In certain instances the College is willing to consider establishing a gift annuity that is funded with a gift of real estate. Due to the nature of gift annuities, and the complexities of real estate, gifts of real estate present special planning issues.
A Key Planning Issue
Because the annuity payment amount must be based on the appraised value (per the IRS), a key concern is that selling expenses, and the potential for a sale price below the appraised value, will result in sale proceeds significantly less than the appraised value. This reduction increases the effective gift annuity rate, thereby increasing the risk that there will be nothing left for charity when the annuity ends.
To minimize this risk, most charities apply inexact discounts for selling expenses and market risk to reduce the value on which the annuity will be based.
FOR EXAMPLE: Charities will estimate the selling expenses and then apply a market risk discount of 5% to 20% in order to establish a value on which to calculate the annuity payment. The gift annuity is issued, and the payment determined, at the time of the gift based on this discounted value. When the property sells, if the market risk discount was too small, the effective gift annuity rate increases. If the market risk discount was too large, the gift annuity payment will be less than it could have been.
The Net-Proceeds Alternative
Rather than applying inexact discounts, CMC uses an innovative and more precise approach we call the Net-Proceeds Gift Annuity. Perhaps the following Scenario best illustrates CMC’s approach.
Mr. Smith, age 74, owns a rental property with an appraised value of $750,000, and a cost basis of $225,000. He transfers the property to the College on March 1, in exchange for an agreement that the College will execute a charitable gift annuity payable to Mr. Smith as of the day the College receives the net cash sale proceeds from escrow.
In early April, the property sells and, on May 15, the College receives $705,000 from escrow. At his age, Mr. Smith is entitled to a gift annuity rate of 8.2%. Thus, based on $705,000 of net cash sale proceeds, the gift annuity will pay him $57,810 annually.
Because the IRS requires the gift annuity rate to be stated as a percentage of the gift value, we divide the annuity amount of $57,810 by the gift value of $750,000 to determine an Interpreted Gift Annuity Rate, which, in this case, is 7.708%. Thus, the gift annuity will be executed using a gift date of March 1, a gift value of $750,000 and an annuity rate of 7.708%.
Because the annuity was funded with appreciated real estate, $30,472 of the payment will be taxed as capital gain, $13,059 will be tax-free and $14,279 will be taxed as ordinary income for the first 13.2 years, per the IRS. Thereafter the entire annuity will be taxed as ordinary income.
Of the $525,000 in total capital gain, Mr. Smith must report only $402,208 of the capital gain. This is reported over 13.2 years, in annual installments of $30,472, as shown above. The remaining $122,792 of capital gain is not subject to tax.
Mr. Smith is also entitled to a charitable deduction of $175,417. He may claim this amount up to 30 percent of his adjusted gross income. Unused deductions may be carried forward for up to five additional years.