What to Do With the Empty Nest?

What to Do With the Empty Nest?

Planned Giving for the Affluent Homeowner
Article posted in Real Property on 9 April 2009| comments
audience: National Publication | last updated: 16 September 2012
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Summary

What happens after the kids have flown the coop and Mom and Dad are left with a large home and an even larger potential capital gains tax on sale? In this article, PGDC Editor-in-Chief Marc D. Hoffman reviews the capital gains tax rules that accompany sales of principal residences and how charitable planning techniques can be blended seamlessly to create a win-win result for the charitably inclined. The original version of this article appeared in the October/November 2002 issue of the Journal of Practical Estate Planning and was presented by the author at the 2002 National Conference on Planned Giving.

by Marc D. Hoffman

Introduction

For the majority of American homeowners, the Tax Reform Act of 1997 was a welcome gift, providing a complete restructuring and liberalization of the capital gains tax rules for sales of principal residences. The Act made two substantive changes: The first was a repeal of the tax deferred exchange provisions of IRC §1034. The second consisted of a complete rewrite of the capital gains exclusion provisions for principal residences under IRC §121.1

For people who own expensive homes, the new rules may not be so welcome. Depending on the sales price and seller's basis, avoiding the recognition of capital gain will require some creative planning.

This article reviews the rules applicable to sales and exchanges of principal residences and the role that charitable gift planning strategies can play in helping homeowners accomplish their personal financial, estate and philanthropic planning objectives. Unless otherwise stated, all section references are to the Internal Revenue Code of 1986, as amended.

Old Rules

Under former section 1034, property owners could sell their principal residence and, subject to limitations, roll their basis over into a replacement property. As long as the replacement property was of equal or greater value, the property owner could avoid realizing any capital gain from the transaction. If gain was realized, former section 121 provided a one-time capital gain exclusion of $125,000 for property owners ($250,000 for married) over age 55.

Current Rules

The new rules under TRA '97 are effective for sales and exchanges occurring after May 6, 1997. First, section 1034 is repealed; thus, deferring gain on a principal residence via an exchange is no longer available.

In addition, section 121 is amended to provide that, in general, if a seller (of any age) has owned the property (or stock in a cooperative housing corporation) and used it as a principal residence for at least two of the five years preceding the date of sale or exchange, the seller can exclude up to $250,000 of gain from his or her gross income.

Married couples can exclude $500,000 of gain if:

  • either meets the two-year holding period rule; and
  • both occupied the property as their principal residence for at least two years of the five years immediately preceding the sale (at the same or different times).

Unmarried joint owners can exclude up to $250,000 attributable to each owner's interest.

Special Rules for Divorced and Widowed. Homeowners who receive the marital home in a divorce may include the period of time their former spouse owned the home when determining whether they meet the ownership requirements. Similarly, widowed homeowners may include the period of time their deceased spouse owned the residence when determining how long they have owned the residence.2

Exception to Use Requirement. An exception to the use requirement applies to those who can no longer provide self-care and reside in a nursing home. In such case, the use requirement is considered met if the homeowner has owned and used the residence as his principal residence for an aggregate of at least one (rather than two) of the five years immediately preceding the sale or exchange.3

Involuntary Conversions. Property subject to involuntary conversion is considered sold at the time of destruction, theft, seizure, requisition, or condemnation.4

Partial Exclusion. Homeowners may be able to use a portion of the exclusion if they do not meet the ownership and residency tests, but experience a change in employment, have health conditions, or are subject to unforeseen circumstances.5 In response to numerous comments to the proposed regulations' definition of unforeseen circumstances, temporary regulations were issued that expand that definition.

Business Use and Depreciation. Under the final regulations, the section 121 exclusion may or may not be available to offset gain arising from the nonresidential (i.e., business) use of residential property. If the residential and nonresidential portions are located within the same dwelling unit, no allocation of gain is required. If the nonresidential portion is not within the same dwelling unit, it is considered an IRC section 1231 asset and is not eligible for gain exclusion. Section 1231 gain is taxed at a maximum rate of 20%.

In addition, the section 121 exclusion is not available to offset gain arising from depreciation claimed after May 6, 1997 in connection with the nonresidential use of a principal residence.6 Such gain is upon sale considered un-recaptured IRC section 1250 gain, taxed at a maximum rate of 25%.

Sales of Partial Interests. The final regulations also clarify the rules regarding sales of a partial interest. Hopeful commentators suggested that taxpayers who sell a partial interest (other than a sale of remainder interest, discussed later) in their home and then at least two years later sell another or the remaining interest should be able to use the full $250,000 exclusion for each sale. The final regulations restrict the use of the exclusion to $250,000 for combined sales or exchanges regardless of the amount of time between them.7 However, this also confirms that the entire exclusion amount can be used to offset gain from a partial sale without prorating, which is critical to the following discussions of split sales and charitable gifts.

Planning Options

As a result of these changes, many people who assumed, perhaps for decades that they could always rely on the tax deferred exchange provisions of former section 1034 to defer their gain are now faced with the reality that selling their residence may be a significant taxable event regardless of how they use the sales proceeds.

