Add this tool to your strategic disposition toolbox the Bargain Sale

Transcription

1 Add this tool to your strategic disposition toolbox the Bargain Sale By Mattias Graff In 1917, The U.S. Congress passed into law and into the IRS code, what is currently known as, Section 170. This section of the IRS code allows for and defines how the deduction of charitable gifts works whether it is cash, goods, stock, art, or real estate. We all recognize the altruistic part of donating something to people and charities that can use the help, but there is also a self-interest aspect to this. You get a valuable tax deduction! One of the requirements for getting the tax deduction for real estate donation over $5,000 in value is a charitable contribution appraisal. The IRS outlines the requirement for the appraisal (done by a certified appraiser), but in general it attempts to ascertain its full value, not necessarily the market value defined by the sales price. The appraiser must assume that neither the Buyer or the Seller is under any compulsion to act and has no urgency to buy or sell. Furthermore, the appraisal allows for property to be valued at highest and best use and allows the necessary time and money to locate an ideal buyer without limitation. The appraiser also takes into account replacement cost similar to an insurance appraisal. As such, this charitable valuation may outstrip the price at which a property is marketed. This often creates opportunity for 501c3 organizations (charities) to be a buyer of real estate via an associated, but different, mechanism called a Bargain Sale. The IRS calls it a Bargain Sale, not a great name, but it implies that someone is getting a deal, and in this case, it is the charity who buys/receives the donation. There are two parts of consideration in a Bargain Sale: a cash portion, that is usually less than market price, and a charitable deduction. The deduction, the second part of the consideration (e.g. the difference between any cash received and the appraised value), can be a substantial. Subsequently the combination of cash and a potentially significant deduction can be higher than a list price. In other words, the overall financial benefit of a Bargain Sale may be in-line with or more than the after tax proceeds the seller may receive from a traditional cash deal. Especially if the seller/donor can use a tax deduction. Let s be honest, money saved is the same as money earned, and isn t it the bottom line that matters? So, this is a powerful tool whereby corporations and other owners of real estate may achieve a twofold result: (1) make a difference in people s lives via a charitable act, and (2) get a financial benefit to their bottom line similar to a cash deal after taxes. The charities that accept real estate generally do one of two things: they can resell it and obtain cash, and use those proceeds to fund their charitable ventures, or they can keep it and use the property themselves. A brief history of the Bargain Sale Congress enacted the War Income Tax Revenue Act of 1917, to not only fund the war effort, but according to the Marquette University Law School, it was to encourage private philanthropy.

2 Actually, the War Revenue Act greatly increased individual income tax rates, doubling the lowest bracket from 2% to 4%, and more than quadrupling the highest rate from 15% to 67% in order to fund the war effort during World War I. However, it was thought that this would impact private support for charity, and so the charitable tax deduction was offered up as a compromise. It capped deductions at 15%. (Interesting note: The precursor to the 1031 like-kind exchange was authorized in The Revenue Act of 1921 as Section 202, 4 years after the donation deduction was introduced. The basis for the current form of 1031 was created in 1954, as you will see, 2 years after the current framework for the Section 170 was established. The current home mortgage interest tax deduction was not an intentional act. The federal income tax was introduced in 1894 which allowed all forms of interest to be deducted; however, income tax was ruled unconstitutional until the Constitution was amended in Once again, interest was deductible. Initially the tax excluded the first $3,000 of income, $4,000 for married couples; less than 1% of the population earned more than that in 1913, and they did not need tax deductions. Scholars now believe the interest tax deduction was therefore intended for business interest as an expense; however, throughout the early 20 s and 30 s, and the creation of FHA and Fannie Mae, homeownership and incomes increased as did the use of the mortgage interest deduction, essentially treating it as a business expense. The home mortgage interest tax deduction is now so ubiquitous that it is thought by many economists to be necessary for the health of the housing market.) The Revenue Act of 1935 made the charitable deduction available to corporations, but the deduction was limited at that time to five percent of the corporation s net income. Despite concerns in earlier debates that charitable giving by corporations would be ultra vires (i.e., beyond the powers of the corporation), the deduction was allowed in order to reduce the level of tax increases needed to provide services to those affected by the Great Depression. Currently C-corporations are permitted to deduct up to 10% of net income. In 1952, deductions for individuals were increased to 20% of Adjusted Gross Income ( AGI ), then in 1954, increased again to 30% of AGI. The rule was also renumbered as the current IRS 170. In 1964, Congress enacted an unlimited charitable contribution deduction for individuals, but this was repealed due to abuse, and most of the current rules were enacted in The Tax Reform Act of The unlimited deduction was slowly phased out and capped at a maximum of 50% of AGI. The 1969 Act reformed the charitable contribution rules by enacting new provisions that were intended to reduce the benefit taxpayers received when donating appreciated property. Under the Act, where a taxpayer contributed appreciated property at fair market value to public charities, the deduction was limited to 30% of the contribution base or AGI. If a taxpayer elected to limit the charitable contribution deduction to the adjusted basis of the contributed property, the maximum deduction was increased to 50% rather than to 30% of the contribution base/agi. Prior to the Tax Reform Act of 1969, much of the taxpayer abuse occurred when taxpayers contributed appreciated property and claimed a deduction for the full value. If a taxpayer elected to claim the deduction based on the adjusted basis rather than on the fair market value, the perceived tax abuse would be greatly reduced. The 1969 Tax Reform Act introduced a basis allocation rule for bargain sales to charitable organizations. The Act required taxpayers to allocate basis to both the sale portion and donated portion of the property. The percentage of basis allocation was determined by computing the ratio

