THE WHALEN GROUP, INC.
Donor-Advised Funds: A Tax Planning Tool for Church andCharity Donations
Do you give money to 501(c)(3) charities?
Do you get a tax benefit from those donations?
Recent changes in the tax code have done much to destroy your benefits from church and other tax-deductible 501(c)(3) donations. But there’s a way to donate the way you want, get revenge on the tax code, and realize the tax benefits you deserve.
This get-even tool is the donor-advised fund, an increasingly popular way to donate to your church and other 501(c)(3) organizations. Indeed, donor-advised funds have exploded over the past few years, with over one million donor-advised fund accounts in existence as of 2020.
Example. You donate $100,000 to the fund today. You get the $100,000 deduction now. From the fund, you donate $10,000 a year to a charitable organization (probably more as your money in the fund grows tax-free).
National investment firms such as Fidelity, Schwab, and Vanguard have all created donoradvised funds. These “commercial” donor-advised funds hire an affiliated for-profit investment firm to manage the assets in the accounts for a fee that varies based on the account balance.
You can also establish a donor-advised fund account with a community foundation that has a local orientation; a single-issue non-profit, such as a university or an environmental charity like the Sierra Club; or an independent, non-commercial organization such as the American Endowment Foundation, National Philanthropic Trust, or United Charitable.
You can always donate cash, including money in IRAs and 401(k)s, to your donor-advised fund account. But many donor-advised funds also accept non-cash donations, including:
- stocks, bonds, and mutual fund shares
- real estate
- privately owned company stock
- LLC and limited partnership interests Bitcoin and other cryptocurrency, and life insurance.
Donating stock or mutual fund shares that have appreciated is a great tax strategy. Here’s why:
- If you owned the stock for more than one year, you get a deduction equal to its fair market value at the time of the donation.
- And you don’t pay any capital gains tax on the appreciated value of the stock.
Example. Dennis owns 1,000 shares of Evergreen stock that’s publicly traded on NASDAQ. He paid $10,000 for the stock back in 2010, and the shares are worth $100,000 today.
He establishes a donor-advised fund in 2022 and donates the stock.
- He gets a $100,000 charitable deduction for 2022. He pays no federal tax on his $90,000 gain.
As you can see, there are many benefits to donor-advised funds for the charitably inclined, and few drawbacks.
Transferring Your Home to Your Adult Child
With today’s home prices and the crazy real estate market, it’s likely difficult for your children to buy a home. And it’s conceivable that you are ready to move on from your existing home.
If this is true, consider the three options below.
Option 1: Make an Outright Gift
Say you’re feeling so generous that you might just simply give your home to your adult child. What a deal for the kid!
Tax-wise, if you make the gift this year, it will reduce your $12.06 million unified federal gift and estate tax exemption. To calculate the impact, reduce the fair market value of the home you would be giving away by the annual federal gift tax exclusion, which is $16,000 for 2022. The remainder is the amount that would reduce your unified federal exemption.
If you’re married, your spouse has a separate $12.06 million unified federal exemption. If you and your spouse make a joint gift of the home, each of your unified federal exemptions will be reduced. To calculate the impact, take half of the fair market value of the home minus the $16,000 annual exclusion. The remainder is the amount by which you would reduce your unified federal exemption. Ditto for your spouse’s separate exemption.
If your child is married and you give the home to your child and his or her spouse, you can claim a separate $16,000 annual exclusion for your child’s spouse.
If you expect the home to continue to appreciate (seemingly a pretty good bet), getting it out of your estate by giving it away is a good estate-tax-avoidance strategy.
Option 2: Arrange a Bargain Sale
Say you’re feeling generous, but not so generous that you want to simply give away your home. Fair enough.
Consider selling the home to your child for less than fair market value. For federal gift tax purposes, this is treated as a gift of the difference between the home’s fair market value and the bargain sale price. Tax-wise, this can work out okay.