Are options available to those who might be subject to a large taxable gain? One option would be to convert the property to business use as a rental and then exchange it under section 1031, thereby deferring gain to the extent of the purchase price of the replacement property.

Certainly some people might just decide to stay put with the hope their property will receive a stepped-up cost basis when it is ultimately passed through their estates to their heirs. However, those who are banking on the stepped-up basis provision being around when their heirs will need it might be in for a disappointment.

Sales by Estates and Heirs

Although the Economic Growth and Tax Relief Reconciliation Act of 2001 is being applauded by those who would be subject to the estate tax, the new rules also ultimately eliminate the current stepped-up basis provisions for those dying after 2009. The repeal of the estate tax and carryover basis provisions of the Act are scheduled to sunset after December 31, 2010, returning to the rules that were in place prior to the Act. Fortunately, section 542(c) of the Act amends subsection (d) of section 121 to extend the capital gains exclusion to property sold by the estate of a decedent; any individual who acquired such property from the decedent (within the meaning of section 1022); and a trust which, immediately before the death of the decedent, was a qualified revocable trust (as defined in section 645(b)(1)) established by the decedent, determined by taking into account the ownership and use by the decedent.8 Accordingly, heirs receiving the principal residence of a decedent dying during 2010 with a carryover basis will be able to take advantage of the exclusion.

Planning for Lifetime Sales

Are there other ports in this tax storm? Yes, and as you might suspect, they are carefully planned charitable gifts. The first idea is intended for those who desire to sell a residence with built-in gain that will significantly exceed their exclusion amount. This concept is simple; only the math is somewhat challenging.

Split Charitable Gift/Sale

Concept: Under the split gift /sale technique, the property owner contributes an undivided fractional interest in the property either outright to a charitable organization or via a deferred gift vehicle such as a charitable gift annuity, charitable remainder trust, or pooled income fund. The property owner and charity (or deferred gift vehicle) then sell their respective interests to a third party.

Basis is allocated to each and gain calculated according to each owner's interest. The property owner will generally only incur gain attributable to sale of the retained portion. Gain attributable to amounts transferred to charity are either eliminated or deferred.

The Section 121 exclusion amount and income tax charitable deduction produced by the contribution are used to mitigate or eliminate the owner's income tax liability attributable to the sale of the retained portion.

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Capital Gains Tax Consequences to Donors. The property owner will generally avoid gain on the portion transferred to charity by outright gift. An exception occurs when the property is subject to indebtedness. In such case, the transfer will be considered a bargain sale with the amount of indebtedness considered realized by the donor for income tax purposes. The adjusted basis for determining gain is that portion of the adjusted basis that bears the same ratio to the adjusted basis as the amount realized bears to the fair market value of the property.9

If the property is free-and-clear, only the gain attributable to the retained portion is realized by the property owner when the property is sold; however, the entire section 121 exclusion amount can be used by the property owner to offset any gain they realize individually.10

If a portion of the property is transferred via a deferred gift vehicle, the rules pertaining to the capital gains treatment for transfers of appreciated property to that specific type of vehicle will apply. For example, in the case of transfers of debt-free property to a charitable remainder trust, the trustor will generally avoid realization of gain upon transfer. Only the unitrust or annuity payments will be taxable according to the four-tier system as they are received. Similar rules apply to pooled income funds. In the case of a transfer in exchange for a charitable gift annuity, although the transfer is considered a bargain sale with the donor realizing gain attributable to the present value of the annuity, the donor may qualify to report gain ratably over his or her lifetime as annuity payments are received.11

Finding the Right Blend. Ideally, the property owner would retain that portion of the property that, when sold, would produce the maximum amount of gain that qualifies for capital gains exclusion. What makes the math challenging is that when calculating the portion to give and sell, planners must consider the effect the income tax charitable deduction from the contributed portion will have on calculating gain on the retained portion; and likewise, the effect that a varying adjusted gross income will have on the property owner's capacity to claim the charitable contribution in the year of sale. The process is as one tax court judge aptly put it, "as difficult as trying to capture a drop of mercury under your thumb."12 Fortunately, today's spreadsheets make quick work of such problems.

Other items to consider include sales expenses (which increase the seller's basis) and valuation discounts that may apply to a charitable gift of other than the donor's entire interest in the property. In addition, if there is any depreciation recapture (such as would be occasioned by the property being used as a home office or rental), although it will reduce the value of the deduction for the contributed portion, the charitable deduction can be used to offset depreciation recaptured on the portion of the property sold on a taxable basis. As noted earlier, the section 121 exclusion amount cannot be used to offset gain attributable to depreciation claimed after May 6, 1997.

Case Study 1: The Charitable Buy-Down

Bob and Betty Smith are in their mid-seventies and enjoying their retirement years. Shortly after WWII, they purchased their first home with an $8,000 VA Loan. Fifty-six years, a successful career, and six homes later, they own a five-acre lakefront estate valued at $1,500,000. Over the years, as they sold one residence and purchased another of equal or greater value, they took advantage of the section 1034 exchange provisions to defer their gain. Qualifying capital improvements made to their homes totaled $242,000. Accordingly, their adjusted cost basis in their current residence is $250,000.

