Contributing Mortgaged Property To Charity

Contributing Mortgaged Property To Charity

Article posted in Real Property on 2 May 2001| 2 comments
audience: National Publication | last updated: 16 September 2012
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Summary

It has been said that one should always look a "gift-house" in the mouth … well, something like that. In this edition of Gift Planner's Digest, Laura H. Peebles from the national office of Deloitte & Touche reviews the tax issues that surround charitable gifts of debt-encumbered property.

by Laura Peebles

This article will discuss the tax aspects of inter vivos contributions to a charity of property subject to a mortgage. It will also touch on additional issues that arise if the donor is considering a transfer to a charitable remainder trust. Before proceeding with any donation of encumbered real estate, all relevant state laws should be reviewed as well.

Potential donors occasionally want to donate encumbered real estate to charity. Perhaps it is the only available asset that they have to donate; perhaps the charity wants that particular piece of property for use in its charitable function.

Often, the proposed donation plan is nipped in the bud after an initial phone call to the tax advisors. Two significant hurdles stand in the way of a tax-effective donation of encumbered property to a public charity: "bargain sale" rules and "debt-financed income" rules. If a private foundation is involved, the "self-dealing rules" are another potential stumbling block.

Bargain Sales

The bargain sale rules are detailed in Treas. Reg. §1.1011-2. Under these rules, the transfer of the property is divided. The portion of the fair market value representing the debt on the property is treated as a sale, and the equity portion is treated as a donation. The adjusted basis of the property transferred must be prorated between the portion deemed sold and the portion deemed donated.

The easiest way to understand these rules is by example.

Assume that our potential donors have property worth $1 million. The property is subject to a mortgage of $300,000, which was placed on the property 10 years ago at purchase. The donors' adjusted basis is $400,000. None of the depreciation that they have taken would be subject to recapture under IRC §1245 or 1250. They are considering donating it to a charity (not a private foundation1). They assume that they would be entitled to a donation deduction for their equity in the building of $700,000 (subject to the various limitations based on adjusted gross income).

After a call to their tax advisor, the donors find that they are partially correct. They are indeed entitled to a $700,000 tax deduction. However, they will also have income due to the debt on the property. Under Treas. Reg. §1.1011-2(b), the basis of $400,000 is allocated 30% ($120,000) to the "sale" portion of the transaction, and 70% to the donation portion of the transaction. (They receive no tax benefit from the 70% of their basis allocated to the donation.) Therefore, they have taxable income of $180,000 ($300,000 mortgage less $120,000 allocable basis). Of course, they have reduced their net income by $520,000 (without considering various limitations and phase-outs on their income tax return).2

The above results are not affected by whether the debt is recourse or non-recourse with respect to either the donor or the donee.3 If a charity is considering accepting property subject to a recourse mortgage, they should consult legal counsel regarding the potential effect of the Intermediate Sanctions rules under IRC §4958, as well as the possibility of private inurnment. This alone may preclude certain donations, since the lender may be unwilling to convert the debt to non-recourse debt, and the charity may be unwilling (or unable under state law) to accept the property unless the mortgage is converted to non-recourse.4 The donation deduction will still be reduced, even if the donor commits to continue to pay the mortgage individually. The tax treatment would be similar to a pledge, so that the payments would only be deductible when actually made.5

Debt-Financed Income

Assuming the charity is interested in the property, it should be concerned with the possibility that a portion of the income from the property will be taxable income under the "debt-financed income" rules under IRC §514. "Debt-financed income" is one type of unrelated business taxable income (UBTI). The charity will pay tax on this type of income, notwithstanding its overall exemption from income tax. If only a portion of the property is subject to debt financing, that portion of the income will be taxable.

Continuing with the example above, since 30% of the building is subject to debt financing, the preliminary conclusion would be that 30% of the net rent would be subject to tax. However, there are a number of exceptions to the definition of "debt-financed income." The clearest one is that the property subject to the mortgage would be used at least 85% in the exempt function of the charity.6 If this exception is met, any income from the property is excluded from the definition of debt-financed income. If the charity is planning on using the donated building as part of its charitable function, then this inquiry ends here.

