9. Taxation of Charitable Gift Annuities, Part 3 of 4

9. Taxation of Charitable Gift Annuities, Part 3 of 4

Article posted in General on 2 March 2016| comments
audience: National Publication, Russell N. James III, J.D., Ph.D., CFP | last updated: 2 March 2016
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....And, speaking of Gift Annuities, Russell James delves into the taxation of gift annuity payments.

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

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

9. TAXATION OF CHARITABLE GIFT ANNUITIES, Part 3 of 4

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

To this point, we have been looking at a Charitable Gift Annuity transaction where the gift annuity is purchased with cash.  However, it is also possible to purchase a Charitable Gift Annuity with appreciated property.  This complicates our tax scenario because when a gift annuity paying to the donor is purchased with appreciated property, some part of the annuity check given to the annuitant will be treated not as ordinary income, nor as tax-free return of investment, but rather as capital gain.
Let’s first consider the straightforward rules that normally apply to capital gains.  If a taxpayer buys an item (for example, shares of stock), for $500,000 and later sells the item for its fair market value of $1 million, then it is simple to calculate the capital gain.  The capital gain is simply what the taxpayer sold the item for ($1,000,000) reduced by what the taxpayer originally paid for the item ($500,000).  Thus, the taxpayer would have a capital gain of $500,000 (i.e., the profit from the sale would be $500,000).
The capital gain calculation becomes more complicated in the context of a bargain sale.  Suppose the taxpayer has the same asset which he purchased for $500,000 that now has the same fair market value of $1 million.  But instead of selling the asset for $1 million, the taxpayer donates the asset to a charity, and in exchange for the donation receives an annuity worth $800,000.  What is the capital gain resulting from that transaction?  It is NOT simply the value of the annuity ($800,000) less the price of the property ($500,000).  The calculation of capital gain for this transaction uses the same process for calculating capital gain in any type of bargain sale.

The reason that the capital gain on the previous transaction is not simply $800,000-$500,000 is because the donor may not use the entire $500,000 cost basis in the property for the annuity part of the transaction.  Part of the cost basis is allocated to the gift portion and part is allocated to the annuity portion (a.k.a. the “sale” portion).

A simple way to think of a capital gain is “What I got for it” less “What I paid for it.”  In this case, it is easy to determine “What I got for it.”  The donor receives an annuity worth $800,000 (and also makes a charitable gift).  Determining the “What I paid for it” is more tricky, because the donor paid for both the portion of the property that bought the annuity and the portion of the property that became a charitable gift.  Only the basis from the share of the property that was used to purchase the annuity can be included in the capital gain calculation.  (In some cases, the basis from the share of the property that became a charitable gift might also be important when, according to the rules on valuing charitable gifts of property, the value of the donation is limited to the basis.)

