Section 1031 and Done: New Opportunities for Charities

Key Takeaways:

• Revisions to various parts of the tax code will challenge charities to be more creative and proactive in their fundraising.
• The changes to code section 1031 provide new opportunities for charitable planning.
• There are a number of tools and techniques for charities that will enable them to provide unique solutions for their donors.

The Tax Cut and Jobs Act that went into effect on Jan. 1 contains sweeping changes to the entire tax system. Corporate, personal and estate taxes have been revamped entirely, and practitioners are scrambling to adapt to the new regime and to provide the “right” advice for their clients. Simply understanding the changes to the tax for individual taxpayers and working through the variations of scenarios as they play out is a monumental chore. Much discussion has been about how the new rules will impact charities and most of that discussion is pessimistic.

One of the little discussed areas of change that will affect many individuals are the revisions to section 1031. This code section refers to “like-kind” exchanges of certain types property. Essentially, a properly executed section 1031 exchange allowed an owner to defer the recognition of gain until the property that was exchanged for was ultimately sold. For many investors, this has been a method for swapping their way to significant gains by delaying the taxes due. In the past, like-kind exchanges included both real and personal property. While the majority of the value of section 1031 exchanges is in real property, those who collect valuable assets such as fine art, collector automobiles and antiques have also utilized the section 1031 exchange to enhance their collections.

By the way, it is estimated that 30 percent of families with net worth in excess of $10 million, collect something. And, while the federal long-term capital gains tax rate for real property is 20 percent, for tangible personal property, it is 28 percent. Add state income tax, the Medicare surtax of 3.8 percent and the loss of itemized deductions for most tax payers and selling collectibles just got much uglier.

What can collectors do? Certainly, collectors are passionate about their collections and often buy or sell in the heat of the moment. While this may be necessary at times, there are still planning considerations that can be implemented, especially before a planned sale. First, there are several charitable techniques that could be considered. One option would be a Flip Charitable Remainder Unitrust (Flip CRT). With this technique, the owner has a special trust created and transfers his collectible to the trust prior to any sales transaction taking place. The trust then sells the asset and receives cash from the sale. At the time of the sale, the donor will receive a charitable income tax deduction based on a number of factors: the donors age, the payout rate of the trust, the cost basis of the asset transferred and a couple of other technical factors. Note that with personal property donated to these types of trusts, the income tax charitable deduction is limited by what the owner paid for the item (cost basis), not its fair market value (what it sells for).

Further, the deduction for personal property is limited to 30 percent of the donor’s Adjusted Gross Income in any given year. However, unused deduction is available to be carried over for five additional years until fully utilized. In this transfer, there is no capital gains tax realized at the time of the sale. However, the donor no longer has access to the cash or the asset, but rather will receive an income stream, usually for life, based on what the property sold for and how the trust payout is structured.

Yet another opportunity for tax savings is the “young” Pooled Income Fund (PIF). Similar to the aforementioned Flip CRT, The PIF provides a means of avoiding the capital gains tax on the sale of personal property while creating a charitable income tax deduction. Major differences between the Flip CRT include the fact the PIF must be established and maintained by a public charity recognized under section 501(c)(3), so it is important to identify the charity that will cooperate with this complexity.

One of the major advantages of the PIF strategy is size of the charitable income tax deduction, which in most cases will be multiples greater than can be accomplished with the CRT. The reasons for this are many and unnecessary to explain here, but because the deduction is likely to be much larger, there is more planning flexibility.

Consider, for example, that it might be possible to contribute only 50 percent of the asset or less and still receive enough deduction to make it worthy of consideration. Indeed, with good planning, it may be possible to leave an income stream for the next generation after the donor is deceased. All while totally avoiding the long-term capital gains tax. Ultimately, money left in the CRT or the PIF will transfer to charity, so careful analysis should be undertaken before entering into either of these arrangements.

Of course, there is also the direct gift to charity that will allow the donor to receive an income tax deduction on either the cost basis or the fair market value depending on the nature of the gift and the charity. Simply put, art donated to an art museum would be at fair market value and that same art donated to a homeless shelter is likely to be at cost basis.

Very few collectors are aware of these opportunities, nor are their advisors. Each of these solutions has an important charitable element and the more the nonprofit world begins discussing these options with their donors or prospective donors, the more likely they are to become a beneficiary.

While the changes in the rules for personal property under section 1031 will limit many collectors, they don’t mean the all sellers will now have to realize tax on sale. For those who own their collectible for more than a year, the long-term capital gains tax can be deferred or eliminated. To do so simply requires different planning and well informed advisors.