Real Estate Depreciation Issues for Charitable Contributions and Charitable Remainder Trusts

Real Estate Depreciation Issues for Charitable Contributions and Charitable Remainder Trusts

Article posted in Income Tax on 4 February 2002| comments
audience: National Publication | last updated: 16 September 2012
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Summary

Most gift planners are aware that the deductible amount of a charitable gift may be reduced when depreciable property is involved; however, there has been little guidance providing planners with a practical summary of the applicable rules. In this edition of Gift Planner's Digest, Minneapolis accountant Tom Wesely clarifies those situations where depreciation can significantly impact the charitable deduction, and also analyzes depreciation issues when property is contributed to a charitable remainder trust.

by Tom Wesely, CPA

Thomas J. Wesely is a partner in the Minneapolis accounting firm of Wesely & Wesely, CPAs. A graduate of the University of St. Thomas (St. Paul 1979), Mr. Wesely worked for 15 years as a tax manager with the regional accounting firm of Virchow Krause (formerly Adrian Helgeson & Co.) with much of his time involved in charitable trusts and the firm's large nonprofit client base. Since starting his own practice in 1994, Tom has become very involved in the planned giving community and has expanded his specialty in that area. Today, approximately one half of his practice is devoted to charitable gift planning, tax preparation and other administrative duties for over 300 CRTs and CLTs for charity, bank and donor trustees.

Mr. Wesely has presented numerous tax and charitable planning seminars to organizations throughout the Minnesota area and has been an instructor in the charitable estate planning course at William Mitchell College of Law. He volunteers as Director of Planned Giving for Westwood Lutheran Church Foundation, is on the planned giving advisory board of Opportunity Partners, and is a director of the Minnesota Planned Giving Council where he has chaired the education committee since 1998. He can be reached at weselycpas@ens.net or (952) 525-9630.


Introduction

Charitable gifts of real estate are generally deductible by individuals based on the property's fair market value (FMV). Most gift planners are aware that the deductible amount may be reduced where depreciable property is involved, depending on how the property was depreciated by the donor. However, there has been little guidance providing planners with a practical summary of the applicable rules. The mechanics of these calculations are often done and seen only by the donor's CPA. This article will clarify the situations when depreciation can significantly impact the charitable deduction, and also analyze depreciation issues after property is contributed to a charitable remainder trust (CRT).

Reduction of Charitable Deduction for Depreciable Real Estate

General

The donor's charitable deduction is reduced by the amount of depreciation which would be recaptured as ordinary income had the donor sold the property. Unlike many tax issues, the reduction rules for depreciable real estate have actually become simpler over the past decade. The following summary is a general guide, which can be used to determine the reduction amount for most gifts of real estate.

Real Estate Placed in Service Before 1981

The charitable deduction will be reduced by the excess of post-1969 accelerated depreciation over straight-line (SL).1 This reduction amount should be little or none by now since the property will have been depreciated for at least 21 years.

Nonresidential Real Estate Placed in Service Between 1981 and 1986

The charitable deduction will be reduced by ALL depreciation taken, NOT just the excess of accelerated over straight-line.2 However, there is no reduction if the SL method was used.3 This is clearly the most troublesome property because the reduction amount will be significant (equal to the original cost of the depreciated property in most cases), and the reduction amount will not diminish over time.

Residential Real Estate Placed in Service Between 1981 and 1986

The charitable deduction will be reduced by the excess of accelerated depreciation over straight-line.4 Based on the chart below, all property placed in service from 1981 to 1983 will be fully depreciated by the end of 1998. Thus, there would be excess accelerated depreciation only for property acquired from 1984 to 1986. The excess depreciation will be relatively small since the property will be nearly fully depreciated.

Real Estate Placed in Service After 1986

There is no reduction since straight-line was the only method allowed.

General Depreciation Rules for Real Estate

To understand the potential for charitable reductions, it is helpful to know the following depreciation rules that have applied over the years for real estate.