Warning. Do not make a bargain sale or an outright gift of the home if you intend to continue living there until you die. In these scenarios, expect the IRS to argue that the home’s full date-ofdeath fair market value must be included in your estate for federal estate tax purposes, even if you were paying fair market rent to your child.
Option 3: Arrange Full-Price Sale with Seller Financing from You
The idea of giving your child a free house might be unappealing to you. Very well.
Consider selling the home to your child for its current fair market value with you taking back a note for a big part of the purchase price.
Assume you’re feeling charitable. If so, you can charge the lowest interest rate the IRS allows without any weird tax consequences. That’s called the “applicable federal rate” (AFR).
AFRs change monthly in response to bond market conditions and are generally well below commercial rates. In May 2022, the long-term AFR, for loans of more than nine years, is only 2.66 percent (assuming annual compounding). The mid-term AFR, for loans of more than three years but not more than nine years, is only 2.51 percent (assuming annual compounding).
As this was written, the going rate nationally for a 30-year fixed-rate commercial mortgage was around 6.1 percent, while the rate for a 15-year loan was around 5.1 percent.
So, for a loan made in May 2022, you could take back a 30-year note that charges the long-term AFR of only 2.66 percent. Alternatively, you could take back a nine-year note that charges the mid-term AFR of only 2.51 percent. Either arrangement would be a money-saving deal for your child.
Selling Your Appreciated Vacation Home? Consider the Taxes
The tax-code-defined vacation home rules come into play when you have both rental and personal use of a home. Thus, you can have tax-code-defined vacation homes in the city, in the suburbs, and in recreation areas.
If you have no combined rental and personal use of the home, the rules are easy. The property is one of the following:
- Principal residence
- Second home
- Rental property
But when you have both rental and personal use of the home, your tax life gets more complicated because you have entered the tax code’s vacation home section. In this situation, the property in a more complicated way is one of the following:
- Principal residence
- Second home
- Rental property
If it’s a principal residence, then the $250,000/$500,000 home sale exclusion is available when you sell.
If it’s simply a second home, you can’t use the exclusion and you pay taxes at capital gains rates—and you may suffer the net investment income tax (NIIT) as well.
If it’s a rental, you face the capital gains rules, NIIT, unrecaptured Section 1250 gain taxes, and release of some (if grouped) or all (if not grouped) passive activity suspended losses.
When you have rental use after 2008 and then convert the rental to your principal residence, you must use a rental/residence fraction to determine how you will be taxed.
Health Savings Accounts: The Ultimate Retirement Account
It isn’t easy to make predictions, especially about the future. But there is one prediction we’re confident in making: you will have substantial out-of-pocket expenses for health care after you retire. Personal finance experts estimate that an average retired couple age 65 will need at least $300,000 to cover health care expenses in retirement.
You may need more.
The time to save for these expenses is before you reach age 65. And the best way to do it may be a Health Savings Account (HSA). After several years, you could have a fat HSA balance that will help pave your way to a comfortable retirement.
Not everyone can have an HSA. But you can if you’re self-employed or your employer doesn’t provide health benefits. Some employers offer, as an employee fringe benefit, either HSAs alone or HSAs combined with high-deductible health plans.
An HSA is much like an IRA for health care. It must be paired with a high-deductible health plan with a minimum annual deductible of $1,400 for self-only coverage ($2,800 for family coverage). The maximum annual deductible must be no more than $7,050 for self-only coverage ($14,100 for family coverage).
An HSA can provide you with three tax benefits:
- You or your employer can deduct the contributions, up to the annual limits.
- The money in the account grows tax-free (and you can invest it in many ways).
- Distributions are tax-free if used for medical expenses.
No other tax-advantaged account gives you all three of these benefits.
You also have complete flexibility in how to use the account. You may take distributions from your HSA at any time. But unlike with a traditional IRA or 401(k), you do not have to take annual required minimum distributions from the account after you turn age 72.
Indeed, you need never take any distributions at all from your HSA. If you name your spouse the designated beneficiary of your HSA, the tax code treats it as your spouse’s HSA when you die (no taxes are due).
