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Donating to charity can be a meaningful way to distribute your assets as part of an estate plan. Still, it’s important to carefully consider certain rules before moving forward with charitable giving. One key rule to understand is the estate plan five and five exception. This exception plays a significant role in how trusts and withdrawals are managed, and it may directly impact your charitable contributions. In today’s blog from the Law Office of Bryan Fagan, we’ll explain what the estate plan five and five exception means and why it might matter in your estate planning process. If you have questions about this topic, our office is here to help—schedule your free consultation today.
Transferring property to a charity of your choice creates an effective way to help an organization, religious group, or other entity through your estate plan. The United States Congress and the IRS have consistently reviewed how property transfers to charities change when debt encumbers the property. The IRS applies specific rules that limit how these transfers take place. Without such rules, you, I, and anyone else could borrow large amounts of money against property and then transfer that property to a charity. That scenario would let a person take on significant debt and remove the collateral from their estate.
Charity property gifts and acquisition indebtedness in estate planning
When a charity acquires property encumbered by debt, the Internal Revenue Code defines this as acquisition indebtedness. Even if the charity you select does not assume the debt tied to the transferred property in your estate plan, the loan or mortgage attached to the property still counts as indebtedness for the charity or religious group.
Suppose you and your spouse support a local charity that you regularly helped financially during your life. You also volunteered time and built a close relationship with the organization. Because of this, you wanted to make sure that your estate plan supported the charity meaningfully. When you drafted your will, you included language directing your estate to pass property to the charity.
You need to recognize that transferring property with debt to the charity carries tax consequences. If the charity holds property with acquisition indebtedness, income generated by that debt-financed property becomes taxable. The IRS labels this taxation as unrelated business taxable income. The law provides an exception if the charity uses the property for its exempt purpose. Because this rarely happens, the charity would most likely face taxation under the unrelated business taxable income provision in the Internal Revenue Code.
How does the five and five exception help charities?
If you transfer property with debt to a charity through your will, the charity named in your will may owe unrelated business income tax once the charity sells the property. The five and five exception could apply in this case. If you owned the property for more than five years and the debt remained on the property for more than five years, the exception applies. That rule prevents the indebted property from subjecting the charity to extra tax.
In this case, the charity receives the property and avoids acquisition indebtedness for 10 years. You need to determine if you meet the five and five requirements. If you meet them, your charity can sell the property within 10 years without paying unrelated business income tax.
Bargain sales and tax implications for charitable property transfers
The charity may face more problems beyond this. The charity receives the property with debt but has no obligation to pay it. In practice, the charity receives the title because you named it in your will, and the charity cannot make debt payments to maintain title. Even if the charity makes payments, it does not put itself in a position with your former lender to repay the indebtedness secured by the mortgage.
When you transfer property with debt to a charity, the law calls this a bargain sale. The Internal Revenue Code allows you to claim a charitable deduction for equity in the property. If the lender releases the debt, that action creates a taxable event. Whenever taxes come into play, you must recognize how your gift may burden the charity. That means the IRS requires a cost basis calculation. The final cost basis determines how much tax the charity owes.
Cost basis and appreciated property gifts in charitable giving
You split the cost basis between your equity and the debt tied to the property. When you gift appreciated property to a charity, you recognize gain on the difference between the debt and the prorated basis. If you owned the property longer than a year, you may claim a charitable deduction equal to the value of your equity. Any savings from transferring debt may trigger long-term capital gains tax.
This can sound confusing in theory, so let’s use an example. Assume Joe Smith bought a plot of land next to his favorite charity 10 years ago for $100,000 in cash. Later, Mr. Smith needed cash for an investment, so he refinanced the land. The debt on the property increased to $200,000, while the property value rose to $300,000.
The $100,000 basis prorates into two halves: $50,000 attaches to the charitable gift portion of $200,000, and $50,000 attaches to the $200,000 mortgage. Mr. Smith receives an appreciated property charitable deduction of $200,000. He also must recognize $150,000 of taxable gain. We calculate this by subtracting the $50,000 prorated basis from the $200,000 mortgage, leaving $150,000 taxable at the long-term capital gains rate.
What does the debt-to-value ratio have to do with anything?
A bargain sale lets you transfer property to a charity and still receive tax benefits. You need to weigh the size of the debt compared to the total property value. If the debt is large, the tax owed on debt relief could outweigh the benefit of the charitable deduction.
For example, Mr. Smith owns a second plot of land next to the charity, purchased 10 years ago for $50,000. He refinanced again to raise cash for another investment. That refinance increased the debt to $160,000, while the property value reached $200,000.