Now that the Smiths are up in years, they would like to move to something smaller with one story and less maintenance. Their property is very popular and they frequently receive unsolicited inquiries from potential buyers and agents. They have located a smaller single story home on less acreage across the lake for $600,000.

Establishing a Baseline. A good starting point for the analysis is to calculate the Smiths' current income tax liability and then project the additional tax they will incur if they simply sell their home with no other planning. Although using only a spreadsheet with an estimated marginal tax bracket can be helpful in getting into the right numerical neighborhood, it is critical to confirm results by running fully integrated trial income tax computations using the best data available and with the assistance of donors' income tax advisors. Simply using marginal income tax brackets to isolate the transaction from the balance of the donors' total tax picture can lead to serious errors, donor remorse, or worse.

The following numbers were run using a consumer tax preparation software package (TurboTax®). To keep things simple, we will assume the Smiths live in a state with no income tax. To further simplify the computations, we will assume their only source of income is $100,000 of taxable interest and dividends. The Smiths' only potential itemized deduction is $2,000 for property taxes; however, in this initial computation, because the standard deduction of $9,650 exceeds this amount, they will not need to itemize. The tax year is 2002. Based on these assumptions, the Smiths will pay $17,131 in federal tax. Click here to review the Smiths' federal income tax return excluding the sale. (Note: Tax returns are provided in Adobe .pdf format. To download a free copy of Adobe Acrobat Reader, go to http://www.adobe.com/products/acrobat/readstep2.html. Click here to review the Smiths' federal income tax return including the sale.

Outright Sale of Residence

  Sales Price $1,500,000
Less: Basis Allocated to Sale Amount $250,000
Less: Sales Expenses Allocated to Sale Amount $90,000
Less: IRC §121 Exclusion $500,000
Equals: Net Schedule D Capital Gain from Sale $660,000
Plus: Other Income $100,000
Equals: Adjusted Gross Income $760,000
Less: Standard Deduction $9,650
Equals: Taxable Income $750,350
     
  Tax on Income Other Than Long-Term Capital Gains 18,197
Plus: Long-Term Capital Gains Tax (due to sale) $132,000
Plus: Alternative Minimum Tax (due to sale)* $7,803
Equals: Total Tax $158,000
     
  Net Proceeds (sales price - expenses - tax allocated to sale) $1,270,197


* Note: The sale triggered an additional alternative minimum tax of $7,803. With Alternative Minimum Taxable Income of $760,000, the Smiths' AMT exemption was reduced to $0. See Form 6251

Split Sale / Charitable Gift Annuity. Now that we have a baseline from which to compare planning options, we can explore how a planned gift can provide the Smiths with a more favorable result.

Suppose as an alternative to an outright sale, the Smiths first transfer a 50% undivided fractional interest in their property to a charitable organization in exchange for a charitable gift annuity.13 They will then join with the charity in selling their respective interests to a third party buyer.

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Based on their ages, the charitable organization offered the Smiths a 6.5% joint and survivor annuity in exchange for the fractional interest in their property.

By contributing a portion of the property to charity prior to sale, the Smiths will realize only the gain attributable to the retained portion in the year of sale. The gain attributable to the portion of the transfer used to purchase the annuity can be reported ratably as annuity payments are received.14

Valuation Discount. For purposes of determining the annuity amount, the charitable organization that issues the annuity is not required to use the fair market value of the property as determined by appraisal. It can offer less (and is well advised to do so) to compensate it for the expenses it will incur to convert the property into cash. The value is negotiated with the donor. In this case, the issuing organization will take the property at a 10% discount to the appraised full fair market value. Accordingly, the annuity payments will be based on $675,000 ($750,000 - $75,000). As an alternative (as permitted by state law), the charity can take the property in at a non-discounted fair market value and reduce the annuity rate to accomplish the same result.

Based on a value of $675,000 (and a 6.5% annuity rate), the Smiths will receive $43,875 per year for as long as either of them survives.

It should also be noted that for purposes of determining the Smiths' income tax charitable deduction, it is the fair market value (as determined by an independent qualified appraiser) that establishes value. An appraiser may apply a larger or smaller discount; or no discount at all. For our numbers, we assume the same 10% discount.

Based on a value of $675,000, the transfer will produce an income tax charitable deduction of $208,802. The deduction will be subject to the 30% limitation. Click here to review the computation of the annuity amount and accompanying deduction.

Income Tax Analysis. It is important to note the relationship between the capital gains exclusion and the charitable deduction. The exclusion is included within the computation of Capital Gains and Losses on Form 1040 - Schedule D. This is commonly referred to as an "above the line" deduction because it is taken into account in determining adjusted gross income and prior to itemized deductions which fall "below the line." This is relevant because the taxpayer's ability to utilize the charitable deduction, which is an itemized deduction on Schedule A, is limited to 30% of AGI in the year of the gift. In this case, the use of the section 121 exclusion reduces the Smiths' AGI and, therefore, their ability to absorb the charitable deduction.

