Sunday March 7, 2021
Article of the Month
Electing the Rate of the Month, Part I
The field of planned giving includes a variety of gift options. While bequests remain the simplest and most popular planned giving solution, many donors prefer to explore other opportunities. Charitable gift annuities, remainder trusts, lead trusts and gifts of remainder interests in certain types of real property are among the most popular charitable gift vehicles. Generally, each of these gift types allows the donor to take a charitable deduction. However, because the donor is retaining an income interest or portion of the gifted property, the full value of the donated property is not deductible. In each of these circumstances, the present value of the charity's interest in the property can be determined using the IRS' prescribed calculation. The IRS requires the use of a prescribed discount rate in calculating the gift's present value.
This article will explore the rules related to the use of the applicable federal rates (AFRs) published under Sec. 7520 and its use in calculating charitable deductions. This is the first article in a two-part series. Part I will discuss the AFR's effect on the present value calculation of several types of planned gifts and provide specific examples of these calculations. Part II will cover the election requirements and provide sample AFR election letters.
Under Sec. 170(f)(3), a charitable gift of a partial interest in property is generally not eligible for a charitable income tax deduction. However, exceptions from this rule apply to certain partial interest gifts. Present value calculations are required to determine the value of the donor's deduction for all charitable remainder trusts, lead trusts, gift annuities and gifts of remainder interests in certain types of real property.
The required discount rate for calculating the present value of these charitable gifts is set by Sec. 7520 of the Internal Revenue Code. The Sec. 7520 rate, also known as the "applicable federal rate" (AFR) or the "Rate of the Month" is published monthly by the IRS. It is 120% of the federal midterm rate, compounded annually, rounded to the nearest two-tenths. When a present value calculation is performed for the purpose of determining a charitable deduction, the rate of the month for the current month or one of the two previous months may be used. Part II of this series will discuss this election in more detail.
The rate of the month will affect the value of the donor's deduction. Depending on the type of gift, a higher rate may either increase or decrease the donor's deduction. For life income gifts such as charitable gift annuities and charitable remainder trusts, the highest available rate will generate the largest deduction. Because many seniors do not itemize deductions, most gift annuity illustrations will select the lowest AFR to maximize the tax-free payout. With other gifts, such as charitable lead trusts and retained life estates, the lowest available rate will lead to the largest deduction.
The funding value of charitable gift annuities may vary greatly. While some organizations may set minimum funding amounts for gift annuities, such as $25,000, other organizations may choose not to set limits. This could lead to gift annuities funded for as little as $5,000. Often charities will balk at accepting significantly larger funding amounts for gift annuities, since the higher value of the payouts represents a greater risk to the charity.
With charitable gift annuities, the AFR affects both the charitable deduction and the taxation of the annuity payouts. Gift annuity payouts are taxed according to a fixed schedule set at the creation of the contract. Generally, a portion of the annuity payout is excluded from ordinary income. The calculation to determine the excluded portion takes the present value of the annuity into account. Using a higher AFR will generate a larger present value of the remainder interest, while the tax-free portion of the annuity payout will be lower. Using a lower AFR will cause the deduction to be lower, but the tax-free portion of the payout will be higher. Therefore, with a charitable gift annuity, it is important for the donor to consider whether a larger deduction or larger tax-free portion of the payout is more important.
The Tax Cuts and Jobs Act of 2017 nearly doubled the standard deduction for taxpayers. Since that time, a much smaller percentage of taxpayers itemize their tax deductions and will instead opt to take the standard deduction. The donor should first determine whether he or she will be able to take a deduction at all before deciding which rate of the month to use. If the donor will take the standard deduction, then the lowest available rate is likely to be the best option if funding a charitable gift annuity.
Thomas wishes to fund a charitable gift annuity with his alma mater. He plans to transfer $25,000 in cash to the university in exchange for a 5.4% annuity payout. He is satisfied with the payout amount but is curious what the value of his charitable deduction will be. The university's gift planner explains to Thomas that the rate of the month for the date on which Thomas plans to make his gift is 1.2%. The rates for the two previous months are 1.8% and 2.2%. Thomas itemizes his deductions and therefore decides to elect the highest available AFR of 2.2%. He receives a charitable income tax deduction of $10,377. He also receives annuity payments totaling $1,350 each year, $1,008 of which is tax-free.
Thomas' cousin Steven wishes to fund a gift annuity with the same university. Just like Thomas, Steven will transfer $25,000 in cash to fund the gift annuity for a 5.4% payout. Steven does not itemize his deductions, so he realizes he would not benefit from electing the highest possible AFR. Instead, he elects the lowest available AFR of 1.2%. Like Thomas, Steven receives annual payments totaling $1,350. However, the tax-free portion of his payout is $1,091. If he were to itemize his deductions, he would be able to take a deduction of $9,174 this year.
Charitable Remainder Trusts
Like charitable gift annuities, the deduction calculation for charitable remainder trusts (CRTs) requires the use of the AFR. For CRTs, a higher AFR will produce a larger charitable income tax deduction. However, unlike gift annuities, the taxation of the CRT payout is not affected by the AFR. CRTs are taxed according to four-tier taxation rather than a fixed taxation schedule. Therefore, the value of the charitable deduction is the only factor in the donor's decision whether to elect the highest or lowest AFR.
Example 3Charitable remainder annuity trusts (CRATs) with a duration of life or lives must pass a unique test to qualify as tax-exempt charitable trusts with the IRS. The probability that the trust will exhaust must be less than 5%. The calculation for this 5% probability test is also influenced by the AFR. The lower the AFR, the harder it is for younger CRAT donors to pass the test. As the AFR rises, beneficiaries at lower ages qualify for life-duration CRATs.