If you maximize your contributions and take few distributions over many years, the HSA will grow to a tidy sum.
Partnership with Multiple Partners: The Good and the Bad
The generally favorable federal income tax rules for partnerships are a common reason for choosing to operate as a partnership with multiple partners instead of as a corporation with multiple shareholders. The most important partnership tax benefit rules can be summarized as follows:
- You get pass-through taxation.
- You can deduct partnership losses (within limits).
- You may be eligible for the Section 199A tax deduction.
- You get basis from partnership debts.
- You get basis step-up for purchased interests.
- You can make tax-free asset transfers with the partnership. You can make special tax allocations.
Partnership taxation is not all good stuff. There are a few important disadvantages and complications to consider:
- Exposure to self-employment tax
- Complicated Section 704(c) tax allocation rules
- Tricky disguised sale rules
- Unfavorable fringe benefit tax rules
Limited partnerships are obviously treated as partnerships for federal income tax purposes, with the generally favorable partnership taxation rules mentioned above.
Limited partners generally are not exposed to liabilities related to the partnership or its operations. So, you generally cannot lose more than what you’ve invested in a limited partnership—unless you guarantee partnership debt.
So far, so good. But you must also consider the following disadvantages for limited partners:
- Limited partners usually get no basis from partnership liabilities.
- Limited partners can lose their liability protection. You need a general partner.
On the plus side, limited partners have a self-employment tax advantage.
Since your partnership will have multiple partners, multiple issues can come into play. You’ll need a carefully drafted partnership agreement to handle potential issues even if you don’t expect them to arise. For instance, you may want to include:
- a partnership interest buy-sell agreement to cover partner exits;
- a non-compete agreement (for obvious reasons);
- an explanation of how tax allocations will be calculated in compliance with IRS regulations;
- an explanation of how distributions will be calculated and when they will be paid (for instance, you may want to call for cash distributions to be made annually in early April to cover partners’ tax liabilities from their shares of partnership income for the previous year);
- guidelines for how the divorce, bankruptcy, or death of a partner will be handled; and so on.
Key point. No type of entity (including a limited partnership in which you are a limited partner) will protect your personal assets from exposure to liabilities related to your own professional malpractice or your own tortious acts.
Send Tax Documents Correctly to Avoid IRS Trouble
You have heard the horror stories about mail sent to the IRS that remains unanswered for months. Reportedly, the IRS has mountains of unanswered mail pieces in storage trailers, waiting for IRS employees to process them.
Because the understaffed IRS is having so much trouble processing all the documents it receives, you need to protect yourself when you send an important tax filing due by a specific deadline.
If you can file a document electronically, do so. The IRS deems such filings as filed on the date of the electronic postmark.
If you must file a physical document with the IRS, don’t use regular U.S. mail, Priority Mail, or Express Mail.
When you mail a document with these methods, the IRS considers it filed on the postmark date, but only if the IRS receives it. What if the U.S. Postal Service doesn’t deliver it or the IRS loses it? You’ll have no way to prove the IRS got it—and the IRS and most courts won’t accept your testimony that it was timely mailed.
Don’t take this chance. Instead, file physical documents by certified or registered U.S. mail, or use an IRS-approved private delivery service (generally, two-day or better service from FedEx, UPS, or DHL Express). When you do this, the IRS considers the document filed on the postmark date whether or not the IRS receives it.
Make sure to keep your receipt.
Tax Implications When Your Vacation Home Is a Rental Property
If you have a home that you both rent out and use personally, you have a tax code-defined vacation home.
Under the tax code rules, that vacation home is either:
- a personal residence or a rental property.
The tax code classifies your vacation home as a rental property if:
- you rent it out for more than 14 days during the year, and
- your personal use during the year does not exceed the greater of (a) 14 days or (b) 10 percent of the days you rent the home out at fair market rates.
