Bargain Sales to Charity
Is it better to give than to receive? Many financial advisors have discovered that it’s possible to help clients do both. Their secret is a charitable strategy known as a bargain sale.
Bargain sales to charity allow donors to support a favorite cause while also gaining some liquidity in return. For example, when appreciated property is worth more than a prospective donor is willing or able to give, a bargain sale can split the asset into two pieces: a deductible contribution and a taxable sale. Using the bargain sale method, advisors can help clients make charitable donations and pay less tax than they would if they had sold an asset and donated the proceeds.
A Strategy for Illiquid Assets
Although bargain sale rules can apply to both tangible and liquid assets, most experts agree that the strategy is most appropriate for disposing of real property. In fact, a bargain sale may be most appropriate when property such as undeveloped real estate or a vacation home cannot be readily divided. Bargain sales are also smart solutions when a donor seeks to recover his or her initial investment and donate only the appreciation.
A bargain sale may come into play when a charity or government agency cannot afford to buy an entire property. Donna Evered, an accountant with BBDO Seidman in Seattle, provides a relevant example. Recently, she says, a county in Washington State sold a bond issue in order to buy development rights to create a park. However, more taxpayers wanted to sell development rights to the land than the state was able to afford. In response, Evered says, the county enabled donors to sell the state a portion of the rights and donate the remainder.
How It Works
In a bargain sale, the property must be appraised to determine fair market value. The donor may then claim a charitable deduction for the donated portion and must pay tax on the sale portion. In the example cited above, if a donor had property worth $1 million and the state had $600,000 available to make the purchase, the charitable portion would be valued at $400,000. The donor would owe capital gains tax on the $600,000 paid by the county and could claim a charitable deduction for the remaining $400,000.
Calculating the Tax on the Gain
In real life, the calculations of taxable gain are a bit more complicated. Often, donors owe tax on the transaction even if they do not realize a profit.
The formula starts with the tax basis of the property, multiplies it by a fraction (using the sale proceeds as the numerator and the property’s fair market value as the denominator), and then subtracts the result from the sale proceeds.
Assume, for instance, that a donor owns a piece of real estate valued at $80,000 with a tax basis of $48,000. To recover the initial investment, the donor sells the property to her alma mater for $48,000. The $32,000 in appreciation - the taxable amount if the entire property had been sold - represents the charitable contribution. However, by using the bargain sale rule, the actual taxable gain is only $19,200, based on the following calculation:
1. The tax basis of the property: $48,000
2. Minus the basis allocated to the sale portion: $48,000 X $48,000
$80,000 = $28,800
3. Taxable gain: $19,200
This formula creates a win-win situation. The college benefits because it pays only $48,000 for property worth $80,000. The donor benefits by obtaining a charitable deduction plus a lower capital gains tax on the transaction. (Remember, selling the property for $80,000 would ordinarily have produced a capital gain of $32,000.) In effect, the bargain sale allows you to avoid paying capital gains taxes on $12,800. It also eliminates brokerage commissions that would otherwise have been incurred.
Calculating the Deduction
Bargain sale contributions are subject to IRS rules on gifts of appreciated property. In general, the rules indicate the following:
• If the property has been held by the donor for more than 12 months and would therefore qualify as a long-term gain if sold, a deduction may be taken for the appreciated value. If the property has been held for a shorter period and would be taxed as ordinary income if sold, the deduction is limited to the cost basis.
• Property qualifying for a deduction on the appreciated value must be put to a related use by the charity, not immediately sold.
• Contributions of real estate and other tangible assets made to a public charity such as a community foundation generally produce a deduction limited to 30 percent of the donor’s adjusted gross income. Amounts in excess of 30 percent of AGI may be carried forward for five years.
Bargain sale arrangements can be individually structured with charitable organizations that are willing to go the extra mile for donors. Since the transactions are somewhat complicated, they represent an opportunity for advisors to add meaningful value to their clients’ wealth-management plans.
Grace W. Weinstein is a freelance writer based in Englewood, New Jersey. She is the author of The Procrastinator’s Guide to Taxes Made Easy (NAL, 2004).
Copyright CFA, 2004
Used with permission