Charitable gift yields taxable gain, despite lack of charitable deduction.

In 1980, the Hodgdons donated a piece of unencumbered realty, worth $800,000, to charity. Later in 1980, they donated a second piece of realty, worth $4 million and subject to liens of $2.7 million, to a second charity. The charity took the property subject to the liens.

After applying the percentage-of-income limitations [Internal Revenue Code section 170(b)(1)(C)] for contributions of capital gain property, the Hodgdons were able to deduct only $450,000 of their $2.1 million in total capital gain contributions [$800,000 + ($4 million -- $2.7 million) = $2.1 million] for taxable year 1980.

Section 170 generally allows a carryforward of contributions exceeding the percentage limits. The Hodgdons deducted $21,000 of the carryforward amount in 1981 but were unable to use the rest. The IRS claimed under the bargain sale rules, the Hodgdons had to recognize gain on the contribution of the mortgaged property.

The IRC section 1011(b) bargain sale rule says, "If a deduction is allowable under section 170 . . . by reason of a sale, then the adjusted basis for determining the gain . . . shall be that portion of the adjusted basis which bears the same ratio to the adjusted basis as the amount realized bears to the fair market value of the property." (Emphasis added.)

If applicable, the rule effectively creates a part-gift, part-sale transaction. Under regulation 1.1011-2(a)(3), when the charity accepted the property subject to the debt, a "sale" occurred, and the "amount realized" by the Hodgdons was the amount of the debt ($2.7 million).

The Hodgdons argued the bargain sale rules did not apply to their gift of the mortgaged property because no deduction was allowable because of the gift. They claimed a "first-in-first-out" (FIFO) ordering rule should apply to the section 170 carryforward calculations.

Under FIFO, the earlier $800,000 contribution had to be used up in determining the amount of capital-gain deduction allowed, before the second contribution could be considered. Under the Hodgdon's theory, the bargain sale rules did not apply: No part of their $471,000 in charitable deductions was attributable to the gift of the mortgaged property, and thus no charitable deduction was "allowable" because of it.

The IRS relied on regulation 1.1011-2(a)(2), which says the bargain sale rules must be applied to a gift carried forward due to the percentage limitations, regardless of whether the carryforward is ever actually used.

Result: For the IRS. The Hodgdons must pay tax on the gain. Reg. 1.1011-2(a)(2) is valid. No FIFO ordering rule may be implied in the bargain sale rules. (Note: The amount of gain the Hodgdons must recognize is not determinable from the decision but is estimated to be about $200,000.)