Charitable Contributions

The category of charitable contributions is an important exception to the general rule that personal expenses are not deductible. For critics, the charitable contributions deduction is an inefficient tax expenditure for pet projects of the wealthy; but for advocates, the nongovernmental funds the deduction creates are put to more effective use than any federally spent dollar. Of even greater significance is the fact that Congress has granted this exception because it believes charitable organizations relieve the government of significant welfare costs. And given the complexity of Code section 170 (”Charitable, etc., contributions and gifts”), one could argue this legislative grace also provides a windfall for tax lawyers and public accountants.

Charitable contributions are deductible below the line, that is, they are classified as itemized deductions. As a general rule, individuals who itemize can deduct the fair market value of property donated to qualified organizations. There are exceptions to this rule, however. In brief, for individuals who itemize, the ceiling for the charitable contributions deduction is 50%, 30%, or 20% of taxpayer’s adjusted gross income (AGI), depending on the character of asset donated and the type of donee organization. In any event, total charitable contributions for the year cannot exceed 50% of the taxpayer’s AGI and may be subject to the phase out of itemized deductions for high AGI taxpayers; in 2008, the phase out will affect individuals married filing jointly with AGI over $159,950 ($79,975 for married filing separately). Charitable contributions that exceed any of the ceilings can be carried forward for five years.

For the most part, deductible charitable contributions are donations of cash or property to or for the use of a qualified charitable organization. Qualified charitable organizations include U.S. governmental entities and any donee organized primarily for charitable, educational, literary, religious, or scientific purposes. In a part sale, part gift transaction, the bargain element (market price less selling price of property) is deductible as a charitable gift, but the donor must apportion basis between the gift and sale components. Amounts paid for admission to fundraising events are deductible only if the taxpayer can demonstrate that a clearly identifiable portion of the admission price is a charitable gift. However, the cost of bingo, lottery, or raffle tickets is not deductible because the purchaser, by reason of having a chance to win a valuable prize, receives full consideration. (In this article, I focus on the charitable contributions deduction for individuals, but for those interested, a corporation can generally deduct for charitable contributions up to 10% of its taxable income.)

Nondeductible charitable contributions include money or property given to individuals, foreign organizations, civic leagues, chambers of commerce, social and sports clubs, lobbying organizations, homeowners’ associations, political parties, or individuals running for public office. Even if made to a qualified donee, contributions earmarked for particular individuals are not deductible. No deduction is allowed for the value of personal services donated to a charitable organization, but a taxpayer can deduct any out-of-pocket expenses incurred while rendering such services. Also, if a charity is given the right to use property but the transfer is for less than the taxpayer’s entire interest, then no deduction is allowed for rent or other value of this right. Instead, the use is viewed not as a gift but rather as a grant of a privilege to the charity. The same type of restriction applies to donations of stock without surrender of voting rights: the IRS considers this to be an incomplete and therefore nondeductible transfer because the donor retains a substantial interest in the property.

In larger terms, a taxpayer cannot take a charitable deduction if he or she benefits from the transaction; any contribution made with the anticipation of economic benefit rather than from a “detached and disinterested generosity” [Commissioner v. Duberstein, 363 U.S. 285 (1960)] is not deductible. Put differently, a contribution is deductible only if made with donative intent and to the extent it exceeds the market value of any benefit received. The burden of proof is on the taxpayer to establish that a contribution does in fact meet these standards.

Several other basic principles apply to charitable contributions. As mentioned earlier, donations must be “to or for the use of” a qualified charity in order to be deductible; “to” a charity is obvious, but “for the use of” means “in trust for” the charity, or, in the words of Justice O’Connor, “the recipient charity exercises control over the donated funds” [Davis v. United States, 495 U.S. 477 (1990)]. In short, to be deductible, the transfer must be directly to the charity or a trust for the charity. Second, the charity must have a possessory interest in the property; this restriction rules out the deductibility of future interests in tangible personal property, but gifts of a fractional or future interest in the donor’s personal residence or farm are deductible for the value of the interest. Another exception to a strict reading of the possessory interest rule is the deduction for a charitable remainder annuity trust or unitrust. These trusts are qualifying split-interest trusts that have noncharitable beneficiaries; a deduction is also available for a pooled income fund, which is essentially the same as a charitable remainder annuity trust or unitrust, except that it is maintained by a public charity authorized to accumulate remainder interests for several donors. Congress has prescribed strict restrictions on these split-interest trusts to ensure that charities actually receive amounts previously deducted by donors. Third, a gift of an income interest is deductible only if the income remains taxable to the donor; this provides a foundation for the deduction and prevents donors from realizing a double tax benefit. Finally, gifts other than cash over $5,000 ($10,000 for nonpublicly traded securities) must be supported by an appraisal. For more on documents needed to substantiate charitable contributions, click on , (pdf file), and (pdf file).

