10. Gifts of Partial Interests, Part 1 of 3

10. Gifts of Partial Interests, Part 1 of 3

Article posted in General on 30 March 2016| comments
audience: National Publication, Russell N. James III, J.D., Ph.D., CFP | last updated: 30 March 2016
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Summary

Russell James begins his exploration of gifts of partial interests, a much broader topic than most gift planners realize.

VISUAL PLANNED GIVING:
An Introduction to the Law and Taxation
of Charitable Gift Planning

By: Russell James III, J.D., Ph.D.

10. GIFTS OF PARTIAL INTERESTS, Part 1 of 3

Links to previous sections of book are found at the end of each section.

This chapter examines charitable gifts of partial interests in property.  The topic of this chapter may initially appear not as interesting or relevant as some of the chapters covering well-known specific charitable planning techniques.  However, gifts of partial interests (specifically retained partial interest gifts where the donor keeps some rights in property and gives other rights in the same property to the charity) are a fundamental concept that will be used again and again in advanced techniques.  For example, Charitable Remainder Trusts, Charitable Lead Trusts, gifts of remainder interests (with retained life estates) in homes and farmland, and even qualified conservation easement gifts are all forms of partial interest gifts where the donor retains some rights in the property given to charity.  Although this chapter does not address the specifics of such gifts (which are covered in their own chapters), this chapter provides a brief theoretical foundation of how and why partial interest gifts, such as these, are sometimes allowed and sometimes disallowed.  Additionally, this chapter also covers some specific gifting techniques that, while relatively straightforward, may be useful in a variety of circumstances.
So, let’s begin with a definition.  What is a retained partial interest gift?  A retained partial interest gift occurs when a donor gives a charity some rights to an item of property, but simultaneously keeps some other rights in the property.  Notice that what is being divided here is not the property itself (such as taking the tire off of a car), but rather the legal rights to the property.  In the law, property ownership represents a bundle of rights.  These rights can be kept together where one person owns all of them, or these rights can be divided where different people own different rights.  For example, the tenant in an apartment has certain rights, such as the right to use the property for residential purposes so long as the rent is paid.  However, the owner of the apartment building also has rights in the apartment property, such as the right to take possession of the apartment at the end of the lease period.  A retained partial interest gift occurs whenever a donor splits types of ownership rights and gives some of them to charity while retaining others.
An example of splitting the rights between the donor and a charity would occur if the donor gave ownership of an automobile to a charity, but retained the right to use the automobile for one year.  Given that the charity has received some rights (i.e., ownership in one year), is it reasonable to allow an immediate tax deduction for this transfer?
Another example of a partial interest gift reverses the previous situation by giving the charity the right to use the property for one year, after which the donor has full ownership rights.  Given that the charity has received some rights (i.e., the right to use the property for one year), is it reasonable to allow a tax deduction for this transfer?
Another example of a partial interest gift would be a transfer of land to a charity where the donor keeps all rights to extract minerals from the land.  Once again, the donor has retained some types of rights and the charity has received different types of rights in an item of property.  Given that the charity has received some types of rights (i.e., the ownership of the land, except for mineral rights), should a tax deduction be allowed for this transfer?
The general rule is that the donor cannot keep ownership rights in gifted property and still deduct the gifts.  There are some very important specific exceptions to this general rule that we will examine in detail later.  However, if none of these specific exceptions apply, the partial interest gift with retained rights will not generate a deduction.

For example, if the donor gives the title to a car to a charity, but retains the right to use it for one year, there is no immediate charitable income tax deduction.  This is a partial interest gift with retained rights because the donor retains rights to the gifted property.  This gift does not qualify for any of the special exceptions to the general rule against deductions for such partial interest gifts, so there is no immediate income tax deduction. 

The emphasis is on there being no immediate tax deduction because the donor could later transfer the remaining rights to the charity or the donor’s rights could expire.  In either case, the transfer to charity would no longer be a retained partial interest gift because the donor would no longer have any retained rights.  At that point, the transfer would become a completed gift not involving any retained interests and would therefore be deductible.  So, in this example, after one year – when the donor’s rights expire – then the gift of the vehicle would be complete and could be deducted based upon its value at that time.