Robert and Sally owned appreciated stock valued at $250,000 and were interested in the benefits of a charitable remainder unitrust (CRUT). They liked the idea of bypassing capital gains and receiving a stream of income for their lifetimes. Robert asked his advisor what the deduction would be if he and Sally were to fund a two-life CRUT with the stock. The advisor explained that the amount of the deduction would depend on the AFR they select. For the month of the gift, the AFR was 1.2%, the previous month's AFR was 1.8% and the month before that, it was 2.2%. The current month's AFR would lead to a deduction of $130,185. Robert and Sally were able to elect to use the AFR from two months prior, which allowed them to take a deduction of $130,683.
Several months ago, George and Maggie, ages 75 and 73, were considering funding a charitable remainder trust with $300,000 in appreciated stock. While George enjoys the idea of potential growth in the value of payouts provided by a unitrust, Maggie prefers the safety of annuity payouts. They asked their gift planner for an illustration showing the benefits of a CRAT. The available AFRs at the time were 2.0%, 2.0% and 1.8%. The gift planner informed George and Maggie that a two-life CRAT would not pass the 5% probability of exhaustion test at their current ages. They decided to let some time pass as they mulled over their decision. The gift planner called back two months later and informed George and Maggie that he had re-run the numbers using the current month's rate of 2.2% and the proposed CRAT passed the 5% test. The maximum allowable payout for George and Maggie's CRAT was 5.05%, slightly above the 5% minimum CRT payout.
Charitable Lead Trusts
While charitable remainder trusts pay out to noncharitable beneficiaries for a time and then transfer the remainder to charity, charitable lead trusts make annual payments to charity before distributing the corpus to noncharitable beneficiaries. The donor's deduction for a lead trust is based on the present value of the payout rather than the present value of the remainder. Therefore, although the present value calculation for a lead trust is similar to the calculation for a remainder trust, the selected AFR has the opposite effect on the donor's deduction. For lead trusts, a lower AFR will produce the greater charitable deduction.
Mia has been very successful in her career and has proven to be a savvy investor. Recently she decided to reevaluate her estate plan. She realized that she now has a taxable estate and wanted to explore options for transferring a portion of her wealth to her nephew and niece. After exploring her options, Mia decides to transfer $2,000,000 to a charitable lead annuity trust. Using the current month's AFR, which was the lowest available, Mia's gift tax deduction for the transfer would total $1,768,730. The highest available rate would have led to a deduction of only $1,604,020.
Life Estate Reserved
Another exception to the partial interest rule is a gift of a remainder interest in a home or farm. Under Sec. 170(f)(3)(B)(i), the owner of a personal residence, farm or ranch may donate the property and take a charitable income tax deduction for the present value of the remainder interest. The donor is able to retain the use and enjoyment of the home during life or for a term of years. With a life estate reserved, the lowest available AFR will benefit the donor with the highest possible charitable income tax deduction. At the end of the donor's life, the home or farm will be fully vested in the charity.
Alex has lived in her home for over 30 years. As a resident of the Bay area, she realized that her modest home has greatly appreciated in value. She was hoping to generate a sizeable charitable income tax deduction this year to offset an unexpected increase in her income. Her advisor suggests that her home might be a great source of value that could be transferred to charity. When Alex objected, stating that she does not want to move out of her home, her advisor assured her that she would be able to donate an interest in the home while remaining there as long as she wants. He showed Alex a proposal with an income tax deduction of $845,394 based on the current month's 1.2% AFR. He also pointed out that if she had elected the highest possible AFR, Alex's deduction would have only been $776,572, a difference of over $68,000.
Gift Annuity for Home
Homeowners with limited assets who wish to make a charitable gift and receive a stream of income may consider combining two of the popular options above. A donor may transfer the remainder interest in his or her home in exchange for a gift annuity. This is a combination of a retained life estate and gift annuity. The donor is able to remain in the home while receiving an income stream based on the value of the remainder interest.
The AFR affects this arrangement in two ways. First, the value of the remainder interest in the property must be calculated. As noted above, a lower AFR will lead to a higher present value of the remainder interest. The gift annuity is based on the value of the remainder interest. The remainder interest amount is used as the funding value to calculate the present value of the gift annuity remainder interest, which is the charitable deduction for this arrangement. While, the lower AFR will lead to a higher present value in the first calculation, it will lead to a lower present value in the second calculation. Because the annuity value and payout amounts are higher with the lower AFR, gift annuity for home donors prefer the lowest AFR.
Byron and Amelia, age 80 and 78, have lived in the same house for many years. While they do not have a large stock portfolio or other real property, their home is valued at $800,000. The couple does not have any children. They reached out to the gift planner at their favorite local charity to ask whether there are any creative ways to make a charitable gift, generate a charitable deduction and receive extra income. The gift planner at their favorite local charity explained to them that a gift annuity for home might be a good option for them. With an AFR of 1.2%, the present value of the remainder interest in Byron and Amelia's home is $638,189. This amount will fund a gift annuity with an annual payout of $35,739 and a $238,142 deduction. If instead they had used a 2.2% AFR which was available at the time, the gift annuity would be based on a lower $569,798 remainder interest, with a $236,285 deduction and a $31,909 annual payout.
It is vital for planned giving professionals to understand and explain the effects of the AFR to potential donors. Donors who are informed about how the AFR will affect their gift are able to maximize the financial benefit of the gift. While the rate in effect for the month of the gift may provide the best benefit, it is important for the donor to know the available options. At times, the rates may fluctuate greatly from month to month. During those times, it is essential that the donors are informed about which rate will help them most fully accomplish their goals.