7. Bargain Sale Gifts, Part 1 of 2

7. Bargain Sale Gifts, Part 1 of 2

Article posted in General on 9 December 2015| comments
audience: National Publication, Russell N. James III, J.D., Ph.D., CFP | last updated: 9 December 2015
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Summary

Dr. Russell James continues with Part 1 of Bargain Sales, a cornerstone of many planned gifts.

VISUAL PLANNED GIVING:
An Introduction to the Law and Taxation
of Charitable Gift Planning

By: Russell James III, J.D., Ph.D.

7. BARGAIN SALE GIFTS, Part 1 of 2

Links to previous sections of book are found at the end of each section.

Bargain sale gifts are at once a relatively rare and quite common form of charitable planning.  What does this mean?  A traditional bargain sale gift, such as where a donor sells land worth $1 million to a charity for $500,000 is not a common occurrence for most charities.  However, other forms of complex charitable planning involve the donor making a transfer and, in exchange, receiving back some benefit from the charity (such as a lifetime income stream resulting from a Charitable Gift Annuity).  Although not referenced by this name, such transactions are, in fact, also bargain sales.  Thus, it makes sense to first understand the rules for the simplest form of bargain sale transactions, because these same rules will apply later when examining more complex charitable transactions.
A bargain sale is the sale of an asset to a charity at less than fair market value.  A bargain sale is the same as a standard sale except that the sale price is intentionally lowered below fair market value for the purpose of making a gift to the purchasing charity.  Alternatively, one may think of a bargain sale as a special form of charitable gift where the donor makes a gift, but also receives money or other valuable property back from the charity in exchange for the gift.
Calculating the charitable deduction for a typical bargain sale transaction can be relatively simple.  The donor deducts the value of what she gave less the value of what she received from the charity in exchange for the gift.  In this way, the rules for deducting bargain sale gifts are like “quid pro quo” gifts.  A donor who makes a $500 contribution and, in exchange, receives tickets to a charity dinner worth $100 may deduct $400 ($500 gift - $100 benefit).  In both cases, the deduction is the value given less the value received.  (This assumes that the donor is giving property which can be valued at fair market value for charitable income tax deduction purposes.  If the donor gives property that can be valued only at the lower of basis or fair market value, then the charitable deduction rules are a bit more complex and will be reviewed later in this chapter.)
Following the same idea, suppose a charity wants land owned for more than a year by the donor that is worth $1 million.  The donor offers a lower price in order to benefit the charity and subsequently sells the land to the charity for $400,000.  In this case, the donor has made a $600,000 charitable gift ($1,000,000 land given to charity - $400,000 payment received from charity).
A bargain sale can occur even where the charity does not directly transfer money to the donor.  For example, a donor could make the gift of a $300,000 house to a charity where the house was subject to a $100,000 mortgage.  The donor has exchanged property worth $300,000 for debt relief of $100,000, thus making a gift of $200,000.  Such transactions may not be ideal, because the $100,000 of debt relief will count as income to the donor.  This treatment of secured debt occurs regardless of the actual agreement for which party will ultimately make the debt payments.  For example, if the donor donates a house with a mortgage, but agrees to make all subsequent mortgage payments, the transaction is still treated as if the donor received $100,000 of debt relief.  Future mortgage payments made on the property owned by the charity will constitute charitable gifts at the time each is made, but the agreement to make future mortgage payments does not change the tax results of the initial transaction.  The initial transaction is still treated as if the donor received a $100,000 benefit in exchange for transferring the property.  Similarly, the donor is treated as receiving $100,000 of debt relief even if the donor is still legally liable to pay the remaining debt.  For this reason, it is often disadvantageous to gift debt-encumbered property to charity.
A Charitable Gift Annuity is another example of a bargain sale.  Suppose, for example, a donor gives $100,000 of publicly-traded securities to a charity in exchange for lifetime payments of $3,000 per year for life from the charity.  In this case, the donor has made a charitable gift of $100,000 less the value of the annuity.  (Calculation of the value of such annuities will be reviewed in the chapter on the taxation of Charitable Gift Annuities.) Although the ultimate calculations for such a charitable deduction are more complex, the fundamental principle of bargain sale transactions is the same.  The donor deducts the value of what he gave less the value of what he received back in exchange from the charity.
The tax consequences resulting from bargain sales become more complex when considering the results of bargain sales in recognizing capital gains.  These calculations differ from the relatively simple capital gain calculations that result from a normal, non-charitable, sales transaction.
