Thursday March 28, 2024

3.3.8 Deduction for Unrecovered Basis

Deduction for Unrecovered Basis

Investment in the Contract:   Under the bargain sale rules, a transfer for a gift annuity produces a charitable deduction and a contract value retained by the donor.

Income Tax Deduction:   The deduction is permitted for the value of the unrecovered basis.

Unrecovered Basis and Net Operating Loss:   In rare cases the donor-annuitant passes away with a net operating loss (NOL) under Sec. 172.

Reinsurance:   A charity that receives money from a donor in exchange for a charitable gift annuity may use that money to purchase a commercial annuity.

Investment in the Contract

Under the bargain sale rules, a transfer for a gift annuity produces a charitable deduction and a contract value retained by a donor-annuitant. Reg. 1.1011-2(a). The total gift less the charitable deduction equals the present value of the annuity. This amount may be described as the investment in the contract or, more simply, the contract value. With a cash annuity, the contract value represents the donor's principal. This principal is returned on a prorated basis each year to the donor-annuitant. Since it is a return of his or her principal, it is tax-free.

If the donor dies prior to his or her life expectancy, then the entire principal has not been returned. In this circumstance, the donor essentially has not received back his or her basis in the contract and could be considered to have a loss similar to a passive capital loss on an investment. However, Sec. 72(b)(3)(A) converts this unrecovered basis loss into an itemized deduction. Consequently, the donor is permitted a deduction on his or her final income tax return for the unrecovered basis.

Income Tax Deduction

An itemized deduction is permitted for the value of the unrecovered basis. Sec. 72(b)(4). The unrecovered basis deduction is not a miscellaneous deduction and therefore was not repealed by the Tax Cuts and Jobs Act of 2017 (TCJA). Sec. 67(b)(10). The charitable deduction, mortgage interest deduction, state and local tax deduction, unrecovered basis deduction, Sec. 691(c) deduction for previously-paid estate tax and other itemized deductions are reported on Schedule A. The unrecovered basis is deductible without limit and does not reduce the charitable deduction. It is usable during the final taxable year of the annuitant.

Unrecovered Basis and Net Operating Loss

In rare cases the donor-annuitant passes away with a net operating loss (NOL) under Sec. 172. While a passive capital loss is ordinarily not deductible for the NOL calculation, for Sec. 172 NOL purposes Sec. 72(b)(3)(C) transforms the unrecovered basis into an active trade or business loss. Therefore, it is deductible as part of the NOL calculation and, in most cases, the full NOL is available (in addition to the itemized charitable deduction and unrecovered basis deduction).

Example 3.3.8A - No Unrecovered Basis

Susan Green purchases a gift annuity with $10,000 of cash. Her charitable deduction is $5,006 and her investment in the contract is $4,994. She receives an 7.2% annuity. Each year until life expectancy, $531 of the $720 annuity is tax-free return of principal.

Susan lived two years beyond her projected life expectancy under the Sec. 72 mortality tables. She received the full $4,994 return of principal by her life expectancy and all subsequent payments were ordinary income. Sec. 72 (b)(2). When Susan passed away, she had zero unrecovered basis and her executor did not report an itemized deduction.



Example 3.3.8B - Unrecovered Basis

Mary Johnson purchases a gift annuity with $10,000 of cash. Her charitable deduction is $5,006 and her contract value is $4,994. She receives an 7.2% annuity. Each year until life expectancy, $531 of the $720 annuity is tax-free return of principal.

Mary passed away less than one year after funding the gift annuity. At that date, she received $265 of tax-free payments. The difference between the initial contract value of $4,994 and the $265 of tax-free income she received is $4,729. This amount is deductible as if it were a net operating loss attributable to a trade or business. Sec. 72(b)(3)(C).