Qualified public charities (also known as “50% organizations”) include:

  1. Churches, church associations, church conventions, mosques, synagogues, etc.;
  2. Educational organizations maintaining a regular faculty and student body;
  3. Government-supported organizations administering property for qualified educational organizations;
  4. Hospitals and medical research organizations;
  5. Governmental units;
  6. Corporations, trusts, foundations, or community chests formed in the United States and operated exclusively for charitable, educational, literary, religious, or scientific purposes;
  7. Corporations, trusts, foundations, or community chests formed in the United States and organized for the promotion of national or international amateur sports competition or the prevention of cruelty to children or animals;
  8. Private operating foundations, organizations that distribute substantially all of their income for charitable purposes; and
  9. Private nonoperating foundations that distribute all of their income to public charities.

Qualified private charities (also known as “30% organizations”) include:

  1. Private nonoperating foundations not meeting the payout requirements for 50% organizations;
  2. Veterans’ organizations;
  3. Fraternal societies; and
  4. Nonprofit cemeteries.

Click on to see a more comprehensive review of qualified charitable organizations and for a list of charitable organizations eligible to receive deductible contributions of cash or property.

The deductibility of charitable contributions for individuals is subject to the following ceiling amounts:

  1. 50% public limitation category. 50% of the donor’s AGI for (a) contributions of cash and ordinary income property (property that if sold rather than donated would cause the taxpayer to recognize income other than long-term capital gains) or capital gain property held short term to 50% organizations or (b) contributions of capital gain property or unrelated use property (i.e., property unrelated to the donee organization’s primary charitable purpose) to 50% organizations where any amount deducted in (a) or (b) is reduced by the property’s unrealized appreciation or depreciation that would be recaptured as ordinary income on a sale.
  2. 30% public limitation category. 30% of the donor’s AGI for contributions of capital gain property or appreciated, publicly traded stock held long term (but limited to 10% of the value of outstanding stock) to 50% organizations.
  3. 30% private limitation category. 30% of the donor’s AGI for contributions of cash and ordinary income property or capital gain property held short term to 30% organizations provided any amount deducted is adjusted downward for unrealized appreciation or depreciation that would be recaptured as ordinary income on a sale.
  4. 20% private limitation category. 20% of the donor’s AGI for (a) contributions of capital gain property or unrelated use property to 30% organizations where the amount deducted is reduced by the property’s unrealized appreciation or recaptured depreciation producing ordinary income or (b) contributions of appreciated, publicly traded stock held long term (no more than 10% of the value of outstanding stock) to 30% organizations.

In a nutshell, a taxpayer may deduct, up to 30% of his or her AGI, the fair market value of long-term capital gain property donated to public charities; but only basis for donations of ordinary income property, short-term capital gain property, and unrelated use property to public or private charities. Regardless of type of property or charitable donee organization, if the property’s fair market value is below its basis, the deduction is limited to fair market value.

An algorithm to figure the overall charitable contributions deduction is detailed below:

  1. Contributions in the 50% public limitation category are limited to 50% of AGI, hereafter referred to as the 50% AGI maximum.
  2. Contributions in the 30% public limitation category are limited to the 50% AGI maximum minus contributions in the 50% public limitation category.
  3. Contributions in the 30% private limitation category are limited to the 50% AGI maximum minus contributions in the 50% public and 30% public categories.
  4. Contributions in the 20% private limitation category are limited to the 50% AGI maximum minus contributions in the 50% public, 30% public, and 30% private categories.

More information on the charitable contributions deduction can be found in the following resources:

Many happy returns, Roger

Basis

An important reason for using the category “key concepts” to describe the federal income tax in this web log is to illustrate important relationships among these concepts and, in the process, provide the reader with the insight needed to master our enormous, and enormously complex, Internal Revenue Code. In short, to really understand the key concepts individually, one must understand them in concert.

