Editor: Anthony Bakale, CPA
Despite the concerns over the potentially negative economic impact the pandemic was expected to have, many taxpayers saw an increase in the value of their portfolios. However, as the calendar turned to 2022, geopolitical events, rising inflation, and supply chain challenges have caused many investors to contemplate exiting their holdings and monetizing previous increases in their fair market value (FMV). When considering a sale of the property, one planning opportunity that a taxpayer may explore is a bargain sale to a charity.
A bargain sale occurs when a taxpayer sells property to a charitable organization for less than its FMV. The difference between the FMV and the amount realized, i.e., the "bargain element," is intended to be a charitable contribution. If the taxpayer has both a donative intent and a desire or need to raise cash at the same time, a bargain sale allows the taxpayer to capture the full amount of the property's FMV at the time of sale while limiting the amount of taxable gain the taxpayer will recognize. If the sale to the charitable organization is for the property's FMV, no charitable contribution element will be associated with the transaction. The transaction will be treated the same as a normal property sale, with the gain or loss determined in reference to the selling taxpayer's basis under Secs. 1011 and 1012 (without regard for the charitable status of the purchaser).
Before taking a closer look at how to calculate the two elements of the bargain sale — gain recognized and a charitable contribution deduction — it is important to have a baseline understanding of the tax treatment of property contributions. When property is contributed to a charitable organization, the general rule under Sec. 170 is that the amount of the charitable contribution is equal to the property's FMV. One exception to the general rule is if the taxpayer would recognize ordinary income from selling the property for its FMV at the time of the contribution. In that case, the charitable contribution amount is reduced by the amount of ordinary income that would be recognized (Sec. 170(e)(1)(A)). This reduction under Sec. 170(e)(1) for certain appreciated property typically results in a taxpayer's deduction for contributing ordinary-income property being limited to the taxpayer's basis in the property. Ordinary-income property includes but is not limited to: (1) property held by the donor primarily for sale to customers in the ordinary course of the donor's trade or business (i.e., inventory); (2) capital assets held for less than one year; and (3) property used in a trade or business (i.e., Sec. 1231 assets) but only to the extent ordinary income would be recognized under Sec. 1245(a) and Sec. 1250(a) (see Regs. Secs. 1.170A-4(b)(1) and 1.170A-4(b)(4)).
When calculating the two elements (gain and deduction) of a bargain sale to a charity, the first step is to determine whether a charitable contribution is allowed. In that determination, the normal rules under Sec. 170 apply, including the percentage limitations (see Regs. Sec. 1.1011-2(a)(1)). If a charitable contribution is allowed, then the special rules under Regs. Sec. 1.1011-2 will be used to determine the amount of the contribution and the amount of gain to be recognized on the transaction. It is important to note that these bargain sale rules apply to the transaction even if the charitable contribution will not be deductible in the year of the sale, as long as the contribution is permitted to be carried over to succeeding tax years, regardless of whether it is actually deducted in a succeeding tax year (see Regs. Sec. 1.1011-2(a)(2)). If a charitable contribution is not allowed, then the gain on the sale is computed under the normal rules for a property sale by subtracting the adjusted basis of the property from the sale price. If a charitable contribution is allowed, then the taxpayer will need to determine both the amount of the gain-on-sale element and the charitable deduction due to the bargain element.
To compute the gain on the sale, the taxpayer must apportion the adjusted basis of the property between the sale portion and the donated portion. The adjusted basis of the property that is sold or exchanged is the portion of the adjusted basis of the entire property that bears the same ratio to the adjusted basis as the amount realized bears to the FMV of the entire property (Regs. Sec. 1.1011-2(b)). The gain on the sale is recognized under normal tax accounting rules, generally, in the year of the sale, irrespective of the fact that the contribution may have to be carried over to a future tax year (Regs. Sec. 1.1011-2(c), Example (2)). The charitable deduction amount will be the difference between the FMV on the date of the sale and the amount realized, with a potential adjustment if the property requires a reduction under Sec. 170(e)(1).
These calculations can be best illustrated by some examples:
Example 1: In year 1, C purchases stock for $40,000. In year 10, C sells the stock, which now has an FMV of $100,000, to a charity for a total sale price of $50,000. The charitable deduction on the bargain sale is $50,000 (the difference between the FMV of $100,000 and the sale price of $50,000 — no reduction under Sec. 170(e)(1) is required). The portion of the adjusted basis of the stock that is allocated to the sale portion is $20,000 ([50,000 ÷ 100,000] × $40,000). C will recognize a long-term capital gain in year 10 of $30,000 (the amount realized of $50,000 less the allocable adjusted basis of $20,000).
Example 2: Assume the same facts as in Example 1, except, instead of waiting until year 10 to sell the stock, C sells the stock to the charity six months after her original purchase. Since the stock would now generate short-term capital gain if it were sold for its FMV on the date it was contributed, it will be subject to a reduction under Sec. 170(e)(1). Therefore, in addition to the short-term capital gain that C will recognize of $30,000, the charitable deduction will be reduced by $30,000 (which is the $50,000 charitable deduction less the share of the property's adjusted basis allocated to the contribution portion of $20,000). C may deduct $20,000 as a charitable deduction ($50,000 charitable deduction less the $30,000 reduction).
Some additional situations where the bargain sale rules apply are not addressed in this item, such as transferring encumbered property, whether by contribution or sale to a charitable organization. The taxpayer is treated as receiving additional consideration equal to the indebtedness — regardless of whether the charity assumes or agrees to pay the indebtedness or takes the property subject to the indebtedness (Regs. Sec. 1.1011-2(a)(3)). Also not addressed is the treatment of a charitable gift annuity, where a deduction is allowed for the excess of the amount paid over the value at the time of purchase of the annuity or portion purchased (Regs. Secs. 1.170A-1(d)(1), 1.170A-1(d)(3), and 1.1011-2(a)(4)(i)).
As is the case with most transactions, documentation of intent and the facts at the time of the transaction can significantly help support the taxpayer's position if the IRS ever chooses to audit the transaction. If the taxpayer does choose to go down the bargain sale route, it will be important that the purchase and sale agreements document both the FMV at the time of the contribution and the seller's donative intent. If the property sold at a bargain price would require a qualified appraisal if donated outright, the bargain sale element will not avoid the need to obtain the qualified appraisal. In the event the charitable contribution is greater than $5,000, the Form 8283, Noncash Charitable Contributions, attached to the donor's tax return will need to include additional information to show that the contribution was part of a bargain sale.
EditorNotes
Anthony Bakale, CPA, is a tax partner with Cohen & Company Ltd. in Cleveland.
For additional information about these items, contact Mr. Bakale at tbakale@cohencpa.com.
Unless otherwise noted, contributors are members of or associated with Cohen & Company Ltd.
