Donating to charity is one of the ways that you can choose to allocate your assets in an estate plan. However, there are some aspects of charitable giving that you should think through clearly before you begin to engage in that kind of planning. One of those aspects of charitable giving that is important for you to be aware of is encapsulated within the five and five exception. In today’s blog post from the Law Office of Bryan Fagan, we are going to discuss what the five and five exception are and how they may be relevant to your estate plan. If you have questions about the material, you read in this article please do not hesitate to contact our office today for a free-of-charge consultation.
Transferring property to a charity of your choice is a great way to help an organization, religious group, or other entity with your estate plan. However, The United States Congress as well as the IRS have always been thoughtful about how transferring property to charities may be impacted by the degree to which the property is encumbered by debt. There are different rules that the IRS has on the books as far as how those transfers are limited. But for these rules, you, I, and anyone else may choose to borrow a lot of money against property and then transfer that property to a charity. This would allow a person to take out large sums of debt and then make it so their estate no longer owns the collateral.
When a charity acquires property that is encumbered by debt this can give rise to a situation that is known in the Internal Revenue Code as acquisition indebtedness. Even if the charity of your choice did not assume the indebtedness on the property transferred to them in your estate plan the amount of the loan or mortgage on the property would still represent the amount of indebtedness taken on by the charity or religious organization.
Let’s say that you and your spouse have a local charity that you all have always sought to help financially during your life. Not only that, but you have also volunteered your time and gotten to know the organization quite well. As a result, you wanted to make sure that that charity was highly considered within your estate plan. When you created your will, you made sure to include language in the will that would allow the charity to receive property out of your estate.
What you need to be aware of is if you transferred property to that charity upon your death you need to be aware of what the indebtedness on the property is. The reason this is the case is that if the charity owns property with acquired debt on it, then any income earned by that debt-financed property could be subject to taxation. The specific kind of taxation will be known as unrelated business taxable income. The exception to this rule would be if the use of the property was related to the exempt purpose. However, since this is rarely the case the charity would likely be subjected to the unrelated business taxable income provision under the Internal Revenue Code.
How does the five and five exception help charities?
If the property is transferred to a charity and your will is subject to debt, then the charity named in your will could be subject to the previously mentioned unrelated business income tax once the property is sold. This is where the five and five exception could come into play. If the property has been owned by you for more than five years and the debt has been on the property for more than five years then this exception would apply. The property subject to the indebtedness would not subject the charity to any additional tax.
In this situation, the charity would be able to receive the property and for 10 years the charity would not be subject to any acquisition indebtedness. For this reason, it is incredibly important that you be able to determine whether you pass the so-called five and five requirements. If you do, then your charity would be able to receive and then sell the property within 10 years all without paying any unrelated business income tax.
However, this is not where the story ends as far as potential problems for the charity. Here, the charity needs to receive the property with the debt but does not have to assume any obligation to pay the debt. How this works out in a practical sense is that the charity will be able to receive the title to the property because of being named as the recipient in your will and then couldn’t even make payments on the debt to make sure that it maintains its position as the title holder. However, even in making payments on the debt it does not necessarily put itself in a position with your former lender to pay any amount of the indebtedness secured by the mortgage loan.
When you decide to transfer property to a charity that is subject to a debt then this is known as a bargain sale. Under the Internal Revenue Code, any equity in the property will create a charitable deduction. However, if the indebtedness is released then that will be treated as an event that will trigger taxes being owed. Whenever we talk about taxes being owed in any situation you must be aware of the situation that your generosity may be putting the charity in. As a result, there is a certain cost basis that will need to be determined. Whatever that cost basis ends up being can determine how much tax is owed.
For these purposes, the cost basis is a prorated amount between the equity in the property and the specific amount of debt tied to the property. In most situations, the gift made to the charity is an appreciated property gift. In that case, you will recognize gain on the difference which is determined between the amount of debt on the property and the prorated basis. If the property has been owned by you for more than one year then you would receive an appreciated charitable deduction for the value of the equity owned in the property. There would be a long-term capital gain tax applied to any amount of money that you save on the indebtedness by transferring the property to the charity.
Admittedly, all of this can get cumbersome when talking about it in theoretical terms. As a result, we would like to spend a moment here going through this situation in greater detail by using a hypothetical circumstance that may match your own. Let’s assume that Joe Smith acquired a plot of land directly next door to his favorite charity 10 years ago for $100,000 cash. At a certain point, Mr. Smith learned of a possible investment opportunity that he needed cash 4 immediately. As a result, you decided to refinance the property and the debt on the property increased to $200,000. The property in question is worth $300,000.
