Although there are important considerations that attend the contribution of real estate to a private foundation, if done carefully and with forethought, donors can mitigate compliance concerns while maximizing their charitable deductions.

A trend to watch is that of donors passing over large gifts to philanthropic organizations and an obvious example is real estate. Donating illiquid assets such as these present particular challenges. And very large gifts in general can be difficult to manage at times. (This is a subject that this publication has written about before.) The complexities of making such transfers work effectively can be considerable.

In this article, Jeffrey Haskell, who is chief legal officer for Foundation Source, walks through the terrain. The editors of this news service are pleased to share these thoughts with readers; they do not necessarily agree with all opinions of guest writers and invite readers to respond if they wish by emailing tom.burroughes@wealthbriefing.com

It is often assumed that donations of real estate to private foundations aren’t ideal because charitable deductions for such donations are typically limited to whichever is less: the donor’s cost basis or the fair market value. And donations of real estate are often dismissed out of hand, regardless of whether the property has depreciated or appreciated in value.

If a property has significantly depreciated in value below its original purchase price, donating it directly to the foundation isn’t recommended because the donor would lose the ability to realize the capital loss. Instead, donors typically are advised to sell the property and then contribute the proceeds. Even a donation of highly appreciated real estate is not usually recommended, as the donor would only be able to claim a cost basis deduction. Yet, despite the impediments that would seem to auger against donating real estate to a private foundation, there are circumstances in which these donations do make sense, both for the foundation and the donor.

For the foundation, a donation of real estate can be used to generate a steady stream of income and liquid funds. If the property is used for charitable purposes, the foundation may be able to qualify for exemption from property taxes. For the donor, contributing real estate to a foundation might be fiscally savvy as well. When weighing the merits of this kind of gift, important factors to consider include the donor’s basis in the property, the property’s fair market value, and whether the donation might be a component of an estate plan.

Here are some of the possible scenarios where donating real estate to a foundation makes sense:

1.    The cost basis and the fair market value of a property are similar.
This is sometimes the case in parts of the country where the real estate market is still recovering. If the donor’s property is worth approximately what he or she invested in it, donating it could be an appealing option.

2.    The donation of the real estate is part of an estate plan.
If this is the case, the basis in the property is stepped up, typically to the date of death, thereby ensuring that the basis is actually equal to the fair market value of the real estate, for at least that point in time. (1)

3. The value of the real estate has appreciated significantly over what the donor originally paid.
If a foundation has accumulated excess distribution carryovers from its preceding five taxable years, the foundation can make a special “conduit election,” which would entitle the donor to receive a fair market deduction (just as if it were donated to a public charity) instead of the more limited cost basis deduction.(2). This would obviate the need to sell the property and donate the proceeds. It also provides higher adjusted gross income (AGI) percentage caps (30 per cent for non-cash donations to a public charity vs 20 per cent for non-cash donations to a private foundation).

Important cautions for donors
Mortgaged property: Keep in mind that the donor should avoid contributing real estate encumbered by a mortgage. Doing so could result in a violation known as self-dealing because through the contribution the donor obtains debt relief. Even when the amount of indebtedness is small relative to the property’s value, it could still trigger penalties for which the donor (not the foundation) would be personally liable. The concern arises where the property is encumbered by a mortgage and the foundation either (a) assumes the mortgage, or (b) takes the property subject to a mortgage that was placed on the property by a “disqualified person” (3) within ten years of the donation of the property to the foundation.

If either of these is the case, the donation will be deemed by the IRS to be a bargain sale of the property to the foundation (because it is deemed sold for the amount of debt relief) and the penalty for which the disqualified person will be personally liable will be 10 per cent of the fair market value of the property (i.e. not 10 per cent of the debt relief).

Pre-arranged sale: Donors also should take pains to avoid a “pre-arranged sale,” which would occur if they were to negotiate the terms of a sale of property, donate the property to their foundation, and subsequently compel the foundation to consummate the sale. Although the application of this “pre-arranged sale” doctrine depends upon the unique facts and circumstances of the situation, the doctrine generally is applied when the foundation is under a binding commitment to consummate the pre-negotiated sale. (From the perspective of the IRS, the existence of a “binding commitment” may indicate that the foundation is being used to effectuate a property transfer to a handpicked buyer while enabling the donor to avoid the tax consequences that would ordinarily result from the donor’s sale of the property.)

Important cautions for foundations
There are also various issues to consider from the foundation’s perspective. For example, will the foundation use the property for charitable or investment purposes? If the property will be used for charitable purposes, such as housing foundation offices or conducting charitable programs, or if it will be leased (4) to a public charity rent-free or for a nominal sum, then the value of the property should be excluded from the asset base upon which the foundation’s annual 5 per cent payout requirement is based. (5)

However, if the property will be used for investment purposes, such as to generate rental income, the value of the property will be included in the asset base referenced to calculate the annual payout requirement. When used for investment purposes, the property needs to be valued using commonly accepted appraisal methodology. Instead of appraising the property annually, the foundation may opt to obtain a certified independent appraisal, which can stand for up to five years.

Additionally, when property will be used for investment purposes, the donor may want to consider whether the foundation has sufficient cash flow and liquid assets to satisfy the increased payout requirement that will result from the contribution to, and retention of, the property by the foundation. If property is donated for investment purposes and it is later converted to a charitable use, the fair market value of the property at the time of conversion would be treated as a qualifying distribution, and at that point would cease to be included in the foundation’s 5 per cent asset base.

Consideration should also be given as to whether the property itself could readily be sold to an unrelated party if the sudden need for cash arose, as the foundation could not sell the property to a disqualified person. If the foundation were to do so, a self-dealing violation would result, the sale would need to be rescinded, and the disqualified person would be personally liable for penalties.

Therefore, a donor should consider whether there are enough unrelated parties in the current market to whom the foundation could sell the property if desired.

Finally, in addition to federal tax law considerations with respect to ownership of real estate by a foundation, there may be state level implications. If a property is used for a charitable purpose (as described above), the foundation may qualify for an exemption from state property taxes. If, however, the property is used for investment purposes, the foundation may be responsible for property taxes in the state where the property is located. Either way, the foundation likely will be required to make ongoing filings in the state in which the property is situated.

Conclusion
Although there are important considerations that attend the contribution of real estate to a private foundation, if done carefully and with forethought, donors can mitigate compliance concerns while maximizing their charitable deductions. In addition, such contributions can be beneficial to their private foundation, whether put to charitable use or used to generate rental income to provide a reliable source of liquid funds for the foundation.

About the author
Jeffrey Haskell, JD, LLM is chief legal officer for Foundation Source, which provides comprehensive support services for private foundations.

References
1. A possible benefit for the foundation in these first two cases is that there may be no more than a nominal tax liability upon the ultimate sale of the donated property, since there would  be little gain. If there is no gain at all, there may be zero tax liability, but even with a liability, the foundation would only be taxed at a 2 per cent tax rate.
2.  Section 170(b)(1)(F)(ii) of the Internal Revenue Code of 1986, as amended.
3. Disqualified persons include substantial contributors to the foundation; foundation managers; owners of more than a 20 per cent interest of an organization that is a substantial contributor to the foundation; family members of the foregoing; and organizations in which any of those previously named parties hold, directly or indirectly, more than a 35 per cent interest
4. It is important to note that the foundation is not permitted to rent its property to a disqualified person under any circumstances, as a self-dealing violation would result.
5. The 5 per cent annual payout requirement, or “minimum distribution requirement,” is the amount that must be distributed by the end of the foundation’s tax year in order to avoid a tax penalty.