3 of the basis and fair market value. A corresponding portion of basis was allocated to the sale, and the taxpayer was required to recognize capital gain from the bargain sale. Of course, the taxpayer was still entitled to a deduction for the gift portion of the property transferred to the charitable organization. In 1993, Congress passed the Omnibus Budget Reconciliation Act, which contained two provisions for 170. First, 170 was amended to disallow any deduction for a contribution of $250 or more unless the taxpayer has written substantiation from the donee organization. This amendment significantly decreased the amount previously set as the substantiation requirement, which had been $2,000 under the Deficit Reduction Act of The second provision required the donee charitable organization to inform, by written statement, any donor of a contribution over $75 made partly as a contribution and partly in consideration of goods and services that the amount allowable for deduction is the excess of the contribution less the amount of goods and services received. This is currently done by the donee organization completing IRS Form 8283 for submittal with individual or corporate tax returns. Summary of Major Changes Charitable contribution rules have encountered many modifications since their early enactment in To recap, the Code limits the maximum deduction for individual donors to 50% of the contribution base, which is defined as the adjusted gross income less any net carryover loss for gifts to charitable organizations such as churches, educational organizations, health care organizations, and private foundations. Congress enacted the 50% ceiling under the Tax Reform Act of If a taxpayer makes a charitable contribution to other types of charitable organizations, such as nonoperating foundations, the maximum deduction is 30% of the contribution base. Congress enacted this amendment under the Deficit Reduction Act of When a taxpayer contributes appreciated property to public charities, claiming the current fair market value for deduction purposes, it is limited to 30% of the contribution base. If the taxpayer contributed property that would have produced ordinary income, the deduction must be reduced accordingly. If a taxpayer elects to limit the charitable contribution deduction to the adjusted basis of the contributed property, the maximum deduction is limited to 50% of the contribution base. Finally, to the extent that a taxpayer's charitable contribution deduction is limited, it is carried forward for up to five years (six total). (Sec. 170(e)(1)(B)(ii) and 170(e)(5)) Donative Intent The term contribution or gift is generally interpreted to mean a voluntary transfer of money or other property without receipt of adequate consideration and with donative intent. A payment or other transfer to a charity (regardless of whether it is called a contribution ) is not deductible if it is made in exchange or in return for an economic benefit. So, to the extent a payment (read contribution value) exceeds the consideration received from the charity, the excess portion may be deductible if the donor can demonstrate that he or she transferred the excess to charity with the intention of making a gift. (United States v. American Bar Endowment, 477 U.S. 105 (1986). Treas. Reg. sec A-

