Thursday April 25, 2024
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5.1.1 Five & Five Rule on Debt
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Congress and the IRS have historically been concerned about transfers to charity of property encumbered by debt. There are several rules and provisions in the Internal Revenue Code designed to create limits on such transfers. If there were no rules, many individuals might choose to borrow significant sums against property and immediately transfer highly debt-encumbered property to charity. It is important to understand the rules on acquisition indebtedness, bargain sales and transfers of debt-encumbered property to charity.
Acquisition Indebtedness
Property acquired by a charity that is encumbered may give rise to "acquisition indebtedness." Sec. 514(c)(2)(A) states the general rule. The amount of the mortgage or lien is indebtedness even if the charity does not formally assume the debt obligation.
If a charity owns property with an acquisition indebtedness, then income earned by the debt financed property may subject the charity to unrelated business taxable income, unless the use of the property is substantially related to the exempt purpose. Sec. 514(b)(1)(A).
Five and Five Exception
If property subject to debt is transferred to charity, then the charity could be subject to unrelated business income tax upon the sale of that property. However, there is an exception for property that has been owned by the donor for more than five years, and the debt has been on the property for more than five years. Sec. 514(c)(2)(B). In this case, the charity may receive the property and there will be no acquisition indebtedness for a period of ten years. Therefore, if the donor passes the "five and five" test, then the charity may receive and sell the property within the ten-year period, without payment of any unrelated business income tax.
There is one important pitfall for the charity to avoid. The charity must receive the property subject to the debt, but may not assume the debt obligation. That is, the charity may receive title and make payments on the debt to defend its position and title, but it may not contractually obligate itself with the lender to pay the indebtedness secured by the mortgage.
Bargain Sales and Indebted Property
If a donor transfers property subject to a debt to charity, there is a bargain sale. Under the bargain sale rules, the equity in the property will produce a charitable deduction, but release of the indebtedness will be treated as a taxable event. Reg. 1.1011-2(a)(3); Rev. Rul. 81-163, 1981-1 C.B. 433.
The cost basis is prorated between the equity and the value of the debt. In most cases, the gift is an appreciated property gift, and the donor will recognize gain on the difference between the face value of the debt and the prorated basis. If property has been held for more than one year, then the donor will receive an appreciated property charitable deduction for the value of the equity and recognize long term capital gain (or ordinary income, if there is recapture for accelerated depreciation or at a 25% rate for straightline depreciation) on the relief from indebtedness.
Example 5.1.1A Bargain Sale
Jane Donor acquired land adjacent to favorite charity ten years ago for $50,000 cash. Six years ago, she needed funds for another investment and refinanced the property. The debt is now $100,000 and the fair market value is $200,000. Jane deeds the property to favorite charity.
The $50,000 of basis is prorated, with $25,000 allocated to the charitable gift portion of $100,000 and $25,000 allocated to the mortgage of $100,000. Jane receives an appreciated property charitable deduction in the amount of $100,000, but must recognize the difference between the $100,000 of debt and $25,000 of prorated basis, or $75,000 of long-term capital gain. Note that the charitable deduction is limited to 30% of adjusted gross income. Jane and her tax advisor believe that it will take two to three years to deduct the full $100,000 because of this rule.
Debt to Value Ratio
The bargain sale can enable an individual to transfer property to charity and still receive net tax benefits. However, if the debt is a very high percentage of the total value, then the tax paid on relief from the debt may exceed the tax savings on the gift portion.
Example 5.1.1B High Leverage Property
Jane Donor has a second parcel of property that is also adjacent to favorite charity. This land was purchased ten years ago for $50,000. However, six years ago, Jane refinanced this property. The debt on this property is now $160,000 and the fair market value is $200,000.
Jane deeds this property to favorite charity. The $40,000 of equity qualifies as a charitable deduction. However, on the $160,000 of debt, there is a prorated basis of $40,000 ($160,000 divided by $200,000 times $50,000). Jane Donor must recognize $120,000 of capital gain on the relief of indebtedness. The tax savings on the gift of $40,000 may offset some of the capital gain Jane would pay tax from personal assets in order to make this gift transfer. Because the debt to value ratio was 80%, it was not possible to have a zero tax transfer.
Debt-Encumbered Property for Gift Annuity
Some donors may be willing to transfer the debt-encumbered property directly to the charity. Others may desire to receive fixed payments as part of the plan. It is possible to transfer debt-encumbered property in exchange for a charitable gift annuity. This transfer is a double bargain sale.
The first bargain sale is a division of the property into the equity and the debt. The donor normally recognizes capital gain on the difference between the debt and the prorated basis. The equity and prorated basis are then used to determine the results with the charitable gift annuity.
Example 5.1.1C Gift Annuity for Debt Property
Jane Donor is considering options for her property. The land is adjacent to favorite charity and was acquired ten years ago for $50,000. It currently has a debt of $100,000 and value of $200,000. Jane transfers the property to charity in exchange for a charitable gift annuity.
On the first bargain sale portion, Jane has been relieved of the $100,000 in debt. She reports gain equal to $100,000 minus the prorated basis of $25,000, or $75,000. The potential tax on this gain at 15% is $11,250.
The $100,000 of equity with $25,000 of prorated basis is then exchanged for the gift annuity. Based on her age, the charity offers to pay 8.1%. There is a partial bypass of the $75,000 gain. The income tax deduction is $56,838.
Since Jane must pay $11,250 of tax on the relief of indebtedness.
Jane receives the $8,100 annuity for life. $6,350.40 of the yearly annuity payment is tax-free. This amount represents a partial return of the $25,000 of prorated basis over Jane's estimated life expectancy.
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Case Studies on Five & Five Rule on Debt
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Private Letter Rulings
PLR
201246040 Church's Property Is Exempt From Debt-Financed Property Provision:
Church was incorporated in a particular state on Date 1. Church purchased three parcels of land. Parcel One was purchased on Date 2, Parcel Two on Date 3 and Parcel Three on Date 4.
PLR
9015049 Debt Not Permitted on Assets for Unitrust:
In PLR 9015049, the Service set forth a specific requirement concerning any asset encumbered by debt. Previously, it was thought permissible to transfer an asset into a charitable remainder trust so long as the debt was at least five years old and the owner had held title for at least five years. However, in PLR 9015049, the Service took the position that if there is any personal liability on the debt, under Sec. 677(a), the payment of debt with potential personal liability causes the unitrust to become a grantor trust. Since the regulations in Sec. 664 preclude a unitrust from being a grantor trust, the trust is disqualified under the rationale of the Service.
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