Despite the adjective “gross,” is a net concept and not the same as . For example, the taxable portion or gain on a transaction involving the sale or disposition of property is equal to the amount realized (or gross proceeds) less return of the cost investment in the property. The taxpayer’s investment in the property is known as basis; it starts with , that is, acquisition and installation costs and is adjusted upward for substantial capital outlays (e.g., expenditures not deductible as current expenses, namely, additions, betterments, improvements, legal fees for defending title) and downward for capital returns (depreciation or other modes of cost recovery, deductible casualty losses, insurance reimbursements, tax credits, etc.). Adjusted basis is an accounting maneuver that not only makes the federal income tax a tax on net gains but also preserves the tax attributes of the property sold so that in the case of, say, a depreciable property, the government will eventually get its fair share because basis in the hands of the buyer reflects downward adjustments for depreciation taken by the seller. In sum, transactions that increase (decrease) a property’s basis will decrease (increase) gain or increase (decrease) loss upon sale or other disposition.

Of course, if the adjusted basis exceeds the amount realized, then the taxpayer experiences a loss on sale that could be deductible as a short-term or long-term capital loss provided the asset involved is not personal in nature.

As a general rule, is equal to the taxpayer’s cost investment in the property. Basis comprises cash paid or other property exchanged and any mortgage or liability assumed in the purchase of the property in question. If several properties are purchased together, basis is allocated according to each property’s proportional share of the fair market value (FMV) of the assets acquired; in this calculus, if a property is worth 60% of the total FMV upon purchase, the basis allocated to it will be 60% of the original purchase cost. (Note: FMV represents what a willing and informed buyer would pay a willing and informed seller in a fair and open transaction, what is also known as an arm’s length transaction.) More complicated calculations are required in determining . And if a transaction involves the acquisition of property in an exchange not involving cash or notes, the buyer’s basis in the property acquired is a substituted basis, that is, the new property is assigned the cost basis of the property given up–all this being grounded on the assumption that if the exchange is made at arm’s length, then the properties exchanged must be of equal value.

In the case of property acquired from a decedent, basis is stepped up or down to fair market value at the date of decedent’s death or an alternate valuation date six months after decedent’s death. The alternate valuation date may be elected only if it will reduce the value of decedent’s estate and the federal estate tax liability. Basis for property distributed before the alternate valuation date is FMV at the date of distribution or other disposition.

The basis of property acquired by gift also deviates from the general rule; it is the lesser of fair market value or the donor’s adjusted basis at the time of gift. And in contrast to inherited property, the basis of gifted property (in the lexicon of tax law, a “gifted property” is not an exceptionally intelligent property but rather something that is given away) is adjusted for tax paid on appreciation up to the time of transfer. However, if property acquired by decedent within one year of death by gift is transferred back to donor or donor’s spouse upon donee’s death, the rule that property acquired from a decedent is stepped up to fair market value is abandoned and the transferred property is assigned a basis equal to the donee’s immediately before death. This provision in the Code denies the tax benefit of a stepped-up basis to the donor in a transaction that is in substance .

Special rules apply to what is known as “loss property.” If a donor’s adjusted basis in a gifted property is greater than its fair market value, then the donee’s basis in the property is FMV for purposes of determining loss by donee on subsequent sale or disposition. (Remember the truism that the lower a property’s basis, the lower the loss upon subsequent sale.) The general effect of this rule is to disallow as a loss to donee any decline in value of a property while in donor’s hands thereby limiting the deductible loss upon subsequent sale or disposition to the decline in the property’s value while in donee’s hands. In short, the donor cannot pass on a loss built into a donated property. Please note this rule applies only to donated property sold at a loss. If the property is sold for an amount in excess of the donor’s adjusted basis, then donee will recognize a gain on the transaction.

For those interested, additional relevant articles on the concept of basis are listed below:

Many happy returns, Roger

Mortgage Interest

Before the Tax Reform Act of 1986, interest was deductible regardless of the loan’s purpose. After the Tax Reform Act, with an important exception for home mortgage interest, only interest expenditures with a business purpose are deductible. In short, although home mortgage interest is a distinctly personal expense, Congress made an exception to the Tax Reform Act’s strict rule prohibiting deductions for personal interest expenses by maintaining in the Code an itemized deduction for interest on home acquisition or home equity loans secured by a qualified residence. A home is a qualified residence if it is (1) the taxpayer’s main home or (2) a second home used by the taxpayer or close relatives for more than the greater of 14 days or 10 percent of the number of days it is rented at fair market value, what I term as the “personal use vs. rental use test.” If the second residence is not used by taxpayer (or close relatives) or rented during the year, the personal use vs. rental use test does not apply and the second home is considered a qualified residence for tax purposes. Many prospective buyers worry that Congress may eliminate the .

