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Funding
Gift Annuities
With Real Estate
by
James
E. Connell
Reprinted from the July 1997 issue of Planned Giving Today.
Copyright © 1997. All rights reserved.
The major job of a planned gift officer (PGO)
is to acquire both current and future assets for his or her charity.
Planned gifts have grown in popularity as fundraisers have directed donor
assets into life-income programs.
Charities have placed little emphasis on
securing current or future gifts of real estate. Several reasons account
for this, including the inexperience of many PGOs regarding real estate,
low risk tolerance of nonprofit boards and lack of adequate financial
models to guide donor negotiations.
Real Estate
The dramatic rise in real estate values in the last 15 years makes
property an attractive gift asset for donors. Senior donors may wish to
simplify their financial lives by selling excess real estate such as
vacation homes, rental buildings, lots and farms. For the donor, a gift of
real estate avoids the burden, bother, expense and taxation associated
with a commercial sale.
Why haven't charities viewed real estate as a valuable asset for
charitable giving? Perhaps it is the administrative concern generated by
gifts of real estate. Perhaps the acquisition risk involved in valuations
and environmental concerns. Perhaps the disposition risk involved in
converting the property into investable assets. Each of these concerns may
be overcome with well-reasoned policies and procedures for real estate
outright gifts and funded life income agreements.
Why should charities consider real estate gifts in a donor-focused
program? First, the vast majority of seniors own real estate, and many
seniors own two homes, investment property or land. Second, most seniors
own their real estate without the burden of mortgage debt. Third, as
seniors simplify their lives during retirement years, the burden of
property management may become far greater than the personal gains
achieved by keeping the property for investment or estate purposes.
As a practical matter, it is easier to fund
a gift annuity with real estate than a charitable remainder trust or a
pooled income fund since the charity's general assets are used to make the
annuity payments. One of the major benefits of a CGA over a CRT is the
charity's immediate promise to pay the donor a fixed guaranteed lifetime
income and no delay of payments or payment risks associated with the
sale of property within a CRT.
Charitable Gift Annuities
The charitable gift annuity agreement (CGA) is the most popular
life-income arrangement for senior Americans. While normally funded with
cash or marketable securities, real estate should be considered as an
acceptable funding asset. Properly structured, a real estate funded CGA
will provide many personal and financial benefits to the donor and a
better-than-average return for the charity's gift annuity account.
The following procedures may be helpful in
developing an acceptable real estate charitable gift annuity agreement.
Donor Negotiations
As with all life-income agreements, the PGO needs to focus on the
financial and personal needs of the donor. In the initial phase, there
should be full and fair disclosure about the nature of the proposed
property gift. Both the donor and the charity must determine what the
property is worth to an interested and motivated buyer. I suggest the
donor obtain an appraisal and the charity obtain an independent appraisal.
Averaging the two appraisals assists in establishing an acceptable
evaluation of the fair market value and avoids a donor-tainted appraisal.
A more conservative approach would be to use the lowest appraisal.
In the early stages of donor discussions,
the charity should present a typical model which will explain the income
the donor may expect to receive from the charitable gift arrangement. The
most appropriate approach is to inform the donor that the income will be
based upon two factors. First, the appraisal will be discounted 15 percent
to compensate the charity for market risks and marketing expenses. Second,
the agreement payment will be based upon 85 percent of the fair market
value and will be a market rate payment determined by the donor's age and
current economic/investment conditions.
Concerns of Charity
The charity must determine the carrying costs for the property on an
annual basis. What are the real estate taxes and when are payments due?
What are the costs for utilities, insurance, property improvements and
management? What are the
costs involved in transferring the deed from the donor to the charity and,
subsequently, from the charity to the new owner?
Will the charity have to pay two sets of
transfer costs? What does state real estate law say about the value of the
transfer when there is a bargain sale arrangement? Is the value of the
transfer a fair market appraisal amount, an amount determined by the
nature of the gift annuity agreement or a value determined by another
method? For example, in Texas there are no significant transfer costs for
real estate given to charity. However, in Pennsylvania there is a one
percent transfer fee payable upon acquisition and disposition determined
by tax value of the property gift. It is valuable to investigate state
laws on real estate transfers to charity to properly explain the financial
aspects of the gift arrangement to both the donor, the advisor(s) and the
charity's board of directors.