Similarly, allowing the charity to use property does not generate a deduction when the donor still retains underlying ownership of the property.  Because the donor is retaining rights in the gifted property, this is a retained partial interest gift.  Because none of the special exceptions apply to this partial interest gift it, therefore, will generate no deduction.  Thus, allowing the charity the rent-free use of a building when the donor retains ownership rights to the building will generate no charitable tax deduction.
As a final example, transferring ownership of land to a charity, but retaining the mineral rights also generates no charitable income tax deductions for the donor.  The donor has given some rights in the property, but retained some other types of rights in the same property, making this a retained partial interest gift.  Because this transfer does not qualify for any of the special exceptions, the general rule (that partial interest gifts are not deductible) will apply.
These are all examples of the general rule (which has some very important exceptions) that donors may not keep some rights in the property and still deduct a transfer of other rights to a charity.  Notice that this rule applies to retaining rights in the same property that was given to the charity.  For example, it does not prevent a deduction for giving a specific 10-acre tract to charity from a 1,000 acre farm.  In that case, the donor retains no rights to the 10-acre tract given to the charity, but retains rights only in the 990 acres not transferred to the charity.  Similarly, a donor could give the steering wheel of an automobile to charity and keep the rest of the car.  This would not be a partial interest gift because the donor retains no rights to the specific item of property (the steering wheel) given to the charity.
We have been examining cases where the general rule against deductions for partial interest charitable transfers applies.  But, why do we have such a rule in the first place?  Why not simply allow deductions for the fair market value of any partial interests transferred to the charity?
The problem with partial interest gifts is that the donor may be able to manipulate the property to get more value for the donor’s share and less value for the charity’s share.  The charity may not complain about such manipulation because it is still getting some value, which is better than nothing.  However, because the charity is getting less value than that assumed by the calculation of the tax deduction, this violates tax policy goals.  How might a donor manipulate the property to reduce the charity’s share if such partial interest gifts with retained interests were deductible?  Let’s look at a few examples.
Suppose a donor could transfer an automobile to charity, retain the right to use the automobile for one year, and still deduct the value of the automobile subtracting only one year of projected depreciation.  Could the donor use the automobile in such a way that the charity would receive very little value at the end of the year?  Yes.  Thus, the donor could receive a tax deduction based upon a much higher value than that actually transferred to the charity.  To avoid this problem, such partial interest gifts do not generate a tax deduction.
Or, let’s reverse the situation and give the charity the right to use the property while the donor retains ownership at the end of the use.  Suppose a donor gives a charity the right to use his newly planted olive tree orchard for seven years.  What if the donor was allowed to deduct the fair market rental value for farmland?  In this case the land produces nothing for the first seven years.  (Newly planted olive trees do not produce until after seven years.) A cooperative charity would not disturb the olive trees, allowing the owner to deduct the gift of a right which has no real value.  Thus, once again, the donor would receive a tax deduction based upon a much higher value than that actually transferred to charity if this prohibition against partial interest deductions were not in place.
As a final example, let’s suppose that a donor gave $2 million worth of stock in his corporation to a charity, but retained the right to repurchase the stock for $2 million any time in the next three years.  This is a retained partial interest gift, because the donor is retaining some rights in the property gifted to charity.  Were it not for the prohibition against deductions for such partial interest gifts, the donor could deduct $2 million.  (This is logical because the charity receives $2 million of property and the right to repurchase the property requires a $2 million transfer.) How could such a transaction be abusive of the tax code?  Suppose that the corporation’s only product was a new cancer drug that would be either approved or rejected by the FDA in three years.  If approved the $2 million of stock would be worth $200 million.  If rejected, the $2 million of stock would be worth zero dollars.  If the partial interest charitable gift were deductible, the donor could guarantee a $2 million deduction – worth nearly $1 million in reduced tax payments depending upon the donor’s income and state of residence – and still retain the repurchase rights to capture the potential $198 million gain.  Even if the donor had no charitable interests, the charitable gift risk scenario (outcomes of $1 million benefit or $198 million benefit) could be preferable to the non-charitable risk scenario (outcomes of $0 benefit or $200 million benefit).  Because of the partial interest rule this transaction would generate no immediate charitable deduction.  If the donor’s right to repurchase expired, then, at that point, the gift would be completed, because the donor would have no retained rights in the stock.  But, the deduction would be based upon the value of the stock at the time that the retained interests expired, not at the time of the initial transaction, thus eliminating the opportunity for changing the donor’s risk scenario.
These examples all serve to explain why the general rule prohibits donors from keeping some rights to a gift of property and still deducting the value of the partial interests gifted to charity.  Understanding this underlying principle also helps to explain why the tax code allows for certain exceptions to the general rule.  Specifically, these exceptions are cases in which the opportunities to abuse the charitable tax deduction have been largely eliminated.

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