The basis amount of $100,000 would be prorated, $50,000 would be spread to the charitable gift portion of the $200,000, and 50,000 would be allocated to the mortgage amount of $200,000. Mr. Smith would receive an appreciated property charitable deduction for $200,000 but, $150,000 would need to be recognized on his taxes. We arrived at this amount by subtracting $50,000 from the mortgage amount of $200,000 this $150,000 amount would be subject to taxes at the long-term capital gains rate.
What does the debt-to-value ratio have to do with anything?
The net result is that a bargain sale can allow you to transfer property to a charity of your choice and still be able to receive some tax benefits. What we need to consider is if the debt is a large figure relative to the total value of the property, then whatever tax is paid on the relief from that debt could be more than the savings on the gift portion.
How this works out is if Mr. Smith from our prior situation owned a second plot of land next to the charity and this land was purchased 10 years prior for $50,000. Again, Mr. Smith needed cash to be able to take advantage of another investment opportunity and as a result refinanced the property. In that case, the debt on the property could become $160,000 while the value of the property was $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?
Despite what we have just covered, you may be still in a position where you want to transfer the property encumbered by debt directly to a charity. Or, on the other hand, you may want to receive payments as part of the plan that are fixed. It can be done where you transfer debt-incurred property to a charity in exchange for something called a charitable gift annuity. In this situation, it would qualify the transfer as what is known as a double bargain sale using the terminology touched on earlier in today’s blog post.
The first of the two bargains would be the division of the property into equity and debt. You would, in most circumstances, recognize capital gain on any equity in the property difference between the debt and the prorated basis as we saw earlier. As well as the prorated basis could be plugged into the equation to determine how much of a charitable gift annuity you may be owed.
Again, let’s use Mr. Smith and his estate as an example for us he discussed this point further. Let’s say that Mr. Smith is considering what he can do with his property. If the land that he owns by the charity was acquired 10 years ago for an amount of $50,000, had debt on it worth 100,000 and whose value was $200,000 then he could decide to transfer the property. In return for him having done so, a charitable gift annuity could be made available to him.
Remember, there will be two bargain sale portions to consider. The first would involve Mr. Smith no longer having an obligation to pay that debt of $100,000. Mr. Smith could report a gain equal to $100,000 and subtract that prorated basis of 25,000 to get to an amount of 75,000. From there, Mr. Smith and his accountant could figure out what the potential tax is on this $75,000 gain. The equity in the property with the prorated basis could be exchanged for a gift annuity. There could be a total or even partial bypass for this gain. An income tax deduction could be made by Mr. Smith as a result. He would still have to pay a tax due to his indebtedness having been relieved by transferring the property to a charity.
An annuity could be paid to Mr. Smith based on several factors. Whatever the prorated basis could be, an annuity could be paid to cover that prorated basis 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 paid to 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. Having an experienced estate planning attorney by your side can help in many ways. For instance, what if you were searching for the right charity or religious organization to donate property to after you pass on? An experienced estate planning attorney could help you examine your life, see what kind of goals you have, and then decide which charity or religious organization would be best served by having left the property. You may quickly find out that what you had considered as far as property that should be left to others may be better suited to be left elsewhere.
Next, an attorney can help you by walking you through complicated and somewhat convoluted statutes regarding charities, taxes, and everything in between. Today’s blog post was a deep dive into a very specific area of the law. However, it is not uncommon for people in your situation to run afoul of these sorts of laws if you do not understand the various intricacies. With so much going on in your life: a family, work, personal responsibilities, and other interests it would be unrealistic to expect that you would have a working knowledge of these sorts of laws. This is where an experienced estate planning attorney can pay major dividends for you and your family.
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.
Bryan Fagan, a native of Atascocita, Texas, is a dedicated family law attorney inspired by John Grisham’s “The Pelican Brief.” He is the first lawyer in his family, which includes two adopted brothers. Bryan’s commitment to family is personal and professional; he cared for his grandmother with Alzheimer’s while completing his degree and attended the South Texas College of Law at night.
Married with three children, Bryan’s personal experiences enrich his understanding of family dynamics, which is central to his legal practice. He specializes in family law, offering innovative and efficient legal services. A certified member of the College of the State Bar of Texas, Bryan is part of an elite group of legal professionals committed to ongoing education and high-level expertise.
His legal practice covers divorce, custody disputes, property disputes, adoption, paternity, and mediation. Bryan is also experienced in drafting marital property agreements. He leads a team dedicated to complex family law cases and protecting families from false CPS allegations.
Based in Houston, Bryan is active in the Houston Family Law Sector of the Houston Bar Association and various family law groups in Texas. His deep understanding of family values and his professional dedication make him a compassionate advocate for families navigating Texas family law.