Let’s apply this concept to our proposed transaction.  The donor purchased property (perhaps intangible personal property like shares of stock) for $500,000 that grew in value to $1,000,000.  He then gave that property to charity in exchange for a gift annuity worth $800,000.  The first step is to divide the property into the part that was used to purchase the annuity (the “sale” part) and the part that was used to make a charitable gift (the “gift” part).  In this case, $800,000 of the $1,000,000 property was used to purchase the $800,000 annuity.  In other words, 80% of the property was used for the “sale” part of the bargain sale.  The remaining 20% of the property was used to make a charitable gift (i.e., the “gift” part of the bargain sale).
Next, we apply this same percentage division to the cost basis.  The total cost basis was $500,000 (i.e., that was the purchase price of the transferred property).  80% of this $500,000 cost basis applies to the annuity purchase (i.e., $400,000 of basis applies to the “sale” part of the transaction).  The remaining 20% ($100,000) of basis applies to the charitable gift.  (And if the charitable deduction were, for some reason, limited to the basis in the property then the deduction would be for this $100,000 basis applying to the charitable gift, rather than for the full $200,000 difference between the transfer and the value of the annuity.)
Now that we know both what the donor received for the property transfer (valued at $800,000) and the amount of the basis that applied to this annuity part (a.k.a. “sale part”) of the transaction (i.e., $400,000), it is easy to calculate the capital gain.  The capital gain is simply the value of the annuity ($800,000) less the amount of basis in the property applied to the annuity part of the transaction ($400,000). 
When is the tax on this capital gain paid?  The answer to this question depends upon who is receiving the annuity payments.  If the donor purchases a gift annuity with appreciated property where the payments are made to another person (not the donor and donor’s spouse), then the capital gain must be recognized immediately.  This eliminates a substantial part of the tax advantage of purchasing a Charitable Gift Annuity with appreciated property.  It also explains why such transactions are relatively rare.  Nevertheless, the donor does still retain some advantage by giving appreciated property, rather than cash, to purchase the gift annuity, in that the capital gain attributed to the gift portion is avoided.
The preferable tax result occurs if the donor is receiving (or the donor and the donor’s spouse jointly are receiving) the annuity payments.  In this case, the capital gain is deferred over the life expectancy of the donor (or joint life expectancy of the donor and donor’s spouse).  The next best result to complete tax avoidance is tax deferral.  In this case, the deferral is for an extraordinarily long period of time, making this a very attractive feature of purchasing gift annuities with appreciated property.  In order to receive this treatment, the annuity must specify that it cannot be assigned to anyone (excepting the charity itself, the donor, and the donor’s spouse).  Even if the donor never uses the right to assign the annuity payments to someone else, simply having this right available will result in immediate recognition of all capital gain.
To calculate the share of each year’s payment that will count as capital gain, the annuitant donor simply divides the total capital gain by his life expectancy at the time of purchase of the gift annuity (or the donor and donor’s spouse’s joint life expectancy if paid jointly).  As before, this original life expectancy is called the “expected return multiple” and is identified in the table found in the Code of Federal Regulations Title 26 §1.72-9.  The process for this calculation is identical to the previously discussed process for identifying how much of each year’s payment will be tax-free return of investment.
For example, if a donor had a five-year “expected return multiple” (i.e., life expectancy at the time of the purchase of the gift annuity) and a capital gain of $10,000 from the purchase of the gift annuity, then 1/5 of the capital gain would be recognized in each of the first five years.  Thus, $2,000 of each annual payment check would count as capital gain for the first five years.  After five years, the entire $10,000 in capital gain would have been recognized.  Similar to the previous discussion of return of original investment, there is no additional capital gain to recognize if the donor outlives his “expected return multiple” (i.e., original life expectancy).  Regardless of the price of the gift annuity or the use of appreciated property, after an annuitant outlives his or her “expected return multiple,” all subsequent annuity payments will consist entirely of ordinary income.

Let’s now return to our previous example, with one modification.  Rather than giving $100,000 in cash, the donor now gives publicly-traded stock worth $100,000.  This is stock that the donor originally purchased for $60,000 (i.e., the basis of the stock is $60,000).  In exchange for this stock, the charity agrees to pay the age 55 donor $4,000 per year for life.  How much of each $4,000 annuity payment will count as capital gain?  To calculate this, we simply divide the total capital gain by the original life expectancy (a.k.a. “expected return multiple”).