Even if the charitable organization will not be using the building, a second potentially relevant exception to the debt-financed income rules applies to property acquired by a gift. These rules are detailed in Treas. Reg. § 1.514(c)-1(b)(3)(ii).7 If the mortgage was placed on the property more than five years before the date of the gift, and the donor had owned the property more than five years prior to the gift, the mortgage will not be considered "acquisition indebtedness" during the 10 years after the donation. Since the mortgage is not considered "acquisition indebtedness," the property is not considered "debt-financed" and therefore none of the income is subject to unrelated business income tax during the 10-year period. This exception does not apply if the donee assumes the mortgage (rather than taking the property subject to the mortgage) or pays the donors anything for their equity in the property. In our example, the donors had owned the property for 10 years before the donation, so the donee organization has 10 years after the donation to pay off the mortgage before the income becomes partially taxable.

Even if our donors, in the example above, had recently purchased the property so that the exception was not met, the organization would probably still want to accept the particular donation. Although 30% of the rental income may be taxable, it would still appear to be a valuable asset to the donee. This assumes that the valuation is satisfactory, there are no environmental issues, and that the cash flow is sufficient to service the debt on the property and still provide a return to the donee.

Basis to the Donee

Property acquired by a gift retains the basis that it had in the hands of the donor.8 Although the examples in these regulations refer to gifts to individuals, there is no exception for gifts to charity. Note that these rules are included in Part II of Subchapter O, Basis Rules of General Application. However, in our example above, only a portion of the transfer of the property was deemed to be a gift. The remainder is deemed to be a purchase, and the donee takes that portion of the property at fair market value. Therefore, the donee's basis is:

Donor's basis allocable to given portion $280,000
Value of portion deemed sold to donee $300,000
Tax basis to donee $580,000


This basis will be important to the donee if the property is sold or rented after the exemption from UBTI has expired because it has held the property past the 10-year exemption period discussed above. The donee will be entitled to depreciation9 to reduce its taxable income. Of course, any remaining basis will be available to reduce the gain on the sale. If the property is subject to the debt-financed rules at the time of the sale, the same proration of taxable to non-taxable gain will be required.10

Self-Dealing Rules Applicable To Private Foundations

An additional complication arises if the intended donee of the mortgaged property is the donor's private foundation. Generally, sales between a private foundation and its creator (a "disqualified person") are prohibited.11 A bargain sale would be included in this definition of "sale." However, the deemed sale will not be treated as self-dealing if the grantor placed the mortgage on the property more than 10 years before the transfer.12 The bargain sale rules above would still apply.

Another exception to the self-dealing rules is sometimes called the "first bite" rule. This rule allows an individual to donate even recently mortgaged property to his or her private foundation if that is the initial donation to the foundation. The logic behind this is that an individual is not a disqualified person until he or she becomes a substantial contributor to the foundation.13

Mortgaged Property And Charitable Remainder Trusts

Occasionally, donors want to transfer mortgaged property to charitable remainder trusts (CRTs). Charitable remainder trusts are subject to the same set of self-dealing rules as private foundations14, so all the issues discussed above would arise. There are additional negative consequences to a donation of mortgaged property to a CRT. Unlike a charity, which would pay tax on only its unrelated business income, a CRT that incurs taxable income will lose its tax exemption for that year-for all its income!15 Also, if the donor remains liable on the mortgage, the CRT would be treated as a grantor trust, and therefore not qualified as a CRT.16

Although it may be technically possible to transfer mortgaged property to a charitable remainder trust, assuming that the mortgage is old enough, and the debt is non-recourse, these transactions should be undertaken only with competent legal advice, and after a thorough review of any relevant state laws.

There are a couple of possible solutions to the above problem. Neither of these are magic bullets that will allow the value of the equity in the real estate to be captured as a donation deduction while still avoiding the consequences associated with the debt. They will, however, minimize the tax impact on the equity portion.