Residential Real Estate Depreciation Rules

Residential real estate means any building or structure if 80% or more of the gross rental income from the building or structure for the taxable year is rental income from dwelling units.5

  Regular Tax   Alternative
Minimum Tax
Date Placed in Service Period (in years) Method Recapture Amount Period (in years) Method
Prior to 1-1-81 Estimated useful life SL or a declining balance method Excess over SL Estimated useful life SL
1-1-81 to 3-15-84 15 SL or 175% declining balance Excess over SL 15 SL
3-16-84 to 5-8-85 18 SL or 175% declining balance Excess over SL 18 SL
5-9-85 to 12-31-86 19 SL or 175% declining balance Excess over SL 19 SL
1-1-87 to present 27.5 SL N/A 40 SL


Nonresidential Real Estate Depreciation Rules

Nonresidential real estate means any real estate that is not residential real estate, as defined above, and is not real estate which has a prescribed life of less than 27.5 years.6

  Regular Tax     Alternative
Minimum Tax
Date Placed in Service Period (in years) Method Recapture Amount Period (in years) Method
Prior to 1-1-81 Estimated useful life SL or a declining balance method Excess over SL Estimated useful life SL
1-1-81 to 3-15-84 15 SL or 175% declining balance All depr., unless SL is used 15 SL
3-16-84 to 5-8-85 18 SL or 175% declining balance All depr., unless SL is used 18 SL
5-9-85 to 12-31-86 19 SL or 175% declining balance All depr., unless SL is used 19 SL
1-1-87 to 5-12-93 31.5 SL N/A 40 SL
5-13-93 to present 39 SL N/A 40 SL


Exceptions to the Above Rules

There are some exceptions to the above rules. This analysis is not intended to cover all exceptions. The most common exception is depreciable real estate used for agricultural purposes. It is generally depreciated over shorter periods7, and all accumulated depreciation (not just the excess of accelerated over SL) will reduce the charitable deduction.8

Alternative Minimum Tax Issues (AMT)

Individuals who make charitable gifts of real estate tend to have relatively high income and are often subject to alternative minimum tax. Thus, it is important to know whether AMT depreciation differences may impact the tax savings from a gift of real estate.

Since the SL method has always been required for AMT purposes for real estate, the AMT charitable deduction is never reduced. Thus, if the regular tax deduction is reduced for accelerated depreciation, the AMT charitable deduction will be higher than the regular tax charitable deduction.9

This difference will be a negative adjustment (i.e., an additional deduction) for AMT purposes. It will be subject to the normal limitations based on the percentage of adjusted gross income (AGI). The taxpayer's regular tax AGI is used for this purpose.10 If the taxpayer would not otherwise have any AMT for the year, then the additional AMT deduction is useless unless it creates a carryover due to the AMT percentage limitations.

Examples

Example 1: Real Estate Placed in Service Prior to 1981

Taxpayer acquires a commercial building on July 1, 1980 for $1,100,000 of which $100,000 is allocable to land. For simplicity, assume there have been no capital improvements made. On July 1, 2002, taxpayer donates the property to a Section 501(c)(3) charitable organization. The property was valued on that date at $3,000,000, including $300,000 for the land. At the time of the contribution, the property had the following accumulated depreciation:

Regular tax depreciation (30-year life, 150% declining balance method, switching to SL when appropriate) $760,505
AMT depreciation (30-year life, SL method) 733,333
Excess of regular tax depreciation over AMT depreciation $27,172
The regular tax charitable deduction is reduced as follows:  
FMV of property $3,000,000
Excess of accelerated depreciation over SL depreciation 27,172
Deductible charitable contribution for regular tax $2,972,828


Since the SL method was required to be used for AMT, the AMT charitable deduction is $3,000,000.

If the contribution had been made to a CRT, the charitable deduction would be computed with reference to the deductible contribution amount. For example, if the value of the remainder interest was 40% and the income interest was 60%, the regular tax charitable deduction would be $1,189,131 ($2,972,828 x 40%). The AMT charitable deduction would be $1,200,000 ($3,000,000 x 40%).

Example 2: Nonresidential Real Estate Placed in Service Between 1981 and 1986
 

Same facts as Example 1 except that the building was acquired July 1, 1984. The donor elected to use the 175% declining balance method. At the time of the gift, the property was fully depreciated for both regular tax and AMT purposes.

The regular tax charitable deduction is reduced as follows:  
FMV of property $3,000,000
Accumulated depreciation 1,000,000
Deductible charitable contribution for regular tax $2,000,000


Note that all of the accumulated depreciation is recaptured because the property is commercial real estate acquired between 1981 and 1986, and the donor used accelerated depreciation. Since the SL method was required to be used for AMT, the AMT charitable deduction is $3,000,000.

If the contribution had been made to a CRT, the charitable deduction would be computed with reference to the deductible contribution amount. For example, if the value of the remainder interest was 40% and the income interest was 60%, the regular tax charitable deduction would be $800,000 ($2,000,000 x 40%). The AMT charitable deduction would be $1,200,000 ($3,000,000 x 40%).

