002.4
  • The total value of all U.S. publicly-traded stocks (NYSE, NASDAQ, etc.) is approximately $27 trillion as of the end of 2016.5
  • A Wall Street Journal article estimated that real estate only represented two percent of total charitable donations.6
  • In 2004, total real estate gifts were $3.1 billion from more than 25,000 donors, with 36,000 distinct contributions and an average gift over $85,000 (the average was $172,000 for gifts exceeding $5,000). This represented slightly more than one percent of total 2004 giving. In 2003, approximately the same number of donors made contributions of real estate, but the total was nearly double, amounting to $6 billion in contributions (these amounts exclude conservation easements). Interestingly, closely held stock gifts were more than $15 billion in 2004, or five times all real estate donations in that year.7

Conservation Easements

A few words about conservation easements may be valuable. Generally speaking, only qualified conservation 501(c)(3) organizations — typically land trusts — and governmental bodies or agencies will accept “gifts” of conservation easements. These easements are essentially a donation by way of permanent restriction on the use of land or structures. They are an exception to the partial interest rule, where no deduction is available for gifts of less than an entire interest.

The owner(s) of the real property enter into a contract with the conservation organization agreeing to limit the use of the property in perpetuity (the easement). In doing so, the owner(s) bind themselves and all future owners to the use limitation specified in the easement contract. This can sharply limit the fair market value of the property, particularly if the limitation is on commercial development, and so the owner is entitled to a deduction equal to the decline in value. Further, the owner may exclude the property, up to a certain amount, from his or her estate for tax purposes.

Stated simply: These figures show that the total value of all privately-held real estate is approximately double that of the entire publicly-traded stock market, yet represents less than three percent of all charitable gifts. Why, if 29 percent of the nation’s private assets are in real estate, has so little of this real estate come to nonprofits as gifts? Certainly much of the disparity between the amount of real estate wealth in the country and its share of total giving has to do with the backgrounds and comfort zones of development personnel. Real estate has traditionally loomed as a very different, more complicated, less liquid asset, requiring expertise gift officers often do not develop.

Real estate gifts often have risks and complications, and the classic real estate donation “horror stories” will reinforce those existing preconceptions. There can be no doubt that these stories, shared among colleagues at other institutions, help to perpetuate the belief that real estate gifts tend to be “more trouble than they are worth.”

On the other hand, many institutions have stories (usually less well-circulated) of successful real estate gifts that proved extremely lucrative while being very satisfying to the donor. Many nonprofit organizations have enjoyed great success in attracting real estate gifts as part of their development operations. Of 590 respondents to the National Committee on Planned Giving’s recent Survey on Real Estate Gifts (NCPG Survey),8 74 (12.8 percent) reported that in the last three years more than 10 percent of the total gifts to their organization, in dollar terms, have come in the form of real estate gifts. Indeed, 38 respondents (6.6 percent) reported receiving more than 15 percent of their total contributions in the form of real estate gifts.

Real Estate Taxation Summary: From the Perspective of the Donor and the Charity

Real estate comes in many types, and each type has a number of ownership forms. The various real estate types and forms of ownership can create an array of tax consequences. For the purposes of this section, remember: if the most efficient charitable gift nearly always comes from the lowest adjusted cost basis, highest capital appreciation property held for the long-term, then real estate is clearly tailor-made for charitable giving.

If the owner sells real estate, the general real estate taxation rules are as follows:

  1. The owner can receive long-term capital gains tax treatment on real estate held more than one year. Under current tax rates, this would generally equate to either 15 or 20 percent federal tax plus any applicable state income tax. To the extent the donor had a negative adjusted cost basis in the property, the IRS generally taxes any recapture at capital gains tax rates as well. Do note that it is particularly important to seek specific tax counsel for the gift the donor is considering.
  2. If the owner has any unrecaptured depreciation Section 1250 gain in the property, the income tax rate is 25 percent.9
  3. If the owner used an accelerated depreciation schedule, then the IRS generally taxes any recapture beyond straight-line depreciation amounts at ordinary income rates.10
  4. If the owner had furnished the property, the IRS would tax any gain on tangible personal property at 28 percent federal tax plus any applicable state income tax.

If the owner instead donates real estate, the general charitable income tax deduction rules instead are as follows:

  1. Charitable gifts of long-term, unencumbered real estate to a qualified public charity allow the donor to receive a deduction of fair market value. The deduction is limited to 30 percent of adjusted gross income with a five-year carry-forward.
  2. The same donor giving piece of real estate to a private foundation would receive a deduction based on the lesser of the fair market value or the adjusted cost basis. Regulations limit the deduction to 20 percent of adjusted gross income limitations with a five-year carry-forward. Note that real estate may be conducive for testamentary funding of a private foundation to the extent the property receives a stepped-up basis.
  3. Regulations reduce any charitable income tax deduction for any ordinary income element of the gift.
  4. If the real estate has any debt — recourse or nonrecourse — the donation will trigger bargain sale rules (as well as a sale to charity for below market value). This results in part-gift and part-sale treatment. To determine the indebtedness the donor realizes, the formula is: Cost Basis x Selling Price (Acquisition Indebtedness in this case)/Fair Market Value = Basis Allocation. Then Selling Price – Basis Allocation = Taxable Gain. The charitable income tax deduction is the Fair Market Value – Selling Price. For a complete explanation see IRC Section 1011(b).