  1. Sale of fractional interest. The grantor could sell a fractional interest in the property to the charitable beneficiary (other than a private foundation) of the remainder trust or to some third party, use the proceeds to satisfy the mortgage and pay the grantor's capital gains tax on the sale. Then the grantor could transfer the remaining fractional interest in the property to the trust unencumbered by any mortgage.
     
  2. Release of security interest. The grantor could try to persuade the mortgage holder to release its security interest in a fraction of the property, and the grantor could give that fractional interest to the trust. The grantor could provide additional security to the lender, or could sell the remaining fraction to the charitable remainder beneficiary (assuming that the remainder beneficiary is not a private foundation).


Conclusion

It is possible to make a tax-effective donation of mortgaged property to a charity. However, both the donor and the donee must proceed with caution to avoid any unpleasant tax surprises.

The author wishes to thank Laura Howell-Smith for her assistance with the article.


Footnotes


  1. The deduction for donations to private foundations (other than donations of "qualified appreciated property") is limited to the donor's basis.back

  2. Assuming the donee is a public charity as defined under IRC § 170(b)(1)(A), the donor's deduction will be limited to 30% of the adjusted gross income. Any excess above the 30% can be carried forward, up to five years. The donors will also be subject to the 3% phase-out of the benefit of itemized deductions imposed by IRC § 67.back

  3. See Treas. Reg. § 1.1011-1(a)(3).back

  4. See, generally, Treas. Reg. § 1.1001-2.back

  5. See Rev. Rul. 68-174, 1968-1 CB 81.back

  6. See Treas. Reg. 1.514(b)-1(b)(1)(ii).back

  7. There are additional exceptions to the debt-financed income rules detailed in Treas. Reg. § 1.514; however, they are unlikely to apply to donated property.back

  8. Treas. Reg. § 1.1015-1(a).back

  9. Straight-line only, see IRC § 512(a)(3).back

  10. Treas. Reg. § 1.514(a)-1(a)(1)(v).back

  11. IRC § 4941(d)(1)(A).back

  12. Treas. Reg. § 53.4941(d)-2(a)(2).back

  13. See Treas. Reg. § 53.4941(d)-1(a) for the example, and IRC § 4946(a)(1) for the definition of a disqualified person.back

  14. IRC § 4947(a)(2).back

  15. See IRC § 664(c) and Lelia G. Newhall Trust (97-1 USTC 50,159).back

  16. PLR 9015049, January 16, 1990.back

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Comments

One of the things you need

One of the things you need to consider when you pay your mortgage or sell your home is the closing cost. The average closing cost is about ten times the cost of the average payday loan. I read this here: "Closing costs increasing for mortgages" The average for closing costs has been going up nationwide. New regulations are in place, and with the turmoil of the real estate industry, it could be hard to tell when it has recovered.

Clarifications requested

I found this article lucid and helpful, but on a few points I would appreciate some clarification: 1. In the example, it is stated, "They receive no tax benefit from the 70% of their basis allocated to the donation." I don't understand how they don't. This $280,000 is part of the $700,000 that they may deduct as an itemized contribution, no? If they are getting a deduction for the contributed basis and for the appreciation on it, why isn't that a tax benefit? 2. Later in the example, it is stated, "Of course, they have reduced their net income by $520,000". It seemed to me that the reduction was $420,000 instead. My reasoning was: If they sold the property for its FMV instead of contributing it, they would be required to report a capital gain of $600,000. By contributing it, they report a capital gain of $180,000. The net-income decrease arising from the contribution is $420,000. 3. Footnote 2 says the contribution deduction usable in any year is limited to 30% of the AGI in that year. But my understanding was that the donors may elect to limit the total (multi-year) contribution deduction to the contributed basis ($280,000 in the example) and then deduct up to 50% of their AGI each year. 4. The section on debt-financed income explains how the debt-financed fraction of rental income can be subject to UBIT, but says nothing about UBIT on the gain from the charity's sale of the property. The following section, on basis, does mention this. Other posted articles I have seen contradict one another on this, so it would be useful to leave no doubt by including sale gain along with rental income in the UBIT section, too.

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