Example 3: Residential Real Estate Placed in Service Between 1981 and 1986
 

Same facts as Example 1 except that the building is a residential apartment building acquired July 1, 1986. At the time of the contribution, the property had the following accumulated depreciation (using IRS tables):

Regular tax depreciation (19-year life, 175% declining balance method, switching to SL when appropriate) $873,750
AMT depreciation (19-year, SL method) 844,167
Excess of regular tax depreciation over AMT depreciation $29,583
The regular tax charitable deduction is reduced as follows:  
FMV of property $3,000,000
Excess of accelerated depreciation over SL depreciation 29,583
Deductible charitable contribution for regular tax $2,970,417


Since the SL method was required to be used for AMT, the AMT charitable deduction is $3,000,000.

If the contribution had been made to a CRT, the charitable deduction would be computed with reference to the deductible contribution amount. For example, if the value of the remainder interest was 40% and the income interest was 60%, the regular tax charitable deduction would be $1,188,167 ($2,970,417 x 40%). The AMT charitable deduction would be $1,200,000 ($3,000,000 x 40%).

Rental of Real Estate by a CRT - Depreciation Calculations

CRT Depreciation For Taxable Income Purposes

Many CRT trustees will attempt to sell depreciable real estate as soon as possible, but sometimes this is not practical or desirable. The trustee may alternatively try to rent the property. The trustee will then need to determine the allowable depreciation for purposes of the CRT's taxable income and its four-tier system of accounting.

The CRT receives a carryover basis for the property from the donor.11 It would be logical to conclude that the CRT would "step into the shoes" of the donor and continue depreciating the donor's cost over the remaining depreciable life. The Internal Revenue Code provides this "step into the shoes" logic for depreciation in several situations, but all of them involve transfers to or from corporations or partnerships, and none involve trusts.12 Thus, it appears that property contributed to a CRT is subject to the general rule that it must be depreciated as newly acquired property subject to the current depreciation rules. Generally, this means that the property is depreciated for regular tax using the SL method over 27.5 years for residential real estate, or 39 years for nonresidential real estate.13

An exception is provided for property that was owned or used by the donor or a related person at any time during 1980. This property is excluded from the current MACRS rules14 and is depreciated based on the trustee's determination of the property's estimated remaining useful life, using either the SL method or a declining balance method that was allowable under the pre-1981 depreciation rules. Alternatively, there appears to be no authority that would prevent the continued use of the depreciable life used by the donor for such property.

Example 4: Depreciation of Real Estate Placed in Service Before 1981

Same facts as Example 1 except that the property is contributed to a CRT. Since the property was owned by the donor during 1980, the CRT depreciates the property over its estimated remaining useful life. The trustee estimates the remaining useful life to be 20 years and elects the SL method.

2002 CRT Depreciation for Taxable Income:

 
Regular Tax
AMT
Adjusted (depreciated) basis of property when transferred to CRT $239,495 $266,667
Divided by estimated life xc3xb720 xc3xb720
Pro-rated for short year (July - Dec.) x 6/12 x 6/12
CRT depreciation for 2002 $5,988 $6,667


Example 5: Depreciation of Real Estate Placed in Service After 1980

Same facts as Example 3 except that the property is contributed to a CRT. Since the property was not owned or used by the donor during 1980, it is subject to the current depreciation rules.

2002 CRT Depreciation for Taxable Income:

 
Regular Tax
AMT
Adjusted (depreciated) basis of property when transferred to CRT $126,250 $155,833
Divided by depreciable life xc3xb739 xc3xb740
Pro-rated for short year (July - Dec.) x 5.5/12 x 5.5/12
CRT depreciation for 2002 $1,484 $1,786


Significance of the AMT Depreciation Calculation
 

The IRS has treated the AMT as a separate tax system.15 Accordingly, the CRT presumably has a separate four-tier system of accounting for AMT purposes. If regular tax depreciation differs from AMT depreciation, it is possible that the ordinary income distributed for regular tax purposes will be less than the amount distributed for AMT purposes. Rather than reporting this difference as a tax preference item, it would seem that the CRT's Schedule K-1 arguably would have a separate column for AMT amounts based on the AMT four-tier system.

CRT Depreciation For Trust Accounting Income Purposes

For net income unitrusts and pooled income funds, the required distribution is determined with reference to "trust accounting income." The IRS has officially required pooled income funds to establish a depreciation reserve (i.e., to reduce trust accounting income for depreciation).16 The amount of depreciation is determined using generally accepted accounting principles (GAAP).

