Can you donate real estate to private foundations?
Yes, it is entirely permissible to donate real estate to private foundations. However, such donations come with potential drawbacks that make them less common compared to donations to public charities. Donors should exercise caution, as the rules governing real estate donations to private foundations differ significantly from those applicable to public charities.
Limited Tax Deductions
The primary reason real estate donations to private foundations are relatively rare is due to the limitations on the charitable tax deduction. For private foundations, the charitable deduction is limited to the lesser of the donor's cost basis or the fair market value (FMV) of the property. This limitation can result in a reduced tax benefit, particularly when the property has either appreciated or depreciated significantly.
• Appreciated Property: If the real estate has appreciated in value, the donor's deduction is capped at the cost basis, which is typically the original purchase price. This means the donor does not benefit from the increased value of the property.
• Depreciated Property: If the real estate has depreciated in value, the charitable deduction is based on the lower fair market value, and the donor cannot recognize a capital loss for tax purposes. In this case, a better tax strategy would be to sell the property, realize the capital loss, and then donate the cash proceeds to the private foundation.
These rules stand in stark contrast to donations of real estate to public charities, where the charitable deduction is generally equal to the fair market value of the property, providing a larger tax benefit when the property has appreciated.
Additionally, donations of real estate to public charities are deductible up to 30% of the donor's adjusted gross income (AGI) on individual tax returns, whereas donations to private foundations are limited to 20% of AGI. Both types of donations allow excess amounts to be carried forward for up to five years.
Donating Real Estate Encumbered by a Mortgage
Donating real estate subject to a mortgage presents several complications and risks, particularly for private foundations. These issues primarily stem from rules related to self-dealing, debt relief, and the potential for unrelated business income tax (UBIT).
One significant risk is the possibility of triggering a self-dealing violation. Under IRC Section 4941, self-dealing refers to prohibited transactions between a private foundation and disqualified persons, which include donors, foundation managers, or related family members. When a foundation assumes a mortgage as part of a donation, the IRS may interpret this as providing a financial benefit to the donor in the form of debt relief. Such a transaction is classified as self-dealing, potentially resulting in substantial excise taxes for both the donor and the foundation’s managers.
Another complication involves the potential for cancellation of debt (COD) income. When the foundation assumes the mortgage, the IRS may treat the forgiven or assumed debt as taxable income to the donor, known as COD income. This could significantly reduce the tax benefits of donating the property, as the donor may need to report the canceled debt as ordinary income, offsetting the charitable deduction.
Additionally, if the foundation rents out the property subject to a mortgage, any rental income could be subject to UBIT under the debt-financed income rules. IRC Section 514 governs these rules, taxing income generated from property encumbered by debt owned by a private foundation.
To mitigate these risks, the most prudent approach is for the donor to pay off the mortgage in full before donating the property. This eliminates the debt-relief component of the transaction, thereby avoiding both self-dealing concerns and the potential for COD income.
Pre-arranged Sale of Real Estate
Donors should also be wary of structuring transactions where the private foundation acts as a conduit in a pre-arranged sale of real estate to a third party. The IRS scrutinizes such arrangements closely, as they may view the transaction as an attempt by the donor to avoid capital gains taxes by claiming a charitable deduction instead.
If a sale agreement with a buyer is negotiated prior to the completion of the real estate donation, the IRS may collapse the transaction and treat it as if the donor sold the property directly. To prevent this, the private foundation must retain full control over decisions related to the property, including whether to sell or hold the real estate. The donor may refer potential buyers but should avoid entering into any legal agreements on behalf of the foundation.
Reasons to Donate Real Estate
Despite the challenges and potential drawbacks, there are still compelling reasons to donate real estate to a private foundation. In some cases, real estate can enhance the foundation's charitable activities.
• Operational Benefits: For example, a private foundation that owns and occupies its own office building may have greater financial security and stability compared to one that leases office space. Ownership of property can reduce ongoing operating expenses and provide a long-term asset for the foundation.
• Tax Exemption: Real estate held by a foundation for charitable purposes often qualifies for property tax exemptions at the county or municipal level, which can further reduce costs associated with ownership.
• Limited Basis Disparity: If the donor's cost basis is similar to the current fair market value, the tax deduction for donating real estate to a private foundation is comparable to donating to a public charity. In this scenario, the tax limitation based on cost basis becomes less of an issue, as the difference between the two values is minimal.
Final Thoughts
While donating real estate to private foundations is allowable, careful planning is essential to avoid potential tax and compliance pitfalls. Donors should consider the differences in tax treatment between private foundations and public charities, particularly in relation to appreciated property, and ensure that any mortgage is fully paid off before donation. Consulting with a tax advisor or legal expert can help ensure that the donation is structured optimally for both the donor and the foundation.
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