Case Study of a Tax-Smart Strategy

Sam is a widower, age 68, in good health and has an estate of $2 million consisting of a $900,000 Individual Retirement Account (IRA), $800,000 securities and cash portfolio, and a $300,000 home. Sam wants to leave his estate primarily to his children but also wants to make a substantial gift or bequest to his favorite charity. Sam is looking for a way to do this simply while being tax smart.

Since Sam is counting on his IRA and securities for income and flexibility, and wishes to continue to live in his home, an outright gift to charity is not an appealing option at this time. The solution Sam is considering is gifting a remainder interest in his home to his favorite charity.

How It Works

Income tax rules contain a specific exception that will allow Sam to both make a gift to charity of his home that won’t take effect until his death and receive a current income tax deduction for the present value of the remainder interest.

The Benefits

The present gift of a remainder interest in Sam’s home will result in three tax benefits:

1.         Based on the current value of the residence and Sam’s age, Sam will be able to receive a charitable income tax deduction of $126,897, using the Internal Revenue Service (IRS) discount rate for the month of the transaction (7520 rate). Sam will need to get a qualified appraisal of his home since the charitable deduction will exceed $5,000. Also, in making the calculation of the present value of the remainder interest, Sam may choose the 7520 rate for the month in which he makes the gift, or for either of the two preceding months. The remainder interest will be valued higher and the charitable deduction will be larger if a lower 7520 rate is used.

2.         Sam’s gift of the remainder interest in his home will also qualify for a gift tax charitable deduction, so he will not have to pay a gift tax on the transfer.

3.         Title to Sam’s home will pass to charity upon his death, and his heirs will not owe estate tax on it.

A Flexible Option

This planning technique can be flexible to meet Sam’s specific needs. For example, if Sam determined that the gift of the entire value of the home was too large, he could leave the charity a fractional portion of the remainder interest.

Another alternative is for Sam to give the right to use the personal residence after his death to someone else before the charity receives it. However, this would significantly decrease the value of the remainder interest, and could cause gift tax. The person receiving the right to live in the house (a second life estate) after Sam’s death would be receiving a gift of a future interest and the gift would not qualify for the $10,000 annual exclusion. If Sam remarried and made the gift to his wife, it would not qualify for the gift tax marital deduction because her interest would not start until Sam’s death.

Generally this gift trap can be avoided if Sam retains the right to revoke the second life estate during his lifetime. This would remove the gift tax issue and would put the property in Sam’s estate for estate tax purposes. Accordingly, the second life estate would then qualify Sam’s wife for the estate tax marital deduction.

A mortgage on the residence at the time of the gift may make the well-intentioned gift more complicated. The contribution of the mortgaged property would be considered a bargain sale, with the donor “receiving” an amount equal to the outstanding debt on the property. The result is gain to the donor.

Additionally, the value of the income tax deduction is affected by the outstanding mortgage. If the existing term of the mortgage extends beyond Sam’s life expectancy, then the gift to charity is in theory subject to a liability. When Sam dies at his expected age, the remainder interest will pass to charity subject to the unpaid mortgage balance. Accordingly, Sam’s income tax deduction probably should be reduced by the amount of the present value of that liability. On the other hand, if the remaining term of the mortgage is less than Sam’s life expectancy, Sam can agree to hold the charity harmless from the mortgage liability so the value of the remainder interest will not be affected.

Smart Choices

Making gifts to charity during your lifetime almost always offers more tax benefits than transfers occurring after death. However, many people do not want to jeopardize their present financial security by donating liquid assets to charity. Giving a remainder interest in a personal residence could be the answer for people who wish to accomplish both charitable and income tax objectives.

Home Improvement

Presumably, Sam will take care of all expenses related to the residence including repairs, maintenance, improvements, taxes, special assessments and utilities during his lifetime. If a successor life estate is being given to someone, then Sam’s estate plan should make arrangements for the payment of these costs.

Anything Goes