It’s often assumed that donations of real estate to private foundations aren’t ideal because the charitable deductions for such donations are typically limited to whichever is less: the donor’s cost basis or the fair market value. And such donations are often dismissed out of hand, regardless of whether the property has depreciated or appreciated in value.
If a property has significantly depreciated in value below its original purchase price, donating it directly to the foundation isn’t recommended because the donor wouldn’t be able to realize the capital loss. Instead, donors typically are advised to sell the property and then contribute the proceeds. Even a donation of highly appreciated real estate typically is not recommended, as the donor would only be able to claim a cost basis deduction.
Yet despite the arguments against donating real estate to a private foundation, there are times in which such gifts do make sense, both for foundations and donors.
Foundations, for their part, can use a real estate donation to generate a steady stream of income and liquid funds (from rentals, for instance). If the property is used for charitable purposes, the organization may be able to qualify for an exemption from property taxes.
This might be a financially savvy move for the donor as well. When they’re weighing the merits of this kind of gift, they should consider their basis in the property, the property’s fair market value, and whether the donation is part of an estate plan.
So when does it make sense to donate real estate to a foundation?
1. When the cost basis and the fair market value of a property are similar.
This is sometimes the case in parts of the country where the real estate market is still recovering. If the donor’s property is worth approximately what he or she invested in it, donating it could be an appealing option.
2. When the donation of the real estate is part of an estate plan.
If this is the case, the basis in the property is stepped up, typically to the date of the donor’s death, which ensures that the basis is actually equal to the fair market value of the real estate, at least at that point in time.
(Note: A possible benefit for the foundation is that there may be no more than a nominal tax liability upon the ultimate sale of the donated property, since there would be little capital gain. If there is no gain at all, there may be zero tax liability. But even if there is, the foundation would only be taxed at a rate of 1.39%.)
3. When the value of the real estate has appreciated significantly over what the donor originally paid.
If a foundation has accumulated excess distribution carryovers as a result of over-granting beyond the required 5% during its preceding five taxable years, it can make a special “conduit election,” which would entitle the donor to receive a fair market deduction (just as if the property were donated to a public charity) instead of the more limited cost basis deduction. This way the donor averts the need to sell the property and donate the proceeds. This method also allows the donor to make use of higher adjusted gross income percentage caps (which are 30% for non-cash donations to a public charity whereas non-cash donations to a private foundation are capped at 20%).
Cautions For Donors
Keep in mind that donors should avoid contributing real estate encumbered by a mortgage, in which case they might run afoul of rules about self-dealing if the contribution results in relief of debt for them. Even when the debt is small in relationship to the property’s value, it could still trigger penalties for which the donor (not the foundation) would be personally liable.
This problem arises when the foundation assumes the mortgage on the property, or takes the property with a mortgage placed on it by a “disqualified person” more recently than 10 years before its donation (disqualified persons include substantial contributors to the foundation; foundation managers; people who own more than 20% of the interest in an organization that contributes substantially to the foundation; certain family members of any of these parties; and organizations in which any of these parties hold, directly or indirectly, more than a 35% interest).
In these cases, real estate donations with mortgages would be deemed by the Internal Revenue Service a “bargain sale” of the property to the foundation (because it’s deemed sold for the amount of debt relief). The penalty for which a disqualified person would be personally liable will be 10% of the fair market value of the entire property (not 10% of the debt relief).
Donors also should take pains to avoid “pre-arranged sales,” which would occur if they were to negotiate the terms of a sale of property, donate the property to their foundation, and subsequently compel the foundation to consummate the sale. From the IRS’s point of view, the existence of a binding commitment to complete the transaction may indicate that the foundation is being used to transfer property to the donor’s handpicked buyer while the donor also avoids the tax consequences that would ordinarily result from his or her sale of the property.
Cautions For Foundations
Foundations have reasons to be careful as well when taking a donation of real estate, especially in deciding whether property will be used for charitable or investment purposes.
If it’s real estate used for charity—perhaps for housing foundation offices or conducting charitable programs, or if the property will be leased to a public charity rent-free or for a nominal sum—then the value of the real estate should be excluded from the asset base upon which the foundation’s annual 5% payout requirement is based. (The payout requirement is the amount that must be distributed by the end of the foundation’s tax year in order to avoid a tax penalty.)
However, if the property is being used as an investment, to generate rental income for instance, its value will be included in the foundation’s asset base to calculate the organization’s annual payout requirement. In its use as an investment, the property needs to be valued using a commonly accepted appraisal methodology. Instead of appraising the property annually, the foundation may opt to obtain a certified independent appraisal, which can stand for up to five years.
Additionally, when property is used for investment purposes, the donor may want to consider whether the foundation has sufficient cash flow and liquid assets to satisfy the increased payout it will need to make if it holds onto the property. Another possibility is that the property is first donated for investment purposes and then later converted to a charitable use; in this case, the fair market value of the property at the time of conversion would be treated as a qualifying distribution and would then cease to be included in the foundation’s asset base when calculating the 5% payout requirement.
The foundation should also consider whether the property itself could readily be sold to a third party for necessary cash, understanding that the property couldn’t be sold to a disqualified person—which would mean a self-dealing violation. If that happened, the sale would have to be rescinded, and the disqualified person could be personally liable for penalties. So the donor should consider whether there are enough eligible parties in the current market to whom the foundation could sell the property if necessary.
The foundation taking on the property must also keep taxes at the state level in mind. If a property is used for a charitable purpose, the foundation may qualify for an exemption from a state’s property taxes. If, however, it’s used for investment purposes, the foundation may be responsible for property taxes in the state where it’s located. Either way, the foundation likely will be required to make ongoing filings there.
After all these things are taken into account, donors and foundations can still find it beneficial to take advantage of real estate donations—if the transfers are done carefully and with forethought. With the right planning, donors can make sure these donations comply with the law and tax rules while also maximizing their charitable deductions.
Jeffrey Haskell, J.D., LL.M., is chief legal officer for Foundation Source, the nation’s largest provider of technology, administration and expertise for private foundations and planned giving. Contact him at [email protected].