Example 3.3.8C - Charitable Deduction, Unrecovered Basis and Net Operating Loss

Mary Jones is a spritely age 90 and runs "Adventure Travel for Seniors LLC (ATFS)." She regularly leads whitewater rafting trips on the Flathead River in Montana. Mary has 2018 AGI of $500,000 and makes a cash major gift of $250,000 to Favorite Charity. She funded a charitable gift annuity when she was 85 with Favorite Charity with $800,000 cash. The unrecovered basis of her gift annuity is $150,000. Because she has not been able to lead whitewater rafting trips this year, ATFS has a net operating loss of $50,000. Mary passes away on August 1, 2018.

Clara Green is her executor and must file her 2018 tax return. First, under the 60% cash gift deduction limit, Clara deducts $250,000 for Mary's cash charitable gifts. Sec. 170(b)(1)(G). Second, the $150,000 unrecovered basis qualifies as a Schedule A itemized deduction under Sec. 72(b)(3). Third, because for Sec. 172 purposes the $50,000 passive capital loss is transformed into an active trade or business loss, it is deductible for purposes of the NOL calculation and the NOL remains $50,000. Clara reports the $50,000 NOL deduction. With the three deductions totaling $450,000, Mary's taxable income is $50,000.



Reinsurance

A charity that receives money from a donor in exchange for a charitable gift annuity may use that money to purchase a commercial annuity. The commercial annuity pays the same amount as the CGA for the same term or life. This process is called reinsurance. Depending upon how reinsurance is used, it may reduce the charitable income tax deduction available to the donor when he or she funds a gift annuity.

First, some charities make the investment decision to reinsure gift annuities. The decision to reinsure is made without the input, consent or requirement of a donor. The gift annuity contract does not state that the gift annuity will be reinsured. In this case, the charity's decision to reinsure does not affect the donor's charitable income tax deduction.

Second, some charities agree to reinsure a gift annuity as part of their agreement with a donor. In these cases, the charitable gift annuity agreement states that an annuity payment obligation has been or will be reinsured by a designated commercial insurance company. In this case, the donor's charitable income tax deduction is reduced by the cost of the commercial annuity. For example, if an annuity is funded with cash of $10,000 and the amount paid (or required to be paid) to the insurance company to reinsure is $7,500, then the charitable income tax deduction will be calculated as $2,500 ($10,000-$7,500). Rev. Rul.62-137, 1962-2 C.B. 28.

Case Studies on Deduction for Unrecovered Basis

An Income Tax Deduction when a Gift Annuitant Dies Early:   Barbara Holmes had been a longtime volunteer and financial supporter of a national charity. She believed that whenever you can assist someone less fortunate with a "helping hand" it is your responsibility to do so. Because of her belief, she gave her time, love, and money whenever possible. In fact, she established a gift annuity with the charity many years ago.

Dying to Deduct, Part 1:   Abigail was a wonderful and spirited 80-year-old woman. Even in her advanced age, she worked in her garden, handled all of her finances and played golf each weekend. In addition to her busy schedule, she also made time to help at a local homeless shelter.

Dying to Deduct, Part 2:   Abigail Green was a wonderful and spirited 80-year-old woman. Even in her advanced age, she worked in her garden, handled all her finances and played golf each weekend. In addition to her busy schedule, she also made time to help at a local homeless shelter.

Dying to Deduct, Part 3:   Abigail Green was a wonderful and spirited 80-year-old woman. Even in her advanced age, she worked in her garden, handled all of her finances and played golf each weekend. In addition to her busy schedule, she also made time to help at a local homeless shelter.

Private Letter Rulings

PLR 200847014 Charitable Gift Annuity With Reinsurance Permitted:   Taxpayer desired to create a charitable gift annuity (CGA) with Charity. Under the proposed terms, Taxpayer would transfer $X to Charity and, in exchange, Charity would pay to Taxpayer an annual annuity of $Y for Taxpayer's life in equal quarterly installments.

PLR 200852037 Reinsurance of CGAs Permitted:   Charity, a qualifying organization under Sec. 501(c)(3), intends to offer charitable gift annuities (CGAs) in combination with a reinsurance plan.


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