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The Charitable Installment Bargain Sale

A bargain sale is a sale of property to charity for less than the property’s fair market value. 

Why would a donor do such a thing? The bargain sale generates an immediate lump sum payment to the donor that she can put toward any private purpose, as well as an income tax charitable deduction equal to the difference between the lump sum payment and the fair market value of the property.

Why would a charity consider a bargain sale? The charity pays less than fair market value for property it can put to a use related to its charitable purpose or, alternatively, sell for more than it paid and use the profit to further its mission.

The charitable installment bargain sale is a special form of bargain sale that can be an excellent way to meet the needs of a donor the charity she wishes to support. Before we delve into this type of gift arrangement, let's first review some elements of bargain sales, generally.

Donative Intent
What distinguishes a bargain sale from a sale of property to a charity in the ordinary course of business? Donative intent.

For a bargain sale to trigger a deduction, the donor must intend to make a gift of the fair market value that exceeds the sales proceeds. Although such intent can be established in a variety of ways, it is probably easiest and best to include in the documentation of a bargain sale a statement of the donor’s intention to make a charitable gift. The donor’s true motive and purpose determine whether a bargain sale was prompted by donative intent. Harold DeJong, 309 F. 2d 373 (9th Cir. 1962); Stubbs v. United States, 428 F. 2d 885, 887 (9th Cir. 1970).

Bargain Sale Rules
The tax code permits a donor to avoid a part of her capital gain if appreciated property is sold to charity in a bargain