There can be significant tax savings when donating appreciated property. Under the right circumstances, a charitable donation is claimed at the fair market value of the donated property, while the unrealized gain is not recognized by the donor. Said another way, the donor avoids income recognition and also receives a fair market value deduction. This strategy works well with highly appreciated low-basis property, and it’s commonly used for donations of publicly traded stock. This method is used less often for real property and promotes (carried interest or LLC/partnership interests received in exchange for services). Regardless, there are times that it can be extremely beneficial and may be worthy of consideration, especially for real estate sponsors considering a donation of their promote. But when it comes to donations of real property, there are two key hurdles that must be overcome to maximize the tax savings.
Two hurdles for real property donations
Anticipatory assignment of incomeUnder the anticipatory assignment of income doctrine, a taxpayer cannot avoid recognizing income by assigning (or donating) the gain in advance to another party. The courts have taken the position that this doctrine will be applied to property that’s under a binding contract at the time of the donation. This means that a donation of appreciated real estate must be made before the property is under contract to be sold. It’s acceptable if the property is subject to a letter of intent, as this is generally not a binding contract.
Bargain sale rules related to encumbered propertyThe bargain sale rules will be applied when the property donated is subject to a mortgage. Anytime encumbered property is donated, the donation will be treated as two separate transactions with a bifurcated basis. The first will be a sale with the proceeds equal to the debt, and gain will be recognized. The second will be a donation equal to the difference between the fair market value of the property and the debt relieved. Depending on the numbers, donating encumbered property may still be beneficial, but the tax savings will be lessened by any recognized gain.
Maximize your donation
In many cases, these hurdles make it difficult to maximize the tax savings of donating appreciated real property. A donation too far in advance of a sale will likely have a lower fair market value and thus a lower donation. Most real estate is leveraged, and a donation would create partial sale treatment. Notwithstanding these two obstacles, philanthropic real estate sponsors may be able to maximize the tax benefits by donating all or part of their promote. This would allow for a charitable donation at the fair market value, as well as the avoidance of income recognized by the sponsor when the property is sold. For this to occur, the sponsor would need to donate an actual interest (i.e. the interest holding the promote) in the partnership itself. The donation would be a partnership interest rather than a direct interest in real property.
Donating real estate and promotes can be a highly effective tax planning strategy, but there are a number of potential pitfalls to navigate.
In many cases, these promotes tend to be held through tiered partnership structures. A donation of an interest in an upper-tier entity could avoid potential concerns with admitting a new partner to the primary property entity. Following are key aspects that must be addressed if considering this type of strategy:
- A qualified appraisal of the partnership interest is necessary.
- The donation must be made before the property is under contract.
- The bargain sale rules can be avoided if there is no liability allocation under IRC 752 to the donated partnership interest.
- Unrelated business taxable income (UBTI) may result to the charity, but some charities are equipped to mitigate this.
- The partnership interest must hold a promote that will be eligible for long-term capital gain or 1231 gain treatment.
- Property donation is subject to 30% adjusted gross income (AGI) limitation (instead of 50% AGI limitation for cash and publicly traded stock) for contributions to public charities and 20% AGI limitation for donations to private foundations.
Donating real estate and promotes can be a highly effective tax planning strategy, but there are a number of potential pitfalls to navigate. The ultimate outcome and benefit will be specific to a taxpayer based on the circumstances of the situation.
If you’d like to discuss this tax-saving opportunity, please contact one of our experts.