There is a silver lining because, even though the Smiths' ability to use the charitable deduction is reduced, the 3% itemized deduction reduction amount is favorably affected. Under IRC 68, some itemized deductions are subject to phase-out rules. In general, when a married couple's adjusted gross income exceeds $137,300, their itemized deduction (excluding those for medical and investment interest expenses; casualty, theft and gambling losses) are reduced by the lesser of 80% or by 3% of excess AGI. Following application of the section 121 exclusion, the Smiths' AGI was $180,000. Accordingly, their itemized deductions will be reduced by $1,281.15

Click here to review the federal income tax return.

Split Gift/Sale

  Sales Price $1,500,000
Less: Gift Amount $750,000
Equals: Outright Sale Amount $750,000
Less: Basis Allocated to Outright Sale Amount $125,000
Less: Sales Expenses Allocated to Outright Sale Amount $45,000
Less: IRC §121 Exclusion $500,000
Equals: Net Schedule D Capital Gain $80,000
Plus: Other Income $100,000
Equals: Adjusted Gross Income $180,000
     
Less: Maximum Allowed 30% Limit Charitable Deduction $54,000
Less: Other Itemized Deductions (property taxes) $2,000
Less: Personal Exemptions $6,000
Less: Standard Deduction N/A
Plus: Sec. 68 Itemized Deduction Reduction $1,281
Equals: Taxable Income $119,281
     
  Income Tax $20,401
  Excess Charitable Contribution Income Deduction Carryover $154,802
  Net Proceeds (sales price - expenses - tax allocated to sale) $701,730


Comparison to Taxable Sale. Based on this fact pattern, the Smiths' total income tax liability is reduced from $158,000 to $20,401 - a savings of $137,599.

In addition, they will have $154,802 of excess charitable contribution deduction they can carry forward up to an additional five tax years. Based on the increased cash flow from the gift annuity, the Smiths should be able to use nearly all of the excess deduction during that time. If their overall effective tax rate is 25%, the additional deductions could reduce their taxes by an additional $38,700 over that period. The combined income tax savings over six years when compared to the taxable sale are estimated at $176,300 ($158,000 - $20,401 + $38,700).

Timing is everything, however. In order for the Smiths to enjoy these tax benefits, they have to make sure the property is sold in the same year it is contributed; otherwise, their income will be lower and they will not be able to use as much their charitable contribution deduction. Therefore, it might be wise to embark on such a program early enough in the tax year to allow adequate time to complete the sales transaction.

Alternative Vehicles

The previous case study was based on a couple in their mid-seventies and the use of a charitable gift annuity. What if the couple is younger than the Smiths and desires a higher income amount than offered by a charitable gift annuity? What if they live in a state that does not allow transfers of real property in exchange for a charitable gift annuity or desire to support an organization that does not issue gift annuities or whose policies prohibit the acceptance of real property in exchange for a gift annuity?

Charitable Remainder Trust. One alternative might be a charitable remainder trust-specifically a unitrust. By using a unitrust, younger property owners can select a higher payout rate than offered by a gift annuity and still have the trust meet the 10% minimum remainder interest test. On the downside, however, there are two restrictions that apply to charitable remainder trusts that do not apply to gift annuities:

Indebtedness. First, although the previous case study dealt with free-and-clear property, it is possible to transfer debt-encumbered property in exchange for a gift annuity; whereas that option is, in the opinion of most practitioners, ill-advised for a charitable remainder trust.16

Self-Dealing. Charitable remainder trusts are subject to the private foundation excise tax rules that prohibit acts of self-dealing under section 4941. Such acts include the use of contributed property by disqualified persons.17 Therefore, all disqualified persons would have to vacate the premises prior to contributing any portion of the property to the trust. In the case of a contribution in exchange for a gift annuity, the self-dealing rules do not apply; therefore, at most, the donors would be responsible for paying the charity fair market value rent for the fractional portion of the property they contributed until they ultimately vacated the property to avoid the issue of private inurement.

Yet another issue of self-dealing arises as a function of co-ownership of property by a charitable remainder trust and a disqualified person. Ltr. Rul. 9114025 suggests a transfer of an undivided fractional interest in property to a charitable remainder trust with an interest retained by a disqualified person may constitute a prohibited act of self-dealing. The ruling stated, "Section 101(1)(2)(E) of the Tax Reform Act of 1969, Pub. L. No. 91-172, 83 Stat. 533 (1969), provides that section 4941 shall not apply to [the] use of property in which a private foundation and a disqualified person have a joint or common interest if the Interests [sic] of both were acquired before October 9, 1969. This provision contains a limited exception to application of 4941, and indicates that a disqualified person's use of jointly-owned property after October 9, 1969, will be self-dealing."

Whether a common ownership interest constitutes a use of property is subject to debate. The example cited in Reg. §53.4941(d)-4(e)(2) illustrates the physical use of property, which may be distinguishable from mere ownership. The taxpayers in the above referenced ruling avoided the problem by establishing a partnership and thereafter transferring portions of their partnership interests to the trust.

