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There are many reasons why a donor would want to contribute encumbered property to charity. Perhaps the property is perfect for the needs of a particular charity, or this may be the only property a donor owns that he is willing to donate. Whatever the reason may be, before a donor decides to donate property that is encumbered to charity, he should consult with a professional to determine the potential tax ramifications of the donation.
For instance, assume Donor purchased a parcel of real property years ago that was used for business purposes. Over the years, Donor sold the property and purchased other real property and was able to defer the gain through IRC Section 1031 because the sale and purchase were considered a like-kind exchange. In fact, Donor entered into several like kind exchange transactions over the years and was able to continuously defer his gain recognition. However, Donor now wishes to sell the business property and does not want to invest the proceeds in new business property. Thus, when this property is sold, Donor will have a substantial capital gains and potential depreciation recapture.
In the hopes of reducing or eliminating the gain recognition, Donor decides to donate the encumbered property to charity and anticipates a large charitable deduction based on the current fair market value of the property. However, though Donor is entitled to a charitable deduction, if he donates this property to charity, the donation may not be as large as he expects. Because Donor’s property is encumbered, Donor will likely be required to report a taxable gain.
For example, assume Donor’s property has a fair market value of $2,000,000, and he has a $600,000 mortgage on the property. Donor assumes that his charitable deduction will be $1,400,000, which is the fair market value of the property ($2,000,000) less the outstanding mortgage ($600,000). While Donor is correct that he is entitled to a $1,400,000 charitable deduction, he is also required to recognize income at the time of the donation which will offset the charitable deduction and make it less valuable. Under the Treasury Regulations, the IRS will divide this donation into two parts: (i) one part is considered a gift; and (ii) one part is considered a sale. The sale part is the portion of the property relating to the mortgage, or 30% ($600,000/$2,000,000). The gift part is difference, or 70% ($1,400,000/$2,000,000).
For purposes of this illustration, assume Donor’s adjusted basis in the property is $800,000. The $800,000 basis must be divided between the gift portion and the sale portion as follows: 30% of the basis will be allocated to the sale ($800,000 x 30% = $240,000) and 70% of the basis will be allocated to the gift ($800,000 x 70% = $560,000). The amount of the gain that Donor must report is the difference between the mortgage and the basis allocated to the mortgage, or $360,000 ($600,000 – $240,000). Unfortunately, there is no tax benefit for the portion of the basis that is allocated to the gift.
Therefore, though Donor is entitled to a charitable deduction of $1,400,000, Donor must also recognize $360,000 of gain which makes the charitable deduction less effective then originally anticipated. There are several other factors that should be considered when deciding whether or not to contribute encumbered property to a charity that are outside the scope of this article. The attorneys at Olive Judd PA can assist donors by creating appropriate vehicles to make desired contributions to charity while avoiding potential tax pitfalls along the way.
To keep this illustration simple, we assumed no depreciation recapture and no limitations or other phase outs on Donor’s individual return.