The IRS has not issued an official ruling regarding CRTs. However, it has privately ruled several times that a depreciation reserve determined in accordance with GAAP must be established for net income unitrusts.17 Until there is an official ruling from the IRS, it may be prudent for drafters to include such a provision in all net income unitrusts.

Sale of Real Estate by a CRT - Depreciation Recapture

When a CRT sells depreciable real estate, it reports part of the gain as depreciation recapture up to the amount of accumulated depreciation. This includes accumulated depreciation taken by the donor as well as depreciation taken by the CRT.18 The CRT reports the depreciation recapture either as ordinary income or as 25% capital gains.

Ordinary Income Recapture

As previously mentioned, the donor's charitable deduction is reduced by the amount of depreciation, which would be recaptured as ordinary income had the donor sold the property. Although there is no guidance directly on point, a strict reading of the applicable statutes and regulations would conclude that this same depreciation recapture (which reduced the charitable deduction) is reported as ordinary income by the CRT when it sells the property.19 Thus, the donor may be required to report significant amounts of trust distributions as ordinary income, even though the donor's charitable deduction has already been reduced for this same depreciation. Remember that logic and the tax code are not always the best of friends.

25% Capital Gains Recapture

Any accumulated depreciation on real estate that is not recaptured as ordinary income is recaptured as Section 1231 gain subject to a maximum Federal tax rate of 25%.20 If the trust has no Section 1231 losses, this gain is reportable as 25% capital gain, also known as "unrecaptured section 1250 gain." It is included in Tier 2 for capital gains. Consistent with the WIFO (worst-in, first-out) feature of the four-tier system, it is distributed after short-term capital gains but before 20% long-term capital gains.21

Conclusion

The issue of depreciation probably ranks as one of the least exciting subjects in the field of planned giving. Fortunately, the potential for reduction of charitable deductions has been eliminated or is minimal for most depreciable real estate owned by potential donors. However, gift planners need to be particularly aware of nonresidential real estate acquired between 1981 and 1986 since the reduction amount, and the impact on the taxation of CRT distributions, can be substantial for that property.

Footnotes


© 2002 Thomas J. Wesely


Readers' Comments:

The following comments were received from:

Byrle M. Abbin, J.D.
Retired partner and consultant to Andersen
Washington, D.C

"I enjoyed Tom Wesely's article you sent out today, but feel the need to provide a different perspective on how depreciation affects charitable remainder trusts. I realize that much of what we deal with is not black and white but shades of gray, often tempered by our own experiences as well as subjectivities and aggressive or conservative approach to practice advice.

In the paragraph headed, "CRT Depreciation for Trust Accounting Purposes", he addresses the need for a depreciation reserve to be provided using GAAP. In two of the citations, PLRs 8931019 and 8931020 in footnote 17, IRS had no choice but to rule that depreciation must reduce trust accounting income as otherwise determined, since establishing a depreciation reserve was a requirement of the governing instrument that established the NIMCRUT. Based on the 1997 Revised Uniform Principal and Income Act, reflection of depreciation in determining fiduciary accounting income (FAI) is discretionary, subject only to trustee's duty of impartiality (UPIA Section 503, cross referencing to Section 103(b) re duty of impartiality that in turn refers to Section 104 regarding the trustee's power to adjust to accomplish that duty). In the commentary to Section 503 it is clear that the prior, 1962 UPIA version, reference to GAAP depreciation as a required charge in determining FAI no longer is applicable; most states have or are in the process of adopting the 1997 Revised UPIA. Thus one might even challenge Rev. Rul. 90-103 re a depreciation reserve being required for pooled income funds. Mr. Wesely's two other cites in footnote 17, PLRs 9030041-042, involve pooled income funds and are consistent with Rev. Rul. 90-103 but are not applicable to NIMCRUTS.

