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The Tax Resource Group: Professional Tax Research Material, Resources, and Consulting

Category: Charitable Contributions; Sales & Exchanges; Deductions & Credits
Subject: Bargain Sale to Charity
Title: Issues Related to Bargain Sale to Charity of Principal Residence
IRC Sections: 170, 1001, 1011
Filename: 1349.html
Date Produced: 12/94

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Individual taxpayer (TP) plans to give his principal residence to a qualified charity. The home is worth approximately $900,000, has a basis of $602,000, and is encumbered by a mortgage of $465,000. The charity will assume the mortgage. After the contribution, TP will lease the home back from the charity and continue occupying the residence.

It is assumed that if TP sold his residence outright and did not reinvest the proceeds, the entire gain from the sale would belong term capital gain.

1. What is the amount of the charitable contribution and how much gain (if any) is recognized as a result of the gift?

2. Are there any cancellation of indebtedness implications for TP?

3. What are the AMT consequences for federal and California tax purposes resulting from a gift of appreciated property?

1. A gratuitous transfer of encumbered property is treated as a sale or exchange of the property, and the amount realized from the sale or exchange is deemed to be the encumbrance assumed by the donee. Regs. Section 1.1011-2(a)(3). Ebben v. Comr., 783 F.2d 906, (9th Cir. 1986); Guest v. Comr., 77 T.C. 9, 24 (1981), acq., 1982-1 C.B. 1; Tidler v.Comr., 53 T.C.M. 934, 945 (1987).

The gain or loss from the transaction is measured by difference between the amount realized (the debt assumed) and the basis of the property allocated to the sale portion of the transaction. When encumbered property is donated, the transaction is broken into two parts, a gift part and a sale part. Under Regulation Section 1.1011-2(b) and Rev. Rul. 81-163, 1981-1 C.B. 433, the basis of the property apportioned to the sale is the entire basis of the property multiplied by the following fraction:

Debt assumed by the charity/FMV of the property.

Accordingly in this case, TP would recognize gain of $153,967 computed as follows.

Amount realized (debt assumed) $465,000

Basis: $602,000 x $465,000/$900,000 = $311,033

Gain $153,967

The charitable contribution amount is the fair market value of the property less the outstanding mortgage. In this case, the charitable contribution would be $435,000 assuming the figures set forth above regarding fair market value are ultimately honored by the IRS. Regulation 1.170A-2.

2. I can see no cancellation of indebtedness (COD) consequences as a result of this transaction. Since the entire amount of debt on the property is treated as proceeds from the sale or exchange of a portion of the property, I cannot envision any COD ramifications. Moreover, there is really no cancellation of the debt in the first instance. There is merely an assumption of the debt by another party.

3. For AMT purposes, the question is whether the difference between the charitable contribution amount and the basis of the donated property related to the contribution is treated as an AMT adjustment or preference. Federal tax law on this issue has changed many times over the past few years, but the Revenue Reconciliation Act of 1993 repealed the AMT adjustment for gifts of appreciated property made after 1992. Accordingly, for federal AMT purposes, there is no add-back with respect to this transaction. California, however, has not conformed to this liberalization of the AMT rules; accordingly, there will be an AMT add-back for California purposes.

$435,000 - ($602,000 - 311,033) = $144,033.

Important Collateral Issue
TP's ability to ultimately enjoy the charitable contribution deduction may turn on the terms of the lease-back arrangement with the charity. The tax literature is filled with cases in which a taxpayer sold or donated property and then leased it back. In some cases, the IRS has successfully challenged such transactions and recharacterized them in accordance with its own view of economic realty. I urge you in the strongest terms to carefully scrutinize the lease-back arrangement with the charity. It is not sufficient that mere legal title to TP's home be transferred. If the terms of the lease give TP rights and benefits he would not otherwise have in a purely arms-length lease arrangement, the IRS could successfully argue that TP has not transferred his interest in the home. In the alternative, the IRS could argue that TP has transferred only a partial interest in the home and reduce or eliminate the contribution while leaving in place the gain on sale. After reviewing the lease agreement, the contribution agreement (if any) and any other side agreements, ask yourself whether all the benefits and burdens of owning the property have been transferred to the charity. Ask yourself whether parties acting purely at arms length would enter into the lease arrangement as it is currently written. If not, there is a potential problem.