4 1(h)). In simple English, if the value of the donation is more than what is received from the charity, the difference can be considered a deductible donation. Without a donative intent, there is no Bargain Sale. Bargain Sale vs. Donation This is where the Bargain Sale differs from the straight donation. The value of a straight donation is easily calculable as is the value of the deduction since 100% of the asset is being donated. In general, the value of the donation times the tax rate equals the deduction benefit. Since the Bargain Sale includes a cash component, the value of the donation deduction is determined by calculating the difference between the cash component and the fair market value of the donation (FMV- Cash=Deduction). Of course, this is simplistic, as there are considerations for debt, basis and adjusted basis, depreciation etc., but whether it is a Bargain Sale or donation, Section 170 permits avoidance of capital gains and recapture taxes on the portion of the donated value. There is an apportionment of capital gains taxes and recapture taxes on the ratio of the cash and donation values over the basis may be; but this is a calculation better left to a CPA. (See IRS Publicatino 544 for details). For this article s sake, if the cash portion of a Bargain Sale is less than or equal to the adjusted basis, there should be little or no tax exposure. For any amount over that, there is a proration based on the ratio of cash and donation value. For companies or individuals that can benefit from the value of a tax deduction, but would like some cash for transactional costs and/or some or all outstanding debt on the asset, this solution can be very effective. Substantiation and other formal requirements The code also requires a donor who claims a deduction for a charitable contribution must maintain written records regarding the contribution, regardless of the value or amount of such contribution (Sec. 170(f)(17)) If the total charitable deduction claimed for non-cash property is more than $500, the taxpayer must attach a completed Form 8283 (Non-cash Charitable Contributions) to the taxpayer s return or the deduction is not allowed. In general, taxpayers are required to obtain a qualified appraisal for donated property with a value of more than $5,000, and to attach an appraisal summary to the tax return. (Sec. 170(f)(11)). Corporate taxpayers A corporation generally may deduct charitable contributions up to 10 percent of the corporation s taxable income for the year. For this purpose, taxable income is determined without regard to: (1) the charitable contributions deduction; (2) any net operating loss carryback to the taxable year; (3) deductions for dividends received; (4) deductions for dividends paid on certain preferred stock of public utilities; and (5) any capital loss carryback to the taxable year. A transfer of property by a corporation to a charity might qualify as either a deductible charitable contribution or a deductible business expense, but not both. No deduction is allowed as a business expense under section 162 for

5 any contribution that would be deductible as a charitable contribution but for the percentage limitations on the charitable contributions deduction (or certain other limits on deductibility under section 170). In addition, a business transfer made with a reasonable expectation of a return benefit is not deductible as a charitable contribution under section 170, because the transferor lacks donative intent. The same transfer, however, might be deductible as a business expense under section 162. Carryforwards of excess contributions Charitable contributions that exceed the applicable percentage limit generally may be carried forward for up to five years. In general, contributions carried over from a prior year are taken into account after contributions for the current year that are subject to the same percentage limit. Determining the Value of Donated Real Estate Because each piece of real estate is unique and its valuation is complicated, a detailed appraisal by a professional appraiser is necessary. The appraiser must be thoroughly trained in the application of appraisal principles and theory. In some instances, the opinions of equally qualified appraisers may carry unequal weight, such as when one appraiser has a better knowledge of local conditions. The appraisal report must contain a complete description of the property, such as street address, legal description, and lot and block number, as well as physical features, condition, and dimensions. The use to which the property is put, zoning and permitted uses, and its potential use for other higher and better uses are also relevant. In general, there are three main approaches to the valuation of real estate. An appraisal may require the combined use of two or three methods rather than one method only to establish the Fair Market Value ( FMV ). 1. Comparable Sales, 2. Capitalization of Income, and 3. Replacement Cost Fair Market Value per 170 is for a donation. As opposed to a bank appraisal, an FMV appraisal for charitable purposes allows the appraiser to appraise the asset at its highest and best use and imposes no time restraints on the sale. This includes uses and zoning not permitted currently, permits the assumption that the property is fully occupied, (depending on the asset class), permits replacement cost as new less observable depreciation and functional obsolescence, and permits sales comps outside the asset area and outside the typically 6-12-month time frame if there are no appropriate sales comparatives within the area or recent past. As such, the FMV valuation may outstrip Broker opinions of value, list prices and bank appraisals. IRS 170 (f)(11)(e) requires a qualified appraisal, which is defined as an appraisal completed by a qualified appraiser. A qualified appraiser per 170 should have an MAI or like designation, be well-versed in the asset type and licensed in the state of the asset, be in good standing with the IRS, and use standards consistent with the Uniform Standards of Professional Appraisal Practice ( USPAP ). The requirements are rigorous, and for good reason. The IRS has to trust the appraisal valuations.

6 The Process Despite what you may have read to this point, the process is not complicated, and is virtually identical to a typical cash transaction. All large transactions typically require some form of the following: Meeting of the Minds on Value Purchase and Sale Agreement Due Diligence Closing Where a Bargain Sale differs from the above is the Consideration (or payment in kind) at Closing. In a traditional closing (whether financing is involved or not) the consideration is usually cash funding. In a Bargain Sale, it s a combination of cash and IRS Form 8283 completed by the appraiser and provided by the charity. IRS Form 8283 is essentially your tax-deductible receipt that makes possible additional cash in the form of tax savings. Depending, on the level of deduction and the filing entity s ownership structure and income, the deduction can be filed, in the case of a C-Corp, as soon as the next monthly filing, or for an individual, the next annual filing. Depending on the method of accounting, cash or accrual, the benefit is realized immediately or at the time of the tax filing. Case Law Case law regarding the applicability and legality of aspects of the Bargain Sale for real estate gifting has been consistent. Section 170 governs charitable deductions, and it states that [a] charitable contribution shall be allowed as a deduction only if verified under regulations prescribed by the Secretary. The Deficit Reduction Act of 1984 (outlined above) provides for certain rules for substantiating charitable contributions and orders the Secretary to prescribe regulations that require a taxpayer who claims a deduction for the donation of property more than $5,000 to obtain a qualified appraisal for the property contributed. These express delegations of authority to the Secretary to issue regulations create the hoops that a taxpayer must crawl through to claim a deduction. And when it comes to noncash charitable deductions greater than $5,000, the substantiation requirements become particularly extensive. See sec A-13(c), Income Tax Regulations. That regulation says that [n]o deduction under section 170 shall be allowed with respect to a charitable contribution * * * unless the substantiation requirements described in paragraph (c)(2) of this section are met. Id. subpara (1)(i). Paragraph (c)(2) provides three specific substantiation requirements: (A) Obtain a qualified appraisal (B) Attach a fully completed appraisal summary to the tax return (C) Maintain records containing the information required

7 As outlined above, the requirements for the appraisal are detailed, and as long as there is donative intent, a taxpayer who makes a Bargain Sale to charity is typically entitled to a charitable-contribution deduction equal to the difference between the fair market value of the property and the amount realized from the sale. Like any purported charitable contribution, a sale for less than full consideration results in a deduction under Section 170 only if it satisfies the statutory requirements. The case law appears to be consistent in this: If the taxpayer has a donative intent and is in substantial compliance of the statutory requirements, the court has supported the Donor. The mere existence of a qualified appraisal has tended to satisfy the concern of overvaluations. Example A very recent opinion to a case in the United State Tax Court, Cave Buttes, LLC (petitioner) v Commissioner of Internal Revenue (respondent), was filed on September 20, The court sided with the Petitioner (the Seller in this Bargain Sale) on the following basis: (A) The petitioner was in substantial compliance with the IRS regulations (in providing qualified appraisals and recordkeeping), AND (B) Simply because the taxpayer s efforts resulted in a windfall does not mean he acted with the intent to benefit from the windfall. This court case and other similar cases are consistent in this: follow the regulations and pursue a donative intent, and you will be in compliance. Conclusion The use of tax subsidies (i.e. tax deductions for charitable donations) is only one way to promote charitable organizations. Alternatively, the state or federal government could subsidize charitable organizations solely through direct expenditures. The justification for the government's grant of tax incentives for charitable organizations and charitable contributions is as follows: The exemption from taxation of money or property devoted to charitable and other purposes is based upon the theory that the Government is compensated for the loss of revenue by its relief from financial burden which would otherwise have to be met by appropriations from public funds, and by the benefits resulting from the promotion of the general welfare. - ROBERT W. WILLAN, INCOME TAXES, CONCISE HISTORY AND PRIMER 31 (1994) The IRS Section 170 Bargain Sale has been in existence for 100 years now, and has gone under several reviews by Congress. It is a recognized and valuable tool where there are several beneficiaries: 1. Promoting the general welfare: The proceeds from these types of sale support many charitable and other purposes the government cannot. 2. Benefitting the seller: A seller is permitted to gain a financial benefit through a bargain sale while simultaneously performing a charitable act.

8 Add this tool to your toolbox, and not only will you and others benefit financially, but you will be a success in your organization for finding and completing a unique and altruistic transaction. Mattias Graff is Director at Welfont, a boutique commercial brokerage company.