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Wednesday October 4, 2023
Article of the Month
Golden Age for Gift Annuities - Part IV
However, in 1946 the fifteen million Americans who served in the military during World War II returned home and started families. As a result, the Baby Boomer generation (born 1946 to 1964) has nearly double the number of individuals turning age 75 each year when compared with the Quiet Generation. Because the senior Baby Boomers are now age 76, for the next two decades there will be a steady growth in the size of the primary gift annuity market. With a dramatic increase in potential annuitants, the coming decade is likely to be a golden age for gift annuities.
Two creative gift annuity concepts for donors to consider are the gift annuity for home and a gift annuity funded through the gift of a unitrust income interest.
Gift Annuity for Home
The gift annuity for home is a combination of two qualified charitable agreements. The donor may desire to live in his or her home for life and receive annuity payouts. If the donor were to create a life estate, the remainder could be transferred to charity and the donor would receive a charitable deduction.
However, with a gift annuity for home, the donor exchanges the remainder value of the home for a gift annuity. In effect, it is a combination of a life estate and a gift annuity. The donor retains the right to live in the home for life and the remainder value is transferred by deed to the charity for the gift annuity. The donor receives a partial charitable deduction for the gift portion of the remainder value and the annuity contract value is the balance of the remainder amount.
Remainder Interest in a Personal Residence
The first step with a gift annuity for home is to value the remainder interest. This value is the same as with a gift of the remainder interest without a gift annuity. A donor may receive a charitable deduction for the transfer of a remainder interest in a personal residence, farm or ranch. Sec. 170(f)(3)(B)(i). The donor deeds the personal residence or farm to a qualified exempt charity and reserves a life estate. The life estate may be a personal right for the donor to use the property, or more commonly a right to use of the property during the donor's lifetime. The latter option would allow the donor to lease the property and receive rental payments during his or her lifetime.
A remainder interest may be transferred in any property used by the donor as a personal residence. Personal residence is defined as "any property used by the taxpayer as his personal residence even though it is not used as his principal residence." This may include the taxpayer's vacation or even stock owned by a taxpayer as a tenant-stockholder in a cooperative housing corporation (as those terms are defined in Secs. 216(b)(1) and (2) and if the dwelling which the taxpayer is entitled to occupy as such stockholder is used by him as his personal residence). Reg. 1.170A-7(b)(3).
Undivided Interests in Life Estates to Solve a Debt Problem
It is also possible to transfer an undivided percentage of the remainder interest. For example, a remainder interest in part of a farm may be transferred to charity. Rev. Rul. 78-303. Alternatively, the remainder interest may be divided with a portion of the remainder transferred to family with the balance transferred to charity. Rev. Rul. 87-37. However, if the charity receives a minority interest in the remainder, it is possible that the minority interest should be subject to a valuation discount.
The ability to transfer part of a remainder interest is beneficial if there is debt on the property. It may be possible to combine a remainder interest gift with a bargain sale. Sec. 1011(a). For example, the charity may purchase a portion of the remainder interest sufficient to pay the debt, and the donor may then give the charity the balance of the remainder interest.
"Maintenance, Insurance and Taxes" Agreement
Since the charity is acquiring real estate, it is essential to create a "Maintenance, Insurance and Taxes" agreement. See GiftLaw Pro Chapter 3.7.2. As life tenant, the donor is obligated to perform normal maintenance, maintain insurance and pay the property taxes on the home. One fortunate tax benefit for the donor is that it is permissible for the donor to use the home-sale exclusion of $250,000 single person or $500,000 married couple filing jointly. Sec. 121(d)(8)(a). This exclusion has the effect of raising the basis on the annuity contract value. For many donors, the entire exclusion ratio amount will be tax free.
The donor is able to live in his or her home for life, receives a substantial charitable income tax deduction and benefits from the annuity payouts, with a majority of the payment often tax-free. This is clearly a very attractive plan for many senior donors.
