Since the original enactment of the charitable deduction in 1917, numerous tax acts have made changes in the law that affected charitable giving in many ways. Periodic changes restricted who could take charitable deductions, how much could be deducted, whether the alternative minimum tax system came into play, and other assorted tinkerings that had, and were intended to have, a direct impact on Americans’ decisions regarding their charitable gifts.
This time it is different
If you search a digest of the law, read press reports, or browse the web, you will find few references to the charitable dimension of this law. Does that mean that nonprofit executives need not concern themselves with this one? Hardly.
The impact of the TRA on charitable giving, though subtle, will be immediate and deep. Organizations that quickly grasp the meaning of this legislation for funding programs stand to benefit; others may be in for some surprises.
It is best to start with the basics. There are five “parts” to a charitable gift who makes it, why it is made, what is given, when it is given, and how it is given. Various changes in basic underlying tax laws brought about by the TRA will have a great impact on the what, when, and how of charitable gifts.
Changes in capital gains tax rates
Most Americans now know that Congress has finally acted to reduce the capital gains tax. Ostensibly, the maximum rate has been reduced from 28% to 20%. That is the same thing Congress did in 1981 at the beginning of the Reagan years.
One unintentional, though very real, effect of this reduction is a rise in the after-tax cost of making gifts of stock and other non-cash assets to charity. Without going through the math, the minimum cost of giving the appreciation element in a gift of an asset that has increased in value has now gone from $.324 to $.404 per dollar donated, an increase of some 25%. In economic terms, if you assume that the “demand” for gifts is “elastic” and it will fall with price increases, then we can expect a big decline in gifts of appreciated assets. Right? Wrong. At least we had better hope that is wrong because each year America’s charities depend heavily on gifts of appreciated assets, especially in a period when the Dow is hovering in the 8,000 range. History reveals that gifts of appreciated assets actually increased during the period from 1978 to 1981 when maximum capital gains tax rates were cut from 35% to 20%.
There are two reasons why the new decreases in capital gains tax rates should also not have a large negative impact on charitable gifts.
First, when a motivated donor compares the minimum after-tax cost of making a gift of cash versus a gift of securities or other qualified non-cash property that has increased in value, that donor will discover that the gift of property is still the way to go. The minimum cost per dollar of cash donated is $.604. That is still some 50% more than the new minimum cost of a gift of appreciated property under a 20% maximum capital gains tax rate.
The exact numbers will vary depending on the cost basis of the property involved. In the case of a $10,000 gift of cash versus a gift of $10,000 worth of stock with a $2,000 cost basis, the gift of cash still costs 36% more for a person who is in top ordinary tax brackets and would be subject to the new 20% capital gains tax rate if the donated property were sold. For someone who is considering a larger gift for whatever the non-tax motivators may be, it is still good planning to make the gift in the form of appreciated assets. A better use for cash is to then repurchase the same or other securities at a new, higher cost basis.
Second, for many persons, the cost of making gifts of appreciated assets has not really changed at all! The key to understanding why this statement is true in light of the previous paragraph is comprehending the mind-numbing complexity of what Congress has just done to our nation’s capital gains tax structure. Hidden in the fine print of the legislation is the reality that the new 20% capital gains tax rate only applies to certain property. Through a process of elimination, the new maximum rate only generally applies to investment securities and certain real estate that has been held for longer than 18 months. Other property, including securities held between 12 and 18 months, works of art, and other collectibles, will still be subject to the previous maximum rate of 28%.
A person who sells commercial real estate that has been subject to depreciation will pay tax on the “appreciation” that is due to previous utilization of straight-line depreciation at a new capital gains tax rate of 25%. Any “gain” that is due to more rapid methods of depreciation (known as “accelerated depreciation”) will be taxed at ordinary income tax rates as high as 39.6%. Finally, gain in excess of the adjusted basis that does not result from prior depreciation will be taxed at the 20% maximum rate provided it has been held for 18 months. If held between 12 and 18 months, the maximum tax rate on that portion of the gain will be 28%. The charitable deduction for the donation of a commercial building that has been held for 12 months or longer will still be the fair market value less accelerated depreciation that has been taken.
Had enough? Some donors and advisors may, in fact, decide that it may be easier to donate real estate rather than try to determine how the gain on a sale would be taxed! The bad news is that the tax treatment for gifts of appreciated property is now more complex. The good news is that Congress did not decide to restrict the deduction to cost basis only.
Charities and advisors working with donors who are considering major gifts will now want to point out that it is not only a good idea to make gifts of non-cash assets, but that those gifts be the right assets, those that would generate the greatest amount of tax if sold. For most donors that will be investment securities that have been held for between 12 and 18 months, art and other collectibles given for a related use, and certain real estate. Considering the large increases in the stock market over the past 18 months, there is an abundant “supply” of such property in the marketplace. Charities need to quickly inform their major donors of the importance of choosing the right property to give. Left to their own devices, the natural tendency of many donors would be to give the property that has appreciated the most and been held the longest, as they have been trained to do in the past. This could be a costly mistake and one for which major donors may, in some instances, blame ! ! charities and advisors they believe failed to adequately inform them.
Gifts of cash remain largely unaffected by the provisions of the TRA. Regular tax rates determine the after-tax cost of such gifts, and those rates have not been changed. There are, however, economic arguments that can be made on the pro and con sides regarding the tangential impact of this bill on gifts of cash.
On the positive side, one could argue that the ability to deduct student loan interest, child credits, and similar tax breaks will put more cash in the hands of middle income taxpayers. With greater discretionary income, they may be prone to increase their charitable giving. Wealthier Americans can now sell homes free of capital gains tax on up to $500,000 in appreciation in the case of a married couple. This will free up significant amounts of cash that can then be used to fund donations. Now may be a good time to approach donors with large outstanding pledges. Persons who are selling out of the stock markets at new lower capital gains rates may also be flush with cash.
On the negative side, a naysayer could argue that other new provisions in the law will tend to soak up cash that would otherwise be donated. Expanded IRA and educational savings account provisions, incentives that encourage the initial purchase of a home, and increased amounts that can be given to friends and family free of estate and gift taxes under expanded annual exclusion and unified credit amounts are examples.
Time will tell the impact of this law, but fund raisers, especially planned and major gift specialists, have their work cut out for them. This law is not simple and donors will, in most cases, not figure it out on their own. And many advisors will be absorbed in sorting out the enormous implications of this law on investment options.