For mortgages taken out after October 13, 1987, acquisition indebtedness is defined as debt incurred to acquire, build, or substantially improve a qualified residence and secured by such residence. The (pdf file) is interest paid on acquisition debt up to $1,000,000 ($500,000 for married filing separately). Moreover, for interest payments to qualify as a deductible expense, the indebtedness cannot exceed the lesser of the residence’s fair market value or the taxpayer’s adjusted basis in the residence; interest paid on borrowings against unrealized appreciation is not deductible. However, taxpayers with qualified residence debt over the $1,000,000 ceiling may consider converting a second home into a full-time rental property. Click on for more details.

Taxpayers with 2007 adjusted gross income over $156,400 ($78,200 for married filing separately) are subject to a . In addition, interest on home equity indebtedness is not allowed when figuring the unless the loan is used to buy, build, or substantially improve a qualified residence.

Home equity indebtedness is debt secured by a qualified residence that exceeds acquisition indebtedness. For interest to be deductible, home equity debt cannot exceed the lesser of (1) $100,000 ($50,000 for married filing separately) for qualified residences combined (i.e., main and second homes) or (2) the fair market value of the residence in question minus total acquisition debt outstanding on that home. Other than the general prohibition against using loans with deductible interest to purchase tax-free investments, home equity loans can be spent (or squandered) for any purpose.

A home refinancing loan to buy, build, or substantially improve a first or second residence is considered home acquisition debt with deductible interest payments provided it does not exceed the adjusted basis of the home (i.e., principal balance outstanding on the original acquisition debt immediately before refinancing plus any portion of the new loan used to improve the residence) or cause total acquisition debt to exceed $1 million. If a home refinancing loan is used for any other purpose, the excess of debt over the home’s adjusted basis is classified as home equity debt and deductible provided it doesn’t exceed the $100,000 maximum for all home equity indebtedness. And if the refinancing proceeds are used for mixed purposes, the combined $1,100,000 acquisition/equity limit applies. A summary and warning: once you pay off all or part of the original mortgage, you lose the corresponding interest deduction and cannot get it back by refinancing unless refinancing includes the cost of substantial improvements to the home (thus increasing the tax basis of the home) or is classified as home equity indebtedness subject to a $100,000 limit for all outstanding home equity debt.

Any home improvement loans that cause the total amount of acquisition indebtedness to exceed $1,000,000 are considered home equity loans and subject to a $100,000 limit and other restrictions for home equity indebtedness. Interest on indebtedness in excess of the combined $1,100,000 acquisition/equity limit is a nondeductible personal expense. The restrictions imposed by the Tax Reform Act of 1986 do not apply to mortgages taken out before October 14, 1987; that is, the rules for home mortgage indebtedness booked before this date are, in effect, grandfathered by the Revenue Act of 1987. Thus, pre-October 14, 1987 mortgages are treated as acquisition indebtedness (but such indebtedness reduces the $1 million limit on new, post-October 13, 1987 acquisition debt) and interest is fully deductible regardless of purpose (but not deductible if used to purchase tax-exempt investments). If pre-October 14, 1987 debt is refinanced after October 13, 1987, it is considered acquisition indebtedness if it doesn’t exceed the original balance outstanding immediately before refinancing and does not extend beyond the original term of the loan or, in the case of a loan without a fixed term, the term of the first refinancing (but not to exceed 30 years).

Generally speaking, points on home mortgages must be charged for the use of money in order to be deductible. Points charged for specific services (appraisal fees, notary fees, settlement fees, etc.) are not interest and therefore not deductible. Points paid on refinancing must be amortized over the life of the loan unless the refinancing is but a temporary step in obtaining permanent financing. However, points allocable to that portion of a refinancing loan used to substantially improve the main residence are deductible in the year paid. Points on a mortgage for a second home must be amortized over the loan term.

Additional information on the mortgage interest deduction is listed below:

Many happy returns, Roger