Partial Interest Rule. A second issue related to co-ownership involves the partial interest rule. Under section 170, a contribution of other than the donor's entire interest in property is not deductible for income, gift and estate tax purposes unless the transfer consists of an undivided fractional interest in the property or a transfer via a qualified trust, including a charitable remainder trust. Can an individual transfer an undivided fractional interest in property to a CRT and still qualify under the rule or must it be the donor's entire interest in the property?18 The solution to this issue may be to have the future charitable remainderman purchase the portion of the interest the homeowners would have otherwise retained and sold outside the trust. The homeowners would then transfer their entire remaining interest to the charitable remainder trust. Notwithstanding the possible implications of the step transaction rules, the subsequent transfer by the homeowners to the trust should satisfy the partial interest rule.

Planning for Murphy's Law. These are not insurmountable obstacles unless the property goes unsold for an extended period of time. Applying Murphy's Law that "if something can go wrong, it will" to this scenario, one should expect the highly qualified buyer who was dying to get his hands on the property to do just that the day after the gift is funded. If a suitable buyer cannot be found, is the charitable remainderman prepared to step in and purchase the balance of the property from the donor and possibly the trust to facilitate the plan?

With respect to the choice of payout format, it is a generally accepted principle among experienced gift planners that non-income producing real property should not be transferred to a charitable remainder annuity trust. The reason is that real property is frequently subject to additional and unforeseen cash needs. Additional contributions can be made to a unitrust whereas such contributions cannot be made to an annuity trust. Likewise, if any form of charitable remainder trust borrows funds, the unrelated business taxable income rules may be implicated causing the entire gain on sale to be subject to the 100 percent excise tax. To make matters worse, the section 121 exclusion would not be available to the trust!

Most planners will consider the flip unitrust variant with the sale of the property as the triggering event. This would protect the trustee from a lack of liquidity until the property is sold. If, however, the donor has additional cash, a standard trust can be used with the understanding the donor may have to make additional contributions to the trust that will then be repaid in satisfaction of the annual unitrust payout amount - the so-called "revolving door technique." The advantage over the flip unitrust is that the income recipients would not have to wait until the year following the triggering event to have the trust assume standard payout format. This would enable the trustee/investment advisor to invest the proceeds for total return immediately without concern for trust's definition of fiduciary accounting income and the need to produce it.

Bargain Installment Sale. An alternative to the charitable gift annuity or charitable remainder trust is known as a "bargain installment sale." Like the other two techniques, the property owner retains an interest in the property which he or she desires to sell outright. The remaining portion is sold to a charitable organization at a discount in exchange for a promissory note.

The technique is very similar to using a gift annuity with three important exceptions:

  1. The property owners can outlive income payments.
  2. The transaction triggers the installment sale rules under IRC §453, which in turn affects the calculation of gain in the year of sale. Computation of gain is performed on Form 6252.
  3. The issuance of a promissory note by the purchasing charity will cause it to have acquisition indebtedness and thereby subject it to the unrelated debt-financed income rules under IRC §514. Any income received by the charity from the property or gain from a subsequent sale will be subject to unrelated business income tax under IRC §511.

Although this plan might work out well for the Smiths, the charity might not fair as well. As previously mentioned, the charity will create acquisition indebtedness upon issuing the note. If it subsequently sells the property with the note in place (or within 12 months of retiring the note), it will be subject to tax on a portion of the gain. The amount of gain that is subject to tax is limited to the gain attributable to the indebtedness.19 If, for example, 75% of the property is subject to indebtedness, then 75% of the gain will be taxable to the charity.

The key question is what is the charity's basis for the purpose of calculating capital gain? The practitioners surveyed for this article all agreed its basis consists of the sum paid for the property plus the donor's prorated basis in the gift component. Thus, even if there is no change in the value of the property from the time of receipt and sale, the charity may still incur a taxable gain on the gift portion. Accordingly, the charity that has the financial resources to pay cash or issue a gift annuity may be best advised to do so and thereby avoid these problems. Organizations issuing charitable gift annuities are conditionally exempt from the acquisition indebtedness rules.20

Purchasing a Replacement Property

The Smiths used the cash proceeds from the transaction to fund the purchase of their new home. However, if the amounts involved are significantly larger, it may be prudent to place a larger amount in the charitable vehicle (thereby sheltering a larger portion of the gain) and finance the acquisition of the new residence.

Some lending institutions will hypothecate income payments from a charitable remainder trust as security for a loan. If the trust is measured by the life of the borrower, the lending institution will most likely require the borrower to carry mortgage completion life insurance to protect against the loss of income payments that would occur when the remainder interest was transferred to charity. If this strategy is employed, very conservative payout rate, asset allocation, and debt service requirements should be used to provide adequate income margins in the event of a market downturn, such as has recently occurred. In other words, "Don't bet the farm on your unitrust."

Planning to Stay Put

Many people have no intention of moving but would prefer to maintain their homestead for their children. The interesting thing is that when you talk to the children, many of whom no longer live in the same community, although they are interested in inheriting the value of the property, they are not too excited about inheriting the property itself. And if there are several siblings, will they each want to receive a fractional interest? Probably not, unless the property is a vacation retreat; but in most cases, parents' residences that are transferred to heirs are sold in the normal course of settling the estate.

If the children don't want the residence, it may be an ideal asset for a charitable bequest or a charitable gift of a remainder interest with a retained life estate. As a third option, if the parents desire income, a charitable organization might offer to purchase a portion of the remainder interest in their personal residence or farm in exchange for a note payable for a fixed term or for life annuity payments-also known as a life estate/bargain sale.21 This would provide a supplemental source of income that could be consumed or used to purchase life insurance to provide estate liquidity and/or replace the value of the property for the heirs.