Determining the original life expectancy (a.k.a. “expected return multiple”) was already completed in the previous scenario.  The table found in the Code of Federal Regulations Title 26 §1.72-9 indicates that for a 55-year-old male, the “expected return multiple” is 21.7 years.  However, we have not yet calculated the total capital gain resulting from this transaction.
To calculate the total capital gain, we simply subtract the basis attributable to the sale part of the transaction from the value of the annuity.  In other words, this is what the donor received (value of the annuity) less the basis in what the donor gave for the annuity portion of the gift annuity (the non-charitable portion of the transaction).
The value of the annuity is $74,723.20 as determined by the calculations from the previous example.  (The fact that the annuity was, in this case, purchased with appreciated property has no effect on the value of the annuity being provided to the donor.) We do not simply subtract the entire $60,000 basis from the value of the annuity in order to calculate the capital gain because only part of the property was used to purchase the annuity and the rest was used to make a deductible charitable gift.  Thus, we can only use the share of the basis that represents the share of the property used to purchase the annuity (i.e., the “sale” part).  In this case, the share of the $100,000 transaction used to purchase the annuity (i.e., the portion that is not a deductible charitable gift) was $74,723.20 Thus, 74.7232% of the property was used to purchase the annuity.  Because 74.7232% of the property was used to purchase the annuity, 74.7232% of the basis may be applied to calculate the capital gain resulting from receiving the annuity.  Thus, 74.7232% of the $60,000 basis (i.e., $44,833.92) may be used to calculate the capital gain.
Subtracting this $44,833.92 (i.e., 74.7232% of the $60,000 basis) from the $72,797.20 value of the annuity results in a capital gain of $29,889.28.  If this annuity were being paid to someone other than the donor (or donor and donor’s spouse), then this capital gain would be recognized immediately.  But, in this case, the annuity is being paid to the donor, so this capital gain can be spread out over the life expectancy of the donor as of the date of the initial transaction (a.k.a. “expected return multiple”).

As a result, $1,377.39 of each check ($29,889.28/21.7) will be counted as capital gain until all of the capital gain ($29,889.28) is recognized.

Now that we know that $1,377.39 of each $4,000 check will be counted as capital gain, this leaves open the question of the tax treatment for the remainder of each check.  As before, part of each gift annuity check (received prior to the annuitant’s outliving his or her “expected return multiple”) will be tax-free return of investment.
To calculate the amount of each $4,000 annuity payment that will qualify as tax-free return of investment, we divide the part of the basis used to purchase the annuity by the annuitant’s “expected return multiple” (i.e., original life expectancy).  In this case, 74.7232% of the property was used to purchase the annuity portion (with the remaining part of the property transferred as a deductible charitable gift), meaning that 74.7232% of the $60,000 basis may potentially be returned to the donor as tax-free return of investment. 
This $44,833.92 (74.7232% of the $60,000) of basis will be returned in equal shares over the first 21.7 years of the annuity payments, meaning that $2,066.08 of each annual $4,000 payment will be tax-free return of investment.
In addition to the $2,066.08 of each annual payment that will count as tax-free return of investment, part of each payment will be capital gain.  As previously calculated, the capital gain portion of each check will be $1,377.39.  Everything else, by definition, is ordinary income.  Thus, in this case the ordinary income portion of each check will be the total check ($4,000) less the portion of each check that is tax-free return of investment ($2,066.08) and the portion of each check that is capital gain ($1,377.39), or $4,000-$2,066.08-$1,377.39 = $556.53.

Until the donor/annuitant lives beyond his “expected return multiple” (i.e., original life expectancy) each $4,000 check will consist of $2,066.08 tax-free return of capital, $1,377.39 capital gain, with everything else ($556.53) treated as ordinary income.  After the annuitant lives beyond his “expected return multiple” each $4,000 check will consist entirely of ordinary income. 

As a side note, the tax treatment of the check in the 22nd year will be slightly different because of the 21.7 year “expected return multiple.”  In that year, all of the remaining will be returned ($2,066.08 X .7=$1,446.26), and all of the remaining capital gain will be recognized ($1,377.39 X .7 = $964.17), leaving the remaining amount of $1,589.57 ($4,000-$1,446.26-$964.17) as ordinary income.

If the donor dies prior to reaching his original life expectancy (“expected return multiple”), then the donor fails to receive his entire original investment in the annuity portion of the transaction, i.e., the “sale” portion of the basis.  In this case, the donor’s last tax return can deduct the portion of the basis allocated to the annuity portion of the transaction not yet returned to the donor.  No additional recognition of capital gain is made.  (This makes sense because the donor, failing to live to his or her life expectancy, did not actually receive any further benefit.)

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