The charity must consider the costs of
selling the property. For example, when the charity lists the property for
sale, what will be the sale's commission to the real estate agent?
Normally, homes carry a 5-7 percent commission and land has a 10 percent
commission. Does the broker expect any up-front money to support
advertising, direct mail or other marketing costs prior to the sale of the
property?
Of course, the charity must determine any
environmental risks associated with the property using either a phase I or
a phase II environmental audit. The charity may choose to skip the audit
if it has some knowledge of the property, or the property is land in a
planned development or the property is recently constructed residential
real estate.
Market Risks and Market Wait
The major financial concern of a charity acquiring real estate pertains to
the market risk and market-timing risk associated with the gift. How do
the risks affect the ultimate financial return to the charity? A charity
should accept a real estate funded gift annuity agreement when it makes
financial sense; it is more an asset than a liability and it is in the
long-term interest of the charity.
In the October 1996 issue of Planned
Giving Today, Scott Goyetche discusses valuation concerns and
conversion costs and says that it is unfair to discount the value and
charge the conversion expenses to the donor. In the same issue, Debra
Ashton discusses the charity's perspective for real estate gifts including
appraisals, environmental assessments, attorney fees, selling costs and
payment liabilities. She suggests the use of a deferred charitable gift
annuity agreement.
State laws may prohibit gifts of real estate
for gift annuity agreements, such as New York does, or may restrict the
nature of the assets a charity may have in their annuity reserve funds.
Not all states regulate annuities and not all states that regulate
annuities restrict the use of real estate.
Some charities may not wish to accept real estate funded gift
annuities as it might affect writing annuity agreements for donors in
regulated states. In real estate prohibited states you may want to
consider a 10-payment bargain sale agreement.
Real Estate Gift Annuity Model
If the charity's board approves accepting real estate, the PGO needs a
gift model that evaluates the financial impact of these gifts.
Establishing a Real Estate Gift Annuity Model (REGAM) will assist
charities with the acceptability of property gifts.
The model form outlined below can be
developed using a computer spreadsheet or a word processing table feature.
The form should allow several assumptions to be compared. The model
forces charities to quantify the risks and costs, and converts the net
cash received from the appraisal to the investment return needed to
support annuity payments. The target investment return goal should be near
the 7 percent stated rate-of-return assumption built into the American
Council on Gift Annuities suggested annuity rates.
Here is a quick summary of the model,
background on the model components and evaluation suggestion. The model
can be used with the donor or by the charity's board to examine the
risk/reward relationship of a real estate gift.
Appraisal. Charity and donor should get independent appraisals.
Average the appraisals or a more conservative approach uses the lowest
appraisal.
Establish Selling Adjustment. The selling adjustment represents
market risks or simply the charity's guess at the property selling price.
Establish risk as a percentage of appraisal value. Use 3-5-7 percent or 10
percent adjustments to test assumptions.
Estimate Selling Expenses. Establish conveyancing costs as a
percentage. Expenses will include the real estate commission, title
report, title insurance, attorney fees, real estate transfer fees,
environmental inspection, home inspection and other miscellaneous closing
fees associated with the deed transfer.
Cash Received by Charity. This represents the net cash available to
charity after market risks and transaction costs.
Carrying Expenses Before Sale. How long must the charity hold
property prior to sale? The gift is completed when the deed is transferred
from donor to charity. Immediately, the charity assumes the costs of
owning the property prior to sale. These costs will include property
taxes, insurance, maintenance, management fees, assessments, promotional
and selling expenses, and any other expenses normally associated with
owning land or buildings.
Annuity Payment Adjustment. Assuming the annuity is an immediate
payment agreement, it is to the charity's advantage to make the payment
annually at the end of the payment period. This may not be acceptable to
many donors as semi-annual or quarterly payments may be preferred. Monthly
payments should be avoided. The charity must use its cash prior to the
property sale. The charity should estimate a one-year payment, or more
conservatively, two years of payments.
Total Cash Received. After the property sale, the charity should
reimburse itself for both the carrying expenses and prior annuity
payments, netting the cash to fund future annuity payments.