Case Study: Getting Paid to Live in Your House

Meet Dr. and Mrs. Johnson. They are both in their seventies and enjoying their retirement years. One of the Johnsons' largest assets is their home. Valued at $750,000, it has been debt-free for many years.

Planning Goals. The Johnsons would like to explore ways they can convert some of their equity into an income stream. They are aware they can leverage their equity by use of a "reverse mortgage" from a commercial lender, but at this point in their lives, they are not interested in going into debt and leaving a large balloon payment for their heirs.

They have discussed their estate planning arrangements with their four children and, in particular, what will happen to their home after they are both gone. The children are financially secure and no longer live in the area. After some discussion, they found that none of the children are interested in living in the property. Furthermore, giving the home to one child might complicate the balance of the Johnsons' estate distribution plan and could create problems of parity.

The Johnsons have always been very community minded, giving generously and volunteering their time to several local charitable organizations. They have decided that after they are both gone, they would like to include charity in their estate planning.

Planning Strategy. After they shared their desires with one of their professional advisors, the advisor introduced the Johnsons to a creative planning strategy -- one that will enable them to access the equity in their home without having to go into debt, increase their cash flow, reduce their income taxes, and make a substantial deferred charitable gift.

The plan involves the combination of two well-known charitable giving techniques: 1) a life estate agreement, and 2) a charitable gift annuity. Their advisor then described each of the techniques and how they could be used in combination:

Life Estate Agreement. A life estate agreement is generally described as an arrangement whereby a property owner transfers title to his or her personal residence to a charitable organization while retaining the right to occupy and otherwise enjoy all of the beneficial rights of ownership for life. When the life tenant dies, the charitable organization takes possession of the property.

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By making a present commitment to a future charitable gift, the donor receives a current income tax deduction for the actuarial present value of the remainder interest. The deduction is calculated from Treasury tables that consider the number of life tenants, their ages, the appraised fair market value of the property, assumptions regarding depreciation, and current interest rates.

For example, if Dr. and Mrs. Johnson transferred their $750,000 residence to charity while retaining a life estate, they would receive a current charitable income tax deduction in the amount of $208,421.22 Although they would receive a significant income tax deduction, the arrangement would not provide them with a continuing source of income.

As an alternative to the Johnsons giving the entire remainder interest in their property to charity and claiming a charitable income tax deduction for the entire $208,421 amount, their advisor then described the second component of the plan -- one that would enable them to claim a smaller deduction, but also to receive a substantial and tax-favored life income -- the charitable gift annuity.

Charitable Gift Annuity. A charitable gift annuity is an arrangement whereby an individual transfers cash or property to a charitable organization in exchange for the organization's promise to make fixed annuity payments for their lifetime. The amount paid by the organization is based on an annuity rate schedule that is intended to enable the organization to make the annuity payments comfortably and provide a charitable gift upon conclusion of the annuitant's actuarial life expectancy.

If the Johnsons transfer the remainder interest from the life estate to charity in exchange for a charitable gift annuity, they will receive fixed annual annuity payments in the amount of $14,798 for both their lives. Assuming that either Dr. or Mrs. Johnson live for 20.6 years (their combined actuarial life expectancies), they will receive total payments of $304,839.

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Taxation of Annuity Payments. One of the major benefits of a charitable gift annuity is that a significant portion of the annuity payments may be considered a tax-free return of principal. In this case, of each $14,798 annual payment, $6,846 will be considered tax-free! The remaining amount will be taxable as ordinary income. The tax-exempt portion of the annuity payments will be available for 20.6 years, after which the annuity payments will be taxable as ordinary income.

Capital Gains Considerations. If the Johnsons transfer a portion of the remainder interest in their residence to charity in exchange for life annuity payments, the transaction will be considered a "bargain sale." Accordingly, the Johnsons will realize capital gain in the amount of $126,317.23

Fortunately, IRC section 121 specifically provides the exclusion applies to sales of remainder interests:

IRC §121(d)(8):

Sales of remainder interests

For purposes of this section--

(A) In general

At the election of the taxpayer,this section shall not fail to apply to the sale or exchange of an interest in a principal residence by reason of such interest being a remainder interest in such residence [emphasis added], but this section shall not apply to any other interest in such residence which is sold or exchanged separately.

(B) Exception for sales to related parties

Subparagraph (A) shall not apply to any sale to, or exchange with, any person who bears a relationship to the taxpayer which is described in section 267(b) or 707(b).