Count actual days of rental and personal use. Disregard days of vacancy, and disregard days that you spend mainly on repair and maintenance activities.
For vacation homes that are classified as rental properties, you must allocate mortgage interest, property taxes, and other expenses between rental and personal use, based on actual days of rental and personal occupancy.
Mortgage Interest Deductions
Mortgage interest allocable to personal use of a rental property does not meet the definition of qualified residence interest for itemized deduction purposes. The qualified residence interest deduction is allowed only for mortgages on properties that are classified as personal residences.
Schedule E Losses and the PAL Rules
When allocable rental expenses exceed rental income, a vacation home classified as a rental property can potentially generate a deductible tax loss that you can claim on Schedule E of your Form 1040. Great!
Unfortunately, your vacation home rental loss may be wholly or partially deferred under the dreaded passive activity loss (PAL) rules. Here’s why.
You can generally deduct passive losses only to the extent that you have passive income from other sources (such as rental properties that produce positive taxable income).
Disallowed passive losses from a property are carried forward to future tax years and can be deducted when you have sufficient passive income or when you sell the loss-producing property.
“Small Landlord” Exception to PAL Rules
A favorable exception to the PAL rules currently allows you to deduct up to $25,000 of annual passive rental real estate losses if you “actively participate” and have adjusted gross income (AGI) under $100,000. The $25,000 exception is phased out between AGI of $100,000 and $150,000.
The Seven-Days-or-Less and Less-Than-30-Days Rules
The IRS says the $25,000 small landlord exception is not allowed:
- when the average rental period for your property is seven days or less, or
- when the average period of customer use for such property is 30 days or less, and significant personal services are provided by or on behalf of the owner of the property in connection with making the property available for use by customers.
“Real Estate Professional” Exception to PAL Rules
Another exception to the PAL rules currently allows qualifying individuals to deduct rental real estate losses even though they have little or no passive income. To be eligible for this exception:
- you must spend more than 750 hours during the year delivering personal services in real estate activities in which you materially participate, and
- those hours must be more than half the time you spend delivering personal services (in other words, working) during the year. If you can clear those hurdles, you qualify as a real estate professional.
The second step is determining whether you have one or more rental real estate properties in which you materially participate. If you do, those properties are treated as non-passive and are therefore exempt from the PAL rules. That means you can generally deduct losses from those properties in the current year.
Meeting the Material Participation Standard
The three most likely ways to meet the material participation standard for a vacation home rental activity are when the following occur:
- You do substantially all the work related to the property.
- You spend more than 100 hours dealing with the property, and no other person spends more time on this property than you do.
- You spend more than 500 hours dealing with the property.
In attempting to clear one of these hurdles, you can combine your time with your spouse’s time. But if you use a management company to handle your vacation home rental activity, you’re unlikely to pass any of the material participation tests.
- “The IRS destroyed data for an estimated 30 million filers in March 2021, according to the Treasury Inspector General for Tax Administration.
- The decision, prompted by a backlog of paper filings, has sparked anger in the tax community.
An audit by the Treasury Inspector General for Tax Administration revealed the IRS had tossed data for millions of payers, sparking anger from the tax community.
The material, known as paper-filed information returns in accounting parlance, is sent yearly by employers and financial institutions, and covers taxable activity, such as W-2 forms, with copies sent to taxpayers and the IRS.
“The continued inability to process backlogs of paper-filed tax returns contributed to management’s decision to destroy an estimated 30 million paper-filed information return documents in March 2021,” according to the report.
The IRS backlog, created by years of budget cuts, understaffing, pandemic-related office closures and added duties, is expected to clear by December 2022, according to Commissioner Charles Rettig.” (Reported by NAEA)
The back log is expected to clear by December 2022, we will see if this estimate is accurate or not, however, it does not speak to the 30 million destroyed records. If we do not maintain proper record keeping, you and I are penalized, who penalizes the IRS?
Look to future Tax-Tips Letters to examine this and other issues.
Al Whalen, EA, ATA. CFP®