From the charity’s perspective, the main tax issue is unrelated business taxable income (UBTI), which gives rise to unrelated business income tax (UBIT). The charity can trigger this treatment if the real estate represents an unrelated business (e.g., a golf course), or if the property has debt financed income.

There are two exceptions to this UBTI rule. The first is debt financed income where the debt was placed on the property more than five years prior to the donation and the donor owned the property for at least five years. This is known as the “old and cold” exception. In this case, the charity has ten years to dispose of the property before it triggers any UBTI. The second exception is where the donor bequeaths encumbered property to the charity. The IRS allows ten years to dispose of the property before UBTI applies.

As it relates to charitable remainder trusts, keep in mind that any UBTI the trust realizes post-January 1, 2007 results in a 100 percent excise tax. While certainly harsh, it no longer automatically disqualifies the trust, so relatively small amounts of UBTI now represent new planning opportunities under the right set of facts.

Remember that there are a number of planning strategies to reduce or eliminate real estate debt for both outright or deferred gifts. The simplest solution is for the donor to pay off the debt. The donor can also try to arrange for a release of the security interest and then can place the debt on a different property. Or, the donor can obtain a bridge loan to pay off the debt, or a margin loan on a securities portfolio, prior to making the transfer. And finally, the charity can buy the debt encumbered proportional interest from the donor and then subsequently sell its interest to recoup the investment.11

Real Estate Risk Continuum

Charitable organizations are increasingly receptive to real estate gifts. In the NCPG Survey, 22 percent of respondents said they were more receptive to such gifts in recent years, compared to only four percent who said they were less receptive. However, the perceived risks and complexity of accepting real estate gifts causes many organizations to devote the bulk of their development resources to the pursuit of cash, securities and retirement fund assets.

What follows is a risk continuum for various kinds of real estate contributions. Clearly, each charity will have its own risk tolerance level with various real estate scenarios, but the continuum can be excellent starting point for gift acceptance discussions, policy drafts and risk management strategies. Donors will also find the continuum applies in terms of the real estate gift’s potential headache. The following 20 real estate cases are subjectively ranked from 1, being the least complex/risky, to 5, the most complex/risky.

Level One

1. Outright gift of local residential property or LLC/limited partnership interests with no debt and a nonbinding “buyer-in-the-wings.”

Level Two

2. FLIP-CRUT gift of local residential property or LLC/limited partnership interests with no debt and a nonbinding “buyer-in-the-wings.”

3. Outright gift of local commercial or agricultural property, or LLC/limited partnership interests with no debt and a nonbinding “buyer-in-the-wings.”

Gifts of Timeshares

From a tax perspective, a timeshare is simply an undivided fractional interest in real estate. For this reason, the IRS allows the donor of a time-share to take a charitable deduction of fair market value. This is one area where difficulty arises — the fair market value of a timeshare in an arms-length transaction is often de minimis.

Another problem with gifts of timeshares is that charities are typically unwilling to accept an asset with limited market value but considerable maintenance fees. Many nonprofits specifically exclude timeshares in their gift acceptance policies for this reason. A nonprofit may be happy to accept the use of a timeshare for a week (as an item in a charity auction, for example), but this is not an ownership interest, nor is it eligible for a deduction.

Plus, it is important to note that virtually no time-share has ever increased in value so it is better for the donor to sell it directly.

Level Three

4. Outright gift of partial interest in undivided real estate.

5. Outright gift of nonlocal residential or commercial property (LLC/limited partnership/fee simple) with no debt and no “buyer-in-the-wings.”

6. Any real estate transaction where donor wishes to make multiple donations to multiple charities.

7. Charitable gift annuity the donor funds with real estate.

8. Real estate charitable installment bargain sale.

9. Any residential or commercial property the owner has listed for sale for more than one year, or has listed several times for sale in the recent past, or has lowered the price several times.

Level Four

10. Operating partnership units from UPREIT exchange.

11. General partnership interests with real estate.

12. Any non-U.S. real estate.

13. Charitable gift annuity issued for retained life estate.

14. Commercial property with multiple tenants or apartment complexes.

15. Charitable remainder annuity trust fund with real estate.

16. Asset donation from a business entity with multiple owners.

Level Five

17. Any real estate donation that triggers unrelated business taxable income (UBTI) — operating business or acquisition indebtedness.

18. Any real estate donation with environmental issues.

19. Any real estate donation with legal issues.

20. Any real estate donation involving three or more layers of entities.

Of course, a charity can (and should) determine its own risk tolerance for various types of real estate and then can develop acceptance policies, legal structures, and referral relationships for anything the charity is uncomfortable accepting.

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