Section 121 and the proposed regulations were silent regarding whether the exclusion must be prorated to the value of the remainder interest as that value bears to the entire fair market value of the property or can be used in its entirety to offset gain from the sale of a partial interest. The Service has the latter position historically. Rev. Rul. 84-43 holds that a sale of a life estate in a principal residence qualified for the exclusion under the pre-TRA 1997 version of section 121 provided the life estate was the taxpayer's entire legal and equitable interest in the residence.24 It was unnecessary for the taxpayer to own the entire fee interest in the residence to qualify for the exclusion. This ruling is also cited in FSA 200149007 (8/10/01), which permitted the application of the entire section 121 exclusion to the sale of a partial interest in stock of a cooperative housing corporation.25

The final regulations illustrate by example that a taxpayer may use their exclusion to offset gain attributable to the sale of a remainder interest without prorating.26

Regarding the mechanics of claiming the exclusion, Reg. §1.121-4(g) provides the election NOT to claim the exclusion in connection with a sale of a remainder interest is made by filing a return for the taxable year of the sale or exchange that includes the gain from the sale in the taxpayer's gross income.

Possible Conflict and Solution: The transfer of a remainder interest in property in exchange for a charitable gift annuity is considered a bargain sale as described in IRC §1011(b). Gain that is recognized from such transactions may be reported ratably over the life expectancy of the annuitant provided the following conditions are met:

  • the transfer qualifies for a charitable contribution income tax deduction under IRC §170;
  • the donor is at least one of the annuitants; and
  • the annuity is non-assignable except to the isxc3x9fsuing organization.27

In this case, however, the donor/annuitant may not desire to report gain from the sale on an installment basis; rather, he or she may want to accelerate all of the gain into the year of sale and offset it with the section 121 exclusion.

The regulations state that when the aforementioned conditions are met:

"...any gain on such exchange is to be [emphasis added] reported as provided in example (8) in paragraph (c) of this section."28

It appears from a literal reading of the regulations that ratable reporting of gain is not an election but a requirement. In Ltr. Rul. 8615025, however, a taxpayer was permitted to utilize the entire section 121 exclusion to offset gain realized in connection with the bargain sale of a residence to a charitable organization in exchange for a charitable gift annuity in the year of transfer without mention of this issue.29

If all gain can be accelerated into the year of the gift, the section 121 exclusion could wash the gain up front. Provided the exclusion amount covers all of the gain, the taxation of annuity payments would be the same as those for a cash transfer. Keep in mind that although a life estate agreement requires only the use of a personal residence or farm, section 121 requires the property to meet the principal residence test, discussed earlier.

Charitable Income Tax Deduction. In addition to receiving life annuity payments, because a Charitable Gift Annuity contains a charitable gift component, the Johnsons will also receive a current income tax charitable deduction in the amount of $68,069. Assuming a combined federal and state income tax bracket of 35%, the deduction will reduce the Johnsons' income tax liability by $28,824!

Estate Tax Benefits. Because the Johnsons will retain the lifetime use of the property, it will be included in their gross estates; however, upon the first death, the decedent's estate will receive a full estate tax deduction for the value of retained life estate and the continuing annuity payments to the surviving spouse. Upon the surviving spouse's death, that spouse's estate will receive a full estate tax charitable deduction for the value of the property. As a result, if an estate tax exists at the time of either of their deaths, the entire value of the property will be effectively removed from both spouses' estates for tax purposes. The net result is the same as if the Johnsons had made a charitable bequest of their residence. However, unlike a bequest, they will also enjoy significant income and income tax benefits during their lifetimes.

Planning Considerations. As previously mentioned, the Johnsons will enjoy all of the lifetime benefits in the property. These include the right to occupy and otherwise enjoy the full use of the property. By the terms of the Gift Agreement, they will remain responsible for maintaining the premises, insuring the property against loss and liability, and repairing the premises in the event of damage.

If the Johnsons should decide they no longer desire to, or cannot for health or other reasons occupy the property, they (or their authorized representative) will have several options:

  • They can rent the property and enjoy the rental income there from.
  • They and the charitable remainderman can join in the sale of the property and divide the proceeds according to their respective interests, or use the proceeds to purchase a new residence which the Johnsons will continue to occupy.
  • If they feel they no longer need the property at all, they can contribute their life interest to the charitable remainderman and claim an additional income tax charitable deduction. The annuity payments would also continue for their lifetimes.

By transferring their personal residence to charity with a retained life estate, the Johnsons can retain the lifetime enjoyment of the property, receive $14,798 per year for their lifetimes, and reduce their income taxes by a projected $28,824. Further, they can enjoy the satisfaction and recognition of making a significant contribution to their community by virtue of their generous charitable gift.

Summary

The repeal of section 1034 and revision of section 121 offer some creative planning opportunities for the charitably inclined. While these plans can provide substantial lifetime financial benefits-in the form of increased cash flow and income tax deductions-these benefits may come at the cost of the remainder interest being unavailable for the donor's heirs. Therefore, as with all planned gifts, planners should always stress the primacy of donative intent when presenting such arrangements.


