Debt-Encumbered Property
The majority of real estate is encumbered by debt. When the real estate is transferred, the debt previously recorded with the County Registrar of Deeds remains on the property. If the obligation is solely against the property, the debt is termed "non-recourse." If the obligation is against both the property and the owner personally, the debt is termed "recourse."
The transfer of debt-encumbered property to charity is also treated as a bargain sale. Reg. 1.1011-2(a)(3). The relief of indebtedness triggers gain to the extent that the debt exceeds the allocated basis.
Charitable Deduction - Appreciated Property
In nearly all cases, bargain sales involve the transfer of appreciated property with a mortgage. For example, assume that a donor transfers to charity land worth $100,000, in which there is a $40,000 mortgage. The land also has a cost basis of $40,000. Since the excess of the fair market value over the price paid is $60,000, the donor receives an appreciated property charitable deduction of $60,000. Reg. 1.1011-2(c), Example 1. As is true of all appreciated property gifts, the charitable deduction is limited to 30% of adjusted gross income, with a potential carry forward for five additional years. Sec. 170(b)(1)(C).
The order for deductions will be the current year cash deductions, taken to 60% of AGI, then current year appreciated deductions taken to the lesser of 30% of AGI or the excess of 60% of AGI over cash gifts. The deductible amount will normally exceed $5,000 and therefore must be based upon an appraisal by a qualified appraiser. Reg. 1.170A-13(c). The appraisal may be made up to 60 days prior to the gift and not later than the date the taxpayer's return is due (with extensions). Since the taxpayer desires to know the value of the deduction and the donor and the charity may negotiate as to the amount to be paid for the asset, it can be beneficial to have a preliminary or full appraisal completed prior to the bargain sale.
Charity Considerations
The receiving charity must consider several factors when a donor offers a gift of debt-encumbered property. First, if the property can not easily be sold, the charity may determine that its best course of action is to defend its position in title by making payments on the mortgage. Second, if the debt is less than five years old and the donor has owned the property for less than five years, there is an acquisition indebtedness. Sec. 514(c)(2)(B). If property not qualified for the "5 and 5" exception is received by a charity and then sold, the charity would pay tax on the sale since the sale would then be unrelated debt-financed income. Sec. 514(b)(1).
There are two ways for the charity to avoid payment of unrelated business income tax. First, if the donor has owned the property for five years and the debt is five years old, a 10-year period is permitted to sell the property. Second, if the property fails the "5 and 5" test, then the charity may receive the property, pay the indebtedness and hold the property for at least 12 months. Since the definition of debt-financed income is property on which there has been debt within the 12-month period prior to the sale, the charity should be permitted to sell the debt-free property after the 12-month period with no unrelated business income tax. Sec. 514(b)(1).
Donor Motivation
Donors who give encumbered property to charity desire both a tax deduction and relief from the debt obligation. If the debt is two-thirds or less of the fair market value of the property, it may be possible for the donor to make the gift to the charity and for the income tax savings on the charitable gift to offset the taxable gain on the relief of indebtedness.
As the proportion of debt to value is lower, there will be greater charitable tax savings and less gain recognition. In most cases, the gift transaction will be completed when the charitable tax savings equal or exceed the tax payable on the gain recognition.
Example 2.1.2A Gift of Property with Debt
Mary Mortgage purchased a duplex several years ago for $60,000. Her accountant has taken straight-line depreciation and the cost basis is now $40,000. The apartment has appreciated in value to $200,000. There currently is a debt on the property that was created six years ago. The balance on the debt is $100,000.
Mary Mortgage offers to give the property to her favorite charity. If the charity accepts the property, with an appraised value of $200,000, she receives a charitable gift receipt for $100,000 and reports a sale of $100,000 on the relief from indebtedness.
The $40,000 adjusted basis is prorated between the mortgage and the charitable gift. The mortgage of $100,000 thus is reduced by $20,000 prorated basis, producing an capital gain of $80,000.
Since the depreciation was straight-line, there is no recapture and the $100,000 contribution saves $30,000. The $80,000 capital gain on relief of indebtedness produces a tax of $12,000. The net tax benefit is $18,000.
By making the gift to charity, Mary no longer has the obligation to pay the mortgage and receives a net tax saving of $18,000.
Since the debt is more than five years old and Mary has owned the property for more than five years, the charity is able to receive the property and sell it without payment of unrelated business income tax, so long as the sale is within the next 10 years. The charity sells the property within the first year and nets $100,000. Mary Mortgage has been able to make a substantial gift to the charity, with positive tax results.