When the 1997 Revised UPIA is considered, along with the 1989 PLRs cited above where the governing instrument required a depreciation charge to be reflected in determining fiduciary accounting income, I conclude Mr. Wesely is too conservative in his conclusion that NIMCRUT governing instruments must require depreciation reserves. From an economic point of view, it is difficult to justify transferring depreciable assets into a NIMCRUT if depreciation is required, since that can significantly reduce, and in many cases "wipe out" all fiduciary accounting income, especially in the initial years, so upon subsequent sale or other disposition gain represented by depreciation recapture and growth in value will not be distributable as a "makeup" distribution. Reflection of a depreciation charge will usually minimize the amount of suspended distribution subject to "makeup" in the future when fiduciary accounting income exceeds the fixed percentage payout. Stated differently, if Mr. Wesely is correct, when a donor desires to transfer real estate into a CRT, (ignoring problems caused by debt related to the property), he/she/they should use a charitable remainder annuity trust (a CRAT), or a charitable remainder unitrust (CRUT) with a standard payout format so depreciation by definition is not reflected in determining the non-charitable distribution, since the payout is based either on a percentage of initial or annual value. Thus depreciation would not reduce their annual distribution significantly (or even to zero) as it would under Mr. Wesely's interpretation.

For full disclosure I have disagreed with Conrad Teitell's similar conclusion for the need of a depreciation charge, that he states in Deferred Giving par. 107(h)(1991), in my book, Income Taxation of Fiduciaries and Beneficiaries par. 903.4.4 (Aspen Publishers 2001, 6th ed)."

Response from Mr. Wesely:

Mr. Abbin makes an excellent observation regarding the impact of the new UPIA. I agree with him that it may now be questionable as to whether a depreciation reserve is required in a NIMCRUT that is governed by a state which has adopted the depreciation provisions of the 1997 UPIA. I might add that the whole issue of state trust law is an area outside the scope of tax law. In our firm we regularly consult legal counsel when there is some doubt about the impact of state trust law on fiduciary accounting income.

However, I do take exception to two of Mr. Abbin's comments. First he states that "from an economic point of view, it is difficult to justify transferring depreciable assets into a NIMCRUT if depreciation is required, since that can significantly reduce, and in many cases "wipe out" all fiduciary accounting income, especially in the initial years." Mr. Abbin seems to imply that the NIMCRUT will hold the property for many years. While that may happen, my experience indicates that the trustee will want to sell the property as soon as possible, and usually does within a year or two.

Mr. Abbin remarks that "reflection of a depreciation charge will usually minimize the amount of suspended distribution subject to makeup." I believe the depreciation charge can only increase the suspended distribution subject to makeup. Since it decreases trust accounting income, it increases the income shortfalls in the early years, which increases the potential makeup distribution. The trust agreement could include a provision that defines capital gains to be income. If the property increases in value and is sold, there will likely be a distribution of the depreciation recapture as well as some or all of the growth in value. If the property decreases in value, then the depreciation reserve will have been justified.

As always, a little timely guidance from our friends at the IRS sure would be nice.


  1. IRC Section 1250(a)back

  2. See IRC Section 1245(a)(5) as in effect prior to its repeal by Section 201(d)(11)(D) of the 1986 Tax Reform Act. Even though this provision has been repealed for property placed in service after 1986, it still applies for property placed in service from 1981 to 1986.back

  3. See IRC Section 1245(a)(5)(C) as in effect prior to its repeal by Section 201(d)(11)(D) of the 1986 Tax Reform Act.back

  4. IRC Section 1250(a)(1)back

  5. IRC Section 168(e)(2)(A)back

  6. IRC Section 168(e)(2)(B)back

  7. IRC Section 168(e)(3)(D) provides that single purpose agricultural structures are depreciated over 10 years.back

  8. IRC Section 1245(a)(3)(D)back

  9. The IRS has indicated that it believes Congress intended the AMT to be a separate tax system. See the preamble to the final ACE regulations (T.D. 8340, 1991-1 C.B. 4).back

  10. Treas. reg. section 1.55-1(b) and IRS Notice 94-28, 1994-1 C.B. 344back

  11. IRC Section 1015(a)back

  12. IRC Section 168(i)(7)back

  13. IRC Section 168(c)back

  14. IRC Section 168(f)(5)(A)(i)back

  15. See the preamble to the final ACE regulations (T.D. 8340, 1991-1 C.B. 4).back

  16. See Rev. Rul. 90-103, 1990-2 C.B. 159back

  17. See Ltr. Ruls. 8931019, 8931020, 9030041 and 9030042.back

  18. See IRC sections 1245(b)(1) and 1250(d)(3), Treas. reg. sections 1.1245-2(c)(2), 1.1245-4(a) and 1.1250-3(a), and Ltr. Ruls. 9035046 and 9037020.back

  19. Id.back

  20. IRC Section 1(h)(1)(D)back

  21. IRS Notice 98-20, 1998-13 C.B. 25back

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