Annuity Payments. Should the charity use the suggested annuity
payment rates established by the ACGA, or another rate? My experience
indicates that donors will accept a "market-based rate" over the
ACGA rate when difficult-to-value and difficult-to-sell property is used
to fund a CGA. With the current economic conditions, I would use a 6 percent
payment rate by donors aged 60-69, a 7 percent payment for donors aged
70-79, and a 7.5 percent payment for those over age 80. Of course, the
rate may be negotiable depending on the acceptability of the property
gift. Never exceed the ACGA rates for property gifts.
Base the annuity payment on the appraisal
value minus a 15 percent adjustment for market risk and marketing
expenses.
Annuity Rate on Appraisal. The model figures the actual annuity rate
the charity is paying on the full appraisal fair market value.
Annuity Rate on Net Cash. The model figures the actual
rate-of-return the net-invested cash must earn to sustain the annuity
payment without using principal.
Tax Considerations
Most property given for a CGA will be appreciated property subject to
capital gains taxation. There are some additional tax considerations for
real estate funded charitable gift annuities where there is both an
outright gift portion and a portion used to fund the annuity agreement.
It is important to allocate the cost basis of the property between
the outright gift portion and the annuity portion.
The donor payments are determined using the
standard federal tables based upon the agreed upon payment rate and age of
the donor(s). The taxability of the payments will be affected by the cost
basis allocated to the annuity portion. The payments will be taxed as
ordinary income, capital gain income and tax-free payments for an annuity
funded with capital gain property. The gain associated with the annuity
portion can be spread out over the period of the donor's life expectancy
rather than being recognized all in the year of the transfer.
Since the annuity is based upon a value
which represents a 15 percent discount from the appraisal fair market
value, this discount must be considered in the overall tax effect for the
donor. The annuity contract and deed transfer should reflect this 15
percent discount as an outright gift to the charity. The annuity agreement
established with 85 percent of the property value generates an additional
charitable contribution deduction.
Thus, the donor receives two income tax
deductions, one for the outright gift and one for the remainder value of
the annuity agreement. In essence, the donor is receiving a charitable
contribution deduction for the market value risks and market timing risk
being transferred to the charity. Provided the donor itemizes, appraisal
fees are deductible as an expense to figure income tax liability.
Case Study
Mrs. Wilson is an 83-year-old (birth date: 7/7/13) widow who wishes to
dispose of one of her several rental properties. Real estate is an
increasing burden and she wishes to simplify her life. Her accountant
points out the value of considering a charitable gift since her current
retirement income provides a comfortable living. Her cost basis is $10,756
and the appraisal value is $102,000.
Here's how the real estate funded CGA would
work for her. Using our model, we take a 6 percent selling adjustment
($6,120) and reduce the expected gross sales price to $95,880. If selling
expenses equal 10 percent ($9,580), the charity will receive net income of
$86,292. Anticipating six months of actual carrying expenses of $1,996
before the sale and adjusting for six months of income paid to Mrs.
Wilson, results in the charity receiving $82,845 of investable assets.
Since one of the apartments is rented, the charity would receive income
for six months of $3,225 for final net investment assets of $84,269.
Mrs. Wilson is being paid a 7.50 percent
payment on 85 percent of the $102,000 appraisal value. Her annual income
would be $6,502.52, with $2,594.51 taxed at ordinary income rates,
$3,495.22 in capital gains income and $412.79 received tax-free. In
addition to a charitable deduction of $56,233 for the annuity portion of
the agreement, she receives an additional $15,300 for the outright portion
of the property value.
The result is an annuity rate on full market
appraisal of 6.38 percent and the charity needs to earn 7.72 percent on
the net cash received to have 100 percent of the annuity gift amount upon
the donor's death.
Conclusion
Combining the benefits of the most popular life income gift arrangement,
the charitable gift annuity, with an asset owned by the majority of
Americans (real estate) can lead to new and rewarding agreements for
charities and the donors who wish to unlock the gift potential of their
property holdings.
James E. Connell, FAHP, CSA is
president of James E. Connell & Associates (Pinehurst, NC) and has logged
30+ years in charitable estate planning. He currently assists charities
throughout the U.S. and Canada with endowment development. For a
complimentary copy of the Evaluation Model work sheet call Jim at
910-295-6800 or consult his web site at
www.connellandassoc.com. |