The gift of a remainder interest in a personal residence or a farm to a charity entitles the donor to an immediate charitable income tax deduction which can be used of off-set taxable income, or keep the donor in a marginally lower income tax bracket. The Tax Code regulates the form and type of charitable gifts that are tax deductible. One such rule is the recognized gift of the remainder interest in a home or farm to a charity.
A gift of a remainder interest in a personal residence or farm produces favorable income tax results due to the current low interest rate environment. The low interest rate is used to value the life estate retained by the donor. The retained use of the real estate is the equivalent to the donor’s retained income stream; the lower the interest rate, the less the retained life estate is deemed to be worth. As a result, the more the gift of the charitable remainder is worth, the larger the current income tax charitable deduction.
For purposes of this tax rule, any personal residence, like a cottage, will suffice. A farm is broadly defined to include any land that is used by the taxpayer, or his or her tenant, for the production of crops or livestock.
The size of the donor’s charitable income tax deduction will depend upon several variables, including: (i) the fair market value of the residence or farm; (ii) the value of the land on which the residence sits; (iii) the useful life of the residence; (iv) the salvage value of the residence at the end of its useful life; (v) the donor’s age at the time of the gift; and (vi) the required federal applicable interest rate that is used when the gift is made to value the donor’s retained life estate.
The charitable gift is made in the form of a simple deed. The donor gives to the charity a deed to the residence or farm, reserving in the body of the deed a life estate. The deed is then recorded. As the life estate holder, the donor is responsible to pay the real property taxes, keep the residence insured, pay the utilities and generally pay for property maintenance expenses. On the donor’s death, his or her life estate ends. The charity simply files with the Register of Deeds a copy of the donor’s Death Certificate. The residence or farm is not part of the donor’s estate, nor will it be subject to probate.
Assume that a donor, age 70, in July 2020 contributed a remainder interest in his $1.0 million waterfront cottage to the local hospital, which previously had been named as a charitable beneficiary of the donor’s estate.
Due to the size of the donor’s available federal estate tax exemption, the donor’s estate would no longer benefit from any federal estate tax charitable deduction. Accordingly, the donor decided to accelerate that charitable bequest to a lifetime charitable gift to take advantage of the federal income tax charitable deduction.
The gift to the local hospital is in the form of a recordable warranty deed in which the donor retained a life estate. There is no mortgage on the cottage.
The donor will continue to use and occupy the cottage for the rest of his life. He will also be responsible for the payment of real property taxes, home owner’s insurance premiums, and general maintenance and repair expenses as the life estate holder.
In July, the applicable federal rate of interest used to value the donor’s life estate was 0.6%. The donor will be entitled to a federal income tax charitable deduction in 2020 of $919,000. For comparison purposes, had the federal interest rate been 6.0%, the donor’s charitable income tax deduction would only have been $480,000.
As noted in the example, one of the reasons for the gift of the remainder interest was because the donor’s estate would no longer benefit from a federal estate tax charitable deduction due to the dramatic increase in the federal estate tax applicable exemption amount. Any existing estate plans that feature a charitable bequest should be revisited, since it is likely that there will be no use for the charitable estate tax deduction, as there will be no taxable estate after the decedent’s available estate tax exemption is used.
There could be yet another reason to accelerate the charitable bequest to a lifetime charitable gift, and that is to create a large federal income tax charitable deduction. At age 70, the donor will be looking at a time in the near future (at age 72) when he will have to start to take required minimum distributions from his IRA. The donor may want to convert his traditional IRA to a Roth IRA, but that conversion accelerates the traditional IRA into the donor’s current income, thus increasing his income tax burden. The gift of the remainder interest in the cottage and the large charitable income tax deduction that it generates can offset, to a large extent, the additional income tax liability that the donor will face with his Roth IRA conversion. One way of looking at this is that the non-income producing equity in the donor’s cottage is used to facilitate the conversion of his traditional IRA to an income tax-free Roth IRA which is not subject to required minimum distributions, at a time when everyone suspects we will be facing higher income tax rates and narrower income tax brackets to help pay for the pandemic relief expenditures.
Accelerating a charitable bequest to a lifetime charitable gift makes a lot of sense. Making an income tax deductible charitable gift with non-income producing assets also makes a lot of sense. Using the large income tax charitable deduction that arises from the gift of a remainder interest in a residence or farm to facilitate the conversion of the donor’s traditional IRA to a Roth IRA to minimize future income tax liabilities perhaps makes the most sense.