  1. In addition, the Internal Revenue Service Restructuring and Reform Act of 1998 made two additional modest amendments to section 121.back

  2. IRC § 121(d)(2) and (3)back

  3. IRC §121(d)(7)back

  4. IRC §121(d)(5)back

  5. Reg. 1.121-3back

  6. IRC §121(d)(6)back

  7. Reg. §1.121-4(e)back

  8. IRC §121(d)(9)back

  9. IRC § 1011(b). Example: If a donor transfers property worth $100,000, having a $50,000 adjusted cost basis and subject to a $25,000 mortgage outright to charity, the donor will realize a $12,500 gain in connection with bargain sale element of the indebtedness (($50,000/$100,000) x $25,000).back

  10. Reg. §1.121-4(e); See also Rev. Rul. 84-43, 1984-1 C.B. 27; FSA 200149007 (8/10/01), discussed supra.back

  11. In Ltr. Rul. 8615025, a taxpayer was permitted to utilize the entire section 121 exclusion to offset gain realized in connection with the bargain sale of a residence to a charitable organization in exchange for a charitable gift annuity.back

  12. Weingarden v. Comm'r, 86 T.C. 669back

  13. Some states and/or the internal policies of some charitable organizations prohibit the transfer of real estate in exchange for a charitable gift annuity. As an alternative, a pooled income fund can be considered; or provided the property is debt-free, a charitable remainder trust can be used.back

  14. Gain that is recognized from the bargain sale of appreciated property may be reported ratably over the life expectancy of the annuitant provided the following conditions are met: 1) the transfer qualifies for a charitable contribution income tax deduction under IRC §170; 2) the donor is at least one of the annuitants; and 3) the annuity is non-assignable except to the issuing organization. See IRC §1011(b); Reg. §1.1011-2(a)(4)(ii).back

  15. ($180,000 - $133,700) x 3% = $1,218. Most taxpayers will not feel the effect of the reduction on their charitable deduction because they have other fixed deductions such as home mortgage interest, or state and local taxes that would bear the brunt of any reduction each year.back

  16. The service has ruled that a transfer of real property subject to a mortgage to a charitable remainder trust on which the trust would service the indebtedness would cause the trust to be a grantor trust. See Ltr. Rul. 9015049.back

  17. With respect to a charitable remainder trust, a disqualified person is: a substantial contributor (a person who contributes more than $5,000 or the creator of the trust); trustee (foundation manager); person who owns more than 20 percent of: - voting power of a corporation, - profit interest in a partnership, or - the beneficial interest of a trust or unincorporated enterprise, where the entity is a substantial contributor to the trust; spouse, ancestors, children, grandchildren, great grandchildren, and their spouses, of persons previously described; or corporation, partnership, trust, estate or enterprise of which more than 35 percent of the total ownership, and the rights thereof, are owned by persons previously described.back

  18. IRC §170(f)(3)(A) and Treas. Reg. §1.170A-7(a)(2)(i).back

  19. IRC §514(a)(1). IRS Manual section 7.27.8.4 (02-23-1999) states:

    1. If an organization sells or otherwise disposes of debt-financed property, it must include in computing unrelated business taxable income an amount with respect to any gain (or loss) which is the same percentage (not over 100%) of the total gain (or loss) derived from the sale as:
    A. The highest acquisition indebtedness regarding the property during the 12-month period preceding the date of disposition is of
    B. The average adjusted basis of such property.
    2. Reg. §1.514(a)-1(a)(1)(v)(b) provides that the tax on this amount is determined in accordance with the rules regarding capital gains and losses. (Subchapter P, chapter 1 of the Code)
    back
  20. IRC §514(c)(5)back

  21. It should be noted that farmland sold in connection with a principal residence does not qualify for exclusion under section 121. H.R. 900, introduced on March 6, 2001 by Wes Watkins, (R-Okla.), would include farmland (and structures located thereon) that is contiguous to the taxpayer's principal residence.back

  22. Present value computations vary significantly for both life estate agreements and charitable gift annuities as a function of the Section 7520 discount rate (charitable federal midterm rate).back

  23. Realized gain is calculated by multiplying the present value of the annuity payments by the ratio the donor's adjusted cost basis in the property bears to the full fair market value of the property on the date of transfer. In this case, the present value of the annuity payments is $140,352. If the Johnsons' basis in the entire property is $75,000, the amount of basis allocable to the annuity will be $14,035 ($140,352 x ($75,000 / $750,000). Realized gain is determined by subtracting the allocable basis of $14,035 from the present value of the annuity payments ($140,352 - $14,035 = $126,317).back

  24. Rev. Rul. 84-43, 1984-1 C.B. 27back

  25. This 35-page document is must reading for beginning gift planners and great review for experienced planners alike as it provides concise descriptions and case law regarding the partial interest rule, assignment of income and step transaction doctrines, valuation issues, and application of the Section 121 capital gain exclusion.back

  26. Reg. §1.121-4(e)(4) Exampleback

  27. Reg. §1.1011-2(a)(4)(ii)back

  28. Id.back

  29. The author has mused that if this did become an issue, gain could be accelerated by making the annuity assignable to a person other than the issuing organization. This would violate Reg. §1.1011-2(a)(4)(ii) which permits gain to be reported ratably over the annuitant's lifetime provided three conditions are met. These include: 1) the transfer qualifying for an income tax charitable deduction under IRC §170(c); 2) the donor being at least one of the annuitants, and; 2) the annuity being non-assignable except to the issuing organization. Violating the latter would produce an intentionally defective gift annuity. In practice, however, this may not work because of state regulatory requirements governing registration of gift annuity agreements.back

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Nice specific Info

This article tackles the meat of specific gift planning, using tools available and pertinent to real estate gifts.

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