by Dennis Bidwell
April, 2016
I’ve previously written about bargain sales – appropriate for situations where a property owner is ready to dispose of a property, has charitable desires, but isn’t in position to give the entire property away. By selling the property to a non-profit at a discounted price, the property owner gets cash from the sale and a tax deduction for the difference between the appraised value of the property and the sales price. The non-profit, in this situation, pays cash for the property, and then sells it, presumably at a price in the vicinity of appraised value. For the non-profit, the difference between what it paid and what it realizes on sale is the net gift amount.
There’s one big problem in this scenario for many non-profits, however – and that’s coming up with the cash for the initial purchase.
A solution to this – an approach that is not used by non-profits with the frequency it should be, in my opinion – is to work with the donor on a gift of a fractional interest in the property. (This is sometimes referred to as donating an undivided interest.)
Here’s how it works, in the case of a property with a value of $1,000,000, where the property owner was contemplating selling the property to a non-profit at the bargain sale price of $250,000. (Representing a potential gift to the non-profit, more or less, of $750,000.)
In the comparable fractional interest donation scenario the property owner would donate a 75% undivided interest in the property to the charity, generating a charitable tax deduction for doing so. (More on tax treatments later.) The charity and the donor would then, as co-owners, jointly market the property. (In some cases the donor would be delighted to let the non-profit assume the lead role in marketing. In other cases, the donor may want to stay very much involved. Either way, both owners sign the listing agreement.) When a buyer is found, a purchase agreement is executed by the parties and at closing the donor and the charity emerges with their respective portions of the net sales proceeds. In our hypothetical case, let’s say the property sold for $1,000,000, for a net (after broker fee, legal, closing costs) of $920,000. The donor’s 25% would be $230,000, with the charity netting $690,000 in cash.
Similar results for donor and charity
In both cases – bargain sale and fractional interest gift – the property owner receives about 25% of the value of the property in cash, generates a charitable tax deduction for the gift portion of the transaction, and is potentially exposed to capital gains tax on the sales portion of the transaction. Also in both cases, the charity will proceed only if its due diligence investigations – title, environmental, marketability – reveal no problems with the property.
But there are differences, pro and con, for both the donor and the charity.
For the charity, the big advantage is that in a fractional interest donation the charity is not required to find the cash for an initial purchase. Also, between the time of the gift and time the property sells, the responsibility for carrying costs (property taxes, utilities, maintenance, etc.) is shared proportionally among the parties. (Hopefully, the donor will agree to cover 100% of these costs.)
A potential downside for the charity is that it may not be in total control of the marketing process, as both parties presumably need to agree on the listing agent and the sales price. Often, however, as mentioned, the donor is more than happy to be a fairly passive participant, involved only when documents needs to be signed.
(The charity would only accept this sort of gift if it had a firm agreement with the donor about marketing the property. Ownership of a 75% undivided interest, absent an agreement with the other owner to market the property, would never be desirable.)
For the donor, a major difference in the fractional interest gift scenario is that they share in the marketing risk with the non-profit. Unlike the bargain sale situation where they receive their purchase price and are out of the deal, with a fractional interest situation they don’t receive payment until the property sells, and the property could of course sell at a lower or higher price than the donor originally thought likely. And, of course, the donor will continue to be responsible for their proportional share of carrying costs until the sale.
Tax treatments
In terms of charitable tax deductions, the outcomes for the donor in the two scenarios are similar but via a different path. The charitable deduction available to the donor in the case of the bargain sale imagined above would be $750,000, assuming a qualified appraisal establishes a fair market value of $1,000,000. The deduction is triggered at the closing on the sale. In the case of a fractional interest donation, the starting point would also be an appraisal, but technically the appraiser is valuing a 75% undivided interest in the property. It’s possible that the appraiser would apply a partial interest discount to the valuation (reflecting the impact on marketability of an interest less than 100%), resulting in a valuation, and thus a potential charitable deduction, somewhat less than $750,000. Here, the deduction is triggered by the conveyance of the property interest.
In both cases the charitable donation deduction flows from the donor’s appraisal, and is not affected in any way by the eventual sales price for the property, regardless of whether that price is higher than, lower than, or the same as the appraised value.
In either case, of course, the donor would be limited to a charitable deduction no greater than 30% of adjusted gross income in the year of the gift, with an ability to carry forward unused deductions for up to 5 additional years.
Sometimes, the donation generated by the fractional interest gift can largely, or perhaps totally, shield the capital gains exposure from the sales component of the transaction.
Applicability
Where is this scenario most likely to be of use? In my experience, whenever a charitably-minded property owner is preparing to sell a vacation home they’re no longer using, or “downsizing” from a current home, or disposing of a commercial property, they should be made aware that there’s a simple way to incorporate a meaningful charitable gift into the real estate transaction. Sometimes, when preparing to dispose of a property, the owners realize the property has appreciated a great deal, providing them the ability to make a meaningful gift while retaining a substantial amount of equity.
Other times, it’s appropriate to introduce the fractional interest gift when a bargain sale is proposed, but the charity is not in position to find the upfront investment dollars necessary for such a transaction.
A hybrid
Sometimes a donor will be willing to give the fractional interest donation scenario a try, but will want certainty that at some date certain they will get the cash they are looking for. This could be accomplished by having the donor initially donate a fractional interest, but to backstop this with an agreement with the donor that if the property has not sold by a certain date, then at that time the charity would buy out the donor’s remaining interest at an agreed price. This would effectively convert the fractional interest scenario in to a bargain sale.