Charitable gift annuities as a planning technique.

Charitable gift annuities are often overlooked as a financial planning technique. Although widely used by the charitable community, many financial planners are unaware of the unique benefits gift annuities can provide. For example, if properly structured, a charitable gift annuity can be used to increase a donor's return on underperforming appreciated assets, as a replacement for a reverse mortgage or to provide a college education fund.

A charitable gift annuity is an arrangement in which a taxpayer transfers property to a charitable organization in exchange for the organization's promise to pay an annuity. Generally, the annuity is for the life of the donor and/or the donor's spouse. A gift annuity cannot be structured for a term certain.

The annuity payment period may begin immediately, or it may be deferred until some future date. if a deferred annuity is selected, the annuity payments will be larger than if the annuity begins immediately after the transfer, since the calculation of the annuity payment is based on the time value of money. Because the charity has the use of all the funds for a longer period of time, the arrangement has the effect of generating a tax-deferred increase in the amount that will be paid to the noncharitable beneficiaries.

In most cases, the property exchanged for the annuity is appreciated property that would generate taxable gain if sold outright. However, if the transaction is properly structured, any taxable gain will be deferred over the annuity period. In addition, the donor will be entitled to a current income tax charitable deduction for a portion of the value of the property transferred.

Most charitable organizations establish a maximum annuity rate they will pay to ensure that a significant portion of the transferred property will be available for charitable purposes. This rate is based on rates established and published by the Committee on Gift Annuities, 2401 Cedar Springs, Dallas, Tex. 75201; [phone]. The rates suggested by the committee generally produce a charitable deduction of 40% to 60% of the value of the property transferred.

For tax purposes, a charitable gift annuity is treated as a bargain sale. A bargain sale is a sale or exchange of property to a charity in which the value of the consideration paid by the charity is less than the property's full fair market value (FMV). Sec. 1011(b) and Regs. Secs. 1.1011-2(a)-(c) and 1.170A-4(b)-(d) provide the framework for the tax treatment of bargain sales. A charitable deduction is allowed for the difference between the FMV of the property contributed and the FMV of the annuity at the time of the transfer.

The annuity's FMV is based on the appropriate Sec. 7520 rate and is determined by reference to IRS tables. The appropriate Sec. 7520 rate is the rate in effect for the month in which the transfer occurs. However, the donor may elect instead to use the Sec. 7520 rate for either of the two preceding months. The IRS tables for single-life and joint-life annuities are included in IRS Publication 1457. In addition, excerpts of the single-life tables (but not the joint-life tables) can be found in Notice 89-60. Regs. Sec. 20.2031-7 explains how to use the tables to calculate the correct value of a retained annuity interest.

As with any charitable gift, the tentative charitable deduction is subject to the reduction rules of Sec. 170(e). If the donor has owned the bargain sale property, which is also capital gain property, for one year or less at the time the transaction occurs, the gain on the transaction will be short-term capital gain, and the charitable deduction must be reduced by the unrecognized gain allocable to the gift portion of the transaction. if property donated to charity in a bargain sale transaction has been subject to depreciation, the portion of the sales price that is recaptured depreciation will constitute ordinary income, and the portion allocable to the gift portion of the transaction must be deducted from the otherwise allowable charitable contribution.

The income tax consequences of annuity payments are governed by the rules for private annuities in Sec. 72 and the accompanying regulations. Under these rules, each annuity payment is treated partially as a tax-free return of capital and partially as a capital gain, with the balance treated as ordinary income. Once the annuitant has recovered his basis, the entire payment will be taxed as ordinary income.

Planning techniques

If properly structured, a charitable gift annuity can provide a donor with a number of valuable benefits, including deferral of gain on appreciated property; tax-deferred build-up in value; current income tax deduction; and increased current cash flow. The following examples indicate some of the opportunities available.

Example 1: Donor D owns appreciated stock in a publicly held company that has historically paid dividends of between 4% and 5%. D would like to increase his current cash flow from the stock, but is concerned that Federal and state taxes on the stock's appreciation will eliminate the benefit of selling the stock and investing in higher yielding securities. As a result, D contributes the stock to a university in exchange for a 7% annuity, payable monthly for the rest of his life. In addition to an increase in current cash flow, D is entitled to a current charitable deduction. Moreover, because a portion of each payment constitutes return of capital, capital gain and ordinary income, D's effective after-tax yield increases significantly.

Example 2: Donor O owns a highly appreciated residence that he wishes to retain until his death. However, O needs additional funds to meet his current living expenses. As an alternative to a reverse mortgage, O transfers the remainder interest in the residence to a university in exchange for an annuity payable for the rest of his life. The amount payable to O each year is significantly more than that available by using a reverse mortgage. Moreover, the annuity will continue for the rest of O's life, regardless of how long he lives. Finally, O is entitled to a current income tax deduction for a portion of his home's value.

Example 3: Donor N owns highly appreciated securities that he intends to use to fund his children's education. However, N is concerned that the tax on the gain on the sale of the securities will significantly reduce the amount of funds available. Consequently, N sells the securities to a charity in a bargain sale. The charity agrees to pay for the securities in six installments beginning in 1995, which is the first year that college funds will be needed. Although the transaction does not involve a gift annuity (a gift annuity cannot be used for a term of years), similar benefits (e.g., effective tax-deferred build-up, deferral of gain, current tax deduction) are available.