John and Mary Enjoy Their Home and Added Income
John and Mary like their home and plan to live there for the rest of their lives. However, they also desire a tax deduction and additional income.
John and Mary transfer the remainder interest in their $800,000 home to a charity in exchange for a gift annuity. Based on Treasury tables, the remainder value is $568,200. The two-life annuity of 5.9% results in a payment of $33,525 annually to John and Mary. In addition, the charitable deduction of $246,386 may save $59,133 in their 24% tax bracket.
They elect under Sec. 121(d)(8)(A) to allocate their $500,000 home-sale exclusion to the sale of the remainder interest (which is used to fund the gift annuity). Under this provision, the home sale capital gain exclusion may be used for a remainder interest. With the increased basis in the contract portion of the gift annuity, there is no capital gain recognition. Since they also have substantial income from their IRAs, they are delighted that the deduction plus the generous tax-free income will produce substantially increased after-tax income for their lifetimes. Not only do they enjoy tax benefits and much greater after-tax income, they have the joy of knowing that their home will eventually fund the mission of their favorite charity.
The charity should consider the gift annuity for home agreement as a purchase of real estate. This plan is most attractive for the charity if the donors are age 80 or older. If the property is in a residential area that is likely to appreciate, the acquisition can be attractive. Alternatively, if the charity is attempting to expand its campus and can acquire surrounding homes through the gift annuity for remainder interest method, the acquisition cost typically will be one-third of the price paid compared with the cost if the charity waits and purchases the home from the estate.
The charity should calculate the internal rate of return through a cost/benefit analysis. The cost to the charity is the payment of the annuity plus the interest cost. Presumably, the annuity amount will reduce the charity's endowment. In addition, during the lifetime of the donor, the charity is also foregoing interest on the amount withdrawn from its endowment to fund annuity payments.
The benefit to the charity is the value of the house, plus appreciation during the life of the donor, less cost of sale after the donor passes away. For donors age 80 and above, the annualized internal rate of return can equal 15% or more. For very senior donors who are holding desirable property, this plan can be quite beneficial for both the donor and the charity.
Unitrust to Gift Annuity Rollover
In PLR 200152018, a unitrust donor was interested in rolling over the income interest of the unitrust into a gift annuity. The donor had created a standard 5% unitrust that made payments quarterly for his lifetime. A single charity was a remainder recipient and held a vested interest in the unitrust remainder.
The charity desired to use the remainder value as a current gift. While it is possible for a nonprofit with a vested remainder to borrow against that interest and fund a current project, the donor and charity proposed a better solution. The donor desired to receive income and was not willing to gift the entire income interest to the charity at present. However, if the income interest from the 5% unitrust could be converted to a gift annuity, the donor could receive an acceptable fixed payment stream for life and the charity could use the remainder value immediately for a current project.
The donor and his counsel requested four specific rulings. These were as follows:
1. That the donor would receive an income tax deduction for a portion of the value of the income stream transferred to charity for the gift annuity.
2. There would be a charitable gift tax deduction for the same portion.
3. The transfer of the unitrust income interest for a gift annuity would not accelerate underlying capital gain in the income interest.
4. The percentage of capital gain and basis as of the date of creation of the trust could be utilized for calculating the tax-free portion of the gift annuity payouts.
Income Tax Deduction
A charitable gift to a public charity normally qualifies for an income tax deduction. Sec. 170(a)(1). However, if an individual makes a transfer of a partial interest, then the deduction is usually denied. There are several exceptions to the partial interest rule. A charitable deduction is allowed for a partial interest gift if the transfer is to a charitable remainder unitrust, a charitable remainder annuity trust, a retained life estate or a pooled income fund. Sec. 170(f)(3)(A).
In addition, a gift annuity is considered a bargain sale. When a property interest is transferred in exchange for a gift annuity, there is a charitable income tax deduction under the bargain sale rules. Reg. 1.1011-2(a)(1).
If a donor created a partial interest in a manner to attempt to circumvent the rules, a charitable deduction could be denied. Reg. 1.170A-7(a)(2)(i). However, in this case, the unitrust was properly created and qualified for a charitable income tax deduction. Since the decision to convert to a charitable gift annuity occurred at a later time, there was no circumvention of the partial interest rule. Therefore, the income tax deduction for the value of the income interest transferred for a gift annuity was permitted.
Susan Donor Makes a Unitrust to Gift Annuity Rollover
Assume that at the time of conversion to a gift annuity, the charitable remainder unitrust holds assets valued at $100,000. Based on the Sec. 7520 Applicable Federal Rate and IRS Pub. 1458, assume that the value of the income interest is determined to be $60,000, with the value of the vested charitable remainder interest equaling $40,000.
Susan Donor transfers the $60,000 income interest in exchange for a charitable gift annuity. The gift annuity is determined under Sec. 72 and applicable regulations to have a charitable gift value of $35,000 and an annuity contract value of $25,000. Based upon these assumptions, the charitable deduction will be $35,000. Susan benefits from the charitable deduction and receives the annuity payments for life. The assumed value of the income interest for the $60,000 gift annuity is $25,000.
Valuation of UT Income Interest
Unitrust income and remainder interests are valued using the methods of Reg. 1.170A-7(a) and IRS Publication 1458. Based upon the age or ages of the income recipients on the date of the income interest gift, the applicable federal rate, the frequency of payment, the unitrust corpus value and the unitrust amount, the present value of the income interest may be determined. If the entire unitrust income is transferred to charity, then the amount calculated using the Treasury method is usually the deduction value. Section 664(e) of the Code provides that the value of the income interest is based on the stated payout percentage.
Because this is a gift of an appreciated asset with value over $5,000, both a contemporaneous written acknowledgement and an appraisal by a qualified appraiser are required.
At one time, the valuation of the income interest for a net plus makeup unitrust (NIMCRUT) or net income unitrust (NICRUT) required the use of the lesser of the AFR or the stated unitrust payout percentage. With the passage of the Protecting Americans from Tax Hikes Act of 2015, Sec. 664(e) was amended to provide that the valuation of an income interest in a NIMCRUT or NICRUT may use the stated payout percentage.
Selection of Gift Annuity Rate
Most charities follow the rate schedules established by the American Council on Gift Annuities. However, with rollovers or conversions from life estates, pooled income funds, unitrusts or annuity trusts, the donor may be interested in a higher rate than the standard ACGA number. For example, if a unitrust has $100,000 in corpus and is a 5% trust, then the payout could equal $5,000 per year. Assuming that the income interest is valued at $60,000, then a 7% annuity would pay $4,200 per year. Thus, it may be preferred by the donor that the charity would pay a higher-than-normal rate in order for the income from the gift annuity to be reasonably close to the unitrust payout.
Is it permissible for a charity to pay a higher rate in order for the gift annuity payout to be reasonably close to the unitrust income? There are two potential limitations on paying a higher rate. First, a charitable gift annuity must qualify with a minimum 10% charitable deduction. Sec. 514(c)(5). The rate on the $60,000 gift annuity may be increased, but not to the point where the charitable deduction would be reduced below $6,000. Second, some state insurance commissioners will not permit an individual annuitant to receive a higher annuity percentage. For example, in California the same maximum rate must be paid to all annuitants of a given age. In some regulated states, a charity may file a rate schedule different from the American Council on Gift Annuities rates, but that nonprofit is required to follow that schedule uniformly for all annuitants.
Charitable Gift Reduction Rules
The donor desired a charitable deduction for a gift of a capital asset. If the income interest were deemed to be an ordinary asset, the charitable income tax deduction would be reduced by the value of the ordinary interest. Sec. 170(e)(1)(B). Fortunately, a life interest is a capital asset. Rev. Rul. 72-243, 1972-1 C.B. 233. Thus, the transfer in exchange for the gift annuity does produce an appreciated property-type charitable deduction.
Gifts to public charities are subject to a limitation of 60% of adjusted gross income for cash gifts and 30% for appreciated property gifts. Sec. 170(b)(1)(C). Since this is a gift of a capital asset, the deduction limit in the year of the gift is 30%, with a carry forward for up to five additional years of any excess deduction.
Gift Tax Deduction
Transfers to public charities ordinarily qualify for both income and charitable gift tax deductions. Sec. 2522(a). Partial interests may be deductible under certain agreements. A charitable gift deduction for a partial interest results from a transfer to a charitable remainder trust or a pooled income fund. Sec. 2522(c)(2).
However, under Rev. Rul. 86-60, 1986-1 C.B. 302, a person who created a charitable remainder annuity trust was permitted to transfer the entire annuity interest to the charitable remainder recipient. In Situation 1 of this ruling, the entire income interest was transferred to the remainder charity and qualified for a charitable deduction.
Since the split interest in the charitable remainder unitrust was created for a charitable purpose, rather than a private purpose, the transfer will be permitted. The transfer of the income interest in exchange for the gift annuity will result in a charitable gift tax deduction for the value of the charitable interest in the gift annuity.
No Capital Gain Acceleration
The income interest in the unitrust was determined to be a capital asset. The transfer of this capital interest in exchange for a gift annuity is a bargain sale. Sec. 1011(a). If a gift annuity is created with appreciated property and the donor is the annuitant, the gain may be prorated over the donor's life expectancy. Reg. 1.1011-2(c), Example 8.
Normally, there is no acceleration of gain upon transfer of a capital asset to charity unless there is some specific "trigger." For example, the transfer of an installment note or a commercial annuity to charity or to a charitable instrument triggers the underlying capital gain.
However, since the donor is the annuitant in this case and there is no specific triggering of gain for transfer of an income interest that is a capital asset, there is no immediate recognition of capital gain.
Prorated Basis Allocated to Annuity
With a charitable gift annuity, a portion of the return is ordinary income, and a portion is the excluded amount. The excluded amount equals the contract value divided by the expected return over the lifetime of the individual. Reg. 1.72-9, Table V. This ratio of each payment is tax free if the annuity is funded with cash, or partly capital gain and partly tax-free return of basis for an annuity funded with appreciated property.
If a gift annuity is funded with a long-term capital gain asset, the gain may be recognized over the lifetime of the donor/annuitant. Reg. 1.1011-2(c), Example 8.
With the unitrust to gift annuity rollover, the owner of the unitrust life interest would prefer to allocate a prorated amount of cost basis to the annuity contract. A unitrust grantor would hope to determine the ratio of basis to fair market value at the time the trust was created and to assume that same ratio for purposes of calculating the basis allocable to the gift annuity agreement.
However, when a transfer is made of a unitrust income interest, the prorated basis is generally disregarded. Sec. 1001(e)(1). The exception to this rule is when the donor transfers his or her entire interest in a single transaction. Sec. 1001(e)(3).
Since the transfer was created in two steps, with the creation initially of the charitable unitrust and then a subsequent conversion to the gift annuity, the Service determined that the prorated basis should not be allowed. Therefore, the payout from the gift annuity of the excluded amount will be all capital gain under this interpretation.
Megan Gifts an Income Interest for a Gift Annuity
Megan created a net income plus makeup charitable remainder unitrust ("NIMCRUT") about 20 years ago with $1 million of appreciated stocks. Because interest rates were substantially higher at that time, Megan's NIMCRUT was drafted with a 10% payout. Unfortunately for Megan, interest rates have now plummeted to 3%. As a result, her trust distributes about $30,000 a year, which is all taxed as ordinary income. In addition, because her trust is invested almost solely in bonds, Megan's trust is still valued at about $1 million. While Megan would like realized capital gain to be paid out of her trust, that trust provision and strategy was not contemplated when she funded the trust.
Knowing of Megan's disappointment and needing to fund a building project now, the charitable remainder beneficiary of the NIMCRUT has approached Megan about a possible change to her plan. How can Megan receive a tax deduction, retain part of her income and make a large charitable gift today? Can charity also benefit from her solution?
The charitable remainder beneficiary suggested that Megan transfer her income interest to the charity in exchange for a charitable gift annuity. It is important to note that Megan may transfer only her income interest and not the entire value of the trust for a gift annuity, since the vested remainder already belongs to the charity.
The value of Megan's income interest is determined by doing a present value calculation (in accordance with Sec. 7520). Because the PATH act of 2015 applies to valuation of NIMCRUT income interests, the 10% stated payout in the unitrust document is used (not the applicable federal rate for the month of the conversion). Based upon her age, using the AFR as the assumed payout and the $1 million value of the trust, Megan's income interest is $459,860. At her age, the American Council on Gift Annuities rate is 7.5%. Therefore, Megan will receive an annuity of $34,489.50 every year with no further fluctuations.
Megan will also receive a charitable income tax deduction for the transfer of her income interest for a gift annuity. The deduction will equal the excess of the value of her unitrust income interest over the value of her gift annuity contract. This deduction is a capital gain-type gift, so it will be limited to 30% of her AGI. In addition, Megan's income taxes will be lower. With her NIMCRUT, all the income was taxed as ordinary income. However, with a gift annuity, the income will be taxed at much lower capital gain rates.
Finally, the charity will benefit greatly from this solution. After Megan transfers her income interest, the charity will own both the income and remainder interest. Therefore, the trust will merge and the trustee may distribute all the trust assets to the charity. The charity will place $459,860 in the gift annuity reserve, and benefit from a current gift of the $540,140. See PLR 200152018.
Specimen Gift of Unitrust Income Interest for Gift Annuity Language
City, State Zip Code
Re: Charitable Remainder Unitrust ______________
I am currently the income recipient of a one life charitable remainder unitrust that was created on (July 4, 2022) with trust grantor (George Washington, 123 Main Street, Anytown, Illinois 00000) and initial trustee (Charitable Organization, 456 Main Street, Anytown, Illinois 00000). The unitrust federal ID number is __________________.
As life income recipient, I have retained the power under section ________________ of that trust document to add, remove or modify by name or percentage the qualified exempt charitable remainder recipients. I declare my intention through this signed and dated writing to modify the charitable remainder recipients by irrevocably designating a percentage of both income and remainder interests to a qualified exempt charity and retaining the balance of the income interest and the right to modify the charitable remainder recipients for the balance of the trust.
It is my intention to use my income interest in this charitable remainder unitrust to establish a charitable gift annuity. Therefore, I hereby irrevocably designate qualified exempt charity ____________________________, of City, State, as the recipient of _____% of both the income and remainder interests in unitrust number _________________, with the income interest being exchanged for a charitable gift annuity.
The trustee is authorized to recognize that under the doctrine of merger of income and remainder interests, the named exempt charity now owns all interests in the specified percentage of this remainder unitrust. Therefore, the trustee may distribute that portion of the trust principal to the named exempt charity.
I understand that this transfer to a charitable organization may qualify under IRC Sec. 170 provisions for a charitable income tax deduction for the actuarial value of the gift passing to charity via the charitable gift annuity.
[Optional (Depending on state law): I am forwarding a copy of this letter to the state attorney general for the State of __________________.]
____________________________ Date: ____________
Unitrust Income Recipient
Golden Age of Gift Annuities
With many Baby Boomers reaching their mid-70s in the coming decade, charitable gift annuities are entering a golden age. Donors will appreciate the fixed payments and generous fixed rates, combined with the ability to provide for family members and loved ones. Many donors may be interested in additional creative structures for funding a gift annuity. Some donors will decide funding a charitable gift annuity with their home is an attractive prospect or using an existing unitrust income interest to fund a gift annuity. These gift annuity funding structures benefit the donor and create legacy gifts with profound impact on the receiving charity's mission.