… even when there’s no income involved.

By Kathleen A. Stephenson and Lisa B. Petkun

A donor owns property that he rents to third parties — property that a charitable organization could use to house its offices or one of its programs. The donor would like to benefit a charity and claim a federal income- and gift-tax deduction for the donation but doesn’t want to part with the property. What options are available?

From a charity’s point of view, being able to use property provides a significant benefit, even if the charity doesn’t become the owner. One option that benefits both parties is the rent-free lease. Such an arrangement won’t provide all the tax benefits an outright donation would,
but it’s not without advantages.

The Internal Revenue Code won’t allow a donor to deduct the value of fair market rent not charged a charitable donee. The donor would be claiming a deduction for income he didn’t receive. Rather, the advantage to the donor is that the rent that otherwise would be included in gross income for federal income tax purposes isn’t received and, as a result, not taxed.

If the donor would rent the property to a tenant and then donate the rental income to charity, the donor would be required to include the rent in income and then claim a charitable deduction. By allowing the charity to use the property rent free, the donor would achieve the result without the necessity of including the rent in income and claiming an income tax deduction for the charitable contribution. Thus, the federal income tax result of such a transaction is straightforward: No income is received, and no income is taxed.

Things to consider

There are, however, federal gift- and estate-tax issues that need to be considered in such a transaction. First, to qualify for a charitable deduction for federal gift- and estate-tax purposes, the donor must convey the entire interest in the property. The only exceptions are charitable split-interest trusts such as a charitable lead trust or charitable remainder trust. These concepts that provide for a charitable and non-charitable interest in an asset have many technical requirements and have been discussed in earlier columns. Giving the right to use property isn’t a transfer of the entire interest in an asset, and therefore the gift of that right will be a taxable transfer for federal gift- and estate-tax purposes.

For federal gift-tax purposes, the right to use the real property is a present interest that will qualify for the annual exclusion. Each year a donor can transfer up to $12,000 to as many individuals as he or she wishes. (Note: Effective Jan. 1, 2006, the annual exclusion amount increased from $11,000 to $12,000.) A charitable donee is considered a person for this purpose. Thus, if the fair market value of the foregone rent is $12,000 or under, the donor will not have made a taxable gift for federal gift-tax purposes. If the donor is married and his or her spouse joins in the gift, that amount will increase to $24,000.

The $12,000 annual exclusion applies only to federal gift tax. With respect to federal estate tax, the issue is more complex. If the donor dies during the term of the rent-free lease, the charitable organization’s interest in the real property — the lease term — won’t provide a charitable deduction to the deceased donor’s estate. Again, this is because the charity’s interest only is in the use of the property and not the deceased donor’s entire interest. Because there’s no federal estate tax equivalent to the annual exclusion, a donor might be well advised to provide that the charitable organization’s right to use the property terminate at the donor’s death.

Donating use is key

This concept isn’t limited to real property. A donor could donate the rent-free use of an automobile or a work of art. The key is that the donor is donating the right to use the property, not the property itself. However, for an item that generally isn’t leased by the donor, the ability to avoid income tax on the forgiven rent is illusory, whereas if the donor ordinarily would lease the property, the donor enjoys a real tax benefit by not having to pay tax on the forgiven rental income.

One important exception to this concept concerns loaning works of art. If art is loaned to a charitable organization that’s described in IRC section 501(c)(3) and is exempt from tax under IRC section 501(c) and the use of the art is related to the organization’s charitable purpose, e.g., a loan of a painting to an art museum, the loan won’t be treated as a taxable transfer for federal gift- or estate-tax purposes. The art must be a “qualified work of art” defined in the IRC as “any archaeological, historic, or creative, tangible
personal property.”

This arrangement requires careful planning to avoid an undesirable federal tax result. But it does provide the opportunity for an organization to benefit from a donor’s generosity while allowing the donor to retain control over the ultimate use of the property.