If an investor pays $500,000 for an item of property (such as shares of stock) and then later sells that property for $1 million, the investor has a capital gain of $500,000.  The $500,000 paid for the property is referred to as “basis.”  The capital gain is simply the amount the investor received for the property less the amount the investor paid for the property or, in this case, $1,000,000 - $500,000.  (This passes over for the moment other potentially complicating factors that can alter the basis such as additional investments in improving the property or depreciation deductions previously taken, in order to focus on the basic concept of capital gain as the difference between the money received at sale and the money paid at purchase.)
In another example, if the investor pays $500,000 for an item of property and then later sells the same item of property for $500,000, the investor has no capital gain.  There is no profit to be taxed.  These examples show the relative simplicity of calculating capital gain in a typical transaction.  This simplicity changes dramatically, however, in the context of a bargain sale.
Suppose the donor pays $500,000 for property and the property grows in value to $1 million.  However, instead of selling the property for $1 million, the donor wishes to benefit a charity, and so he sells the property to the charity for a bargain price of $800,000.  What is the donor’s capital gain on this type of transaction?  The tempting, but wrong answer is to simply subtract the $500,000 purchase price from the $800,000 received from the charity.  This is not the correct answer.  The donor does indeed receive $800,000.  However, because part of the value of the property was donated, part of the $500,000 basis in the property will apply to the “gift” portion of the transaction.  Only the remaining share of the basis will be applied to the “sale” part of the transaction, and only this “sale” portion of the basis may be subtracted from the $800,000 received from the charity when calculating the capital gain.  The next section walks through this calculation process step by step.
The first step in calculating the capital gain resulting from a bargain sale transaction is to divide the property value into the gift part and the sale part.  In this case, the donor gave property worth $1 million to the charity in exchange for $800,000.  Thus, $800,000 of the transaction was a sale (because the donor received full compensation for that share of the property).  The remaining $200,000 of the transaction was a gift.  Another way of thinking of this is that the donor sold 80% of the property and gifted 20% of the property.
The donor received $800,000 from the “sale” part of the transaction.  Thus, the donor will have $800,000 of capital gain income less the “sale” part of the donor’s basis in the gifted property.  Determining the “sale” part of the donor’s basis requires dividing that basis between the “sale” part and the “gift” part.
Because the donor is treated as having sold 80% of the property and gifted 20% of the property, 80% of the basis will apply to the “sale” part of the transaction and 20% of the basis will apply to the “gift” part of the transaction.  Thus, the $500,000 original cost basis is divided between the “sale” part and the “gift” part of the transaction.  Because 20% of the value of the property was gifted to the charity, 20% of the $500,000 original cost basis (i.e., $100,000) is applied to the “gift” part of the transaction.  The remaining 80% of the value of the property was sold, i.e., the donor received full compensation for 80% of the value of the property.  Thus, 80% of the $500,000 original cost basis (i.e., $400,000) is applied to the “sale” part of the transaction.
Because, the donor received 80% of the value of the property, the donor can use 80% of the value of the cost basis when calculating capital gain.  In this case, 80% of the cost basis is $400,000.  This is the portion of the cost basis applied to the “sale” part of the transaction.
The donor’s capital gain is the $800,000 he received from the bargain sale transaction less the $400,000 of basis that applies to the “sale” part of the transaction.  Thus, the donor’s capital gain is, in this case, $800,000-$400,000, or $400,000.  It may seem disadvantageous to lose the ability to subtract the full $500,000 basis.  Consider, however, the alternate transaction where the donor sold the property at a fair market value of $1,000,000 and then gifted $200,000 of the proceeds to the charity.  The charity would receive the same $200,000 benefit in either transaction.  However, if the donor sold the property he would pay tax on $500,000 of capital gain ($1,000,000 sale price - $500,000 basis).  By using a bargain sale transaction, the donor has reduced his capital gain from $500,000 to $400,000.  Considering that combined federal and state long-term capital gains tax rates (including Affordable Care Act taxes) can be in excess of 33.3%, structuring this transaction as a bargain sale (rather than a sale then gift) can result in substantial tax savings for the donor.
The basic principle of calculating capital gain in a bargain sale transaction is simply that the percentage of the property value that is sold (i.e., the percentage of the fair market value the donor receives in exchange for the property) is the percentage of the cost basis that can be used for calculating capital gain.  The most important idea is to avoid the temptation of simply subtracting the amount paid for the property (basis) from the amount received for the property.  Although this works for other types of capital gain calculations, it is not appropriate here because part of the basis is applied to the “gift” part of the transaction.

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