If Mr. Smith decided to deed the property to the charity of his choice, then the $40,000 equity position would count as a charitable deduction. What Mr. Smith would also need to keep in mind is that of the $160,000 in debt, there will be a basis amount of $40,000. This amount can be arrived at by taking the $160,000 debt and dividing it by the value of the property, which in this case was $200,000. This amount multiplied by $50,000 would help you arrive at the $40,000 prorated basis. Therefore, the capital gains rate for taxes will be applied against the $120,000 difference between the amount of debt and the prorated basis of $40,000.
What is a debt-encumbered property for a gift annuity?
You may still decide to transfer property encumbered by debt directly to a charity, despite the issues already explained. You may also choose to receive fixed payments as part of the plan. Also, you can transfer debt-incurred property to a charity in exchange for a charitable gift annuity. That transfer qualifies as what tax law calls a double bargain sale, using the terminology described earlier in this blog.
Equity, debt, and charitable gift annuities in property transfers
The first bargain involves dividing the property into equity and debt. In most cases, you recognize capital gain on the equity difference between the debt and the prorated basis, as shown earlier. You can also factor the prorated basis into the calculation to determine the charitable gift annuity amount owed to you.
Let’s use Mr. Smith and his estate to illustrate this. Mr. Smith wants to decide what to do with his property. If the land he owns next to the charity was acquired 10 years ago for $50,000, carries $100,000 in debt, and holds a value of $200,000, he may choose to transfer the property. In return, the charity provides him with a charitable gift annuity.
Two bargain sale portions and tax impact in charitable transfers
You need to account for two bargain sale portions in this type of transfer. The first portion eliminates Mr. Smith’s obligation to pay the $100,000 debt. Mr. Smith reports a gain equal to $100,000 and subtracts the $25,000 prorated basis, leaving $75,000. Mr. Smith and his accountant calculate the potential tax on that $75,000 gain. The prorated equity portion of the property can then be exchanged for a charitable gift annuity. This exchange may allow a total or partial bypass of the gain. Mr. Smith also claims an income tax deduction as a result. He must still pay tax because the transfer relieved him of indebtedness.
The charity pays Mr. Smith an annuity based on several factors. The annuity covers the prorated basis and continues for the remainder of Mr. Smith’s life.
Thinking about planning your estate? Consider working with an experienced estate planning attorney
Today’s blog post from the Law Office of Bryan Fagan involves a very specific subject in the world of estate planning. The ability to transfer property to a charity is not something that is reserved for the ultra-wealthy or rich. Any of us can decide to leave money, property, or both to a charity as a part of a will or trust. However, when the property being left is some kind of real property, then special care needs to be taken in how this transfer is being done. Doing this out of the kindness of your heart will not produce the type of benefit intended unless careful consideration is given.
Even if you want to serve that charity or religious organization that has benefited you or the lives of other people that you know, then it may not be possible unless you have the help of an experienced estate planning attorney. An experienced estate planning attorney can guide you in choosing the right charity or organization for your property. They’ll help you review your goals, weigh your options, and ensure your gift goes where it can make the greatest impact.
An attorney can guide you through the tricky laws on charities and taxes that most people don’t have time to learn. With family, work, and daily life on your plate, relying on an experienced estate planning attorney can save you from costly mistakes and give you peace of mind.
Conclusion
Understanding the estate plan five and five exception gives you clarity and control when shaping your legacy. By knowing how this rule works, you can make smarter decisions about charitable giving, trust withdrawals, and protecting your assets from unnecessary tax issues. With the right planning, you can use the five and five exception to ensure your loved ones and chosen charities benefit from your estate in the way you intend.
Again, given how hard you have worked to build property and how diligent your attempts to create an estate plan have been, the last thing you want to do is see the property you wanted to leave to a charity end up harming that charity in some way. Understanding the five and five exception and similar rules can be the difference between taking advantage of a favorable situation to being generous while benefiting a charitable organization as well. Thank you for your interest in today’s blog post, and we hope that you will join us again tomorrow as we continue to post relevant and interesting information on the world of Texas estate planning.
Questions about the material contained in today’s blog post? Contact the Law Office of Bryan Fagan
If you have any questions about the material contained in today’s blog post, please do not hesitate to contact the Law Office of Bryan Fagan. Our licensed estate planning attorneys offer free-of-charge consultations six days a week in person, over the phone, and via video. These consultations are a great way for you to learn more about the world of Texas estate planning as well as about how your family circumstances may be impacted by the filing of a probate case.
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