Sam is a widower, age 68 and in good health, with an estate of $2 million consisting of a $900,000 individual retirement account (IRA), an $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.

The Benefits

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

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 $143,073 using the 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 on 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 determines that the gift of the entire value of the home was too large, he can 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 will significantly decrease the value of the remainder interest, and can cause gift tax. The person receiving the right to live in the house (a second life estate) after Sam’s death will receive a gift of a future interest, and the gift will not qualify for the $10,000 annual exclusion. If Sam remarries and makes the gift to his wife, it will not qualify for the gift tax marital deduction because her interest will not start until Sam’s death.

Generally Sam can avoid this gift trap if he retains the right to revoke the second life estate during his lifetime. This removes the gift tax issue and places the property in Sam’s estate for estate tax purposes. Accordingly, the second life estate then qualifies 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 is 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 passes 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 is not affected.

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.

The special income tax exception that applies to Sam’s situation requires only that the remainder interest be in a personal residence. It does not have to be Sam’s primary residence and accordingly, if Sam has a vacation home, the remainder interest in that property can be used for the gift to charity. Of course, the definition of “home” also includes a condominium as well as a cooperative apartment. In fact, under the right circumstances, a house boat or a yacht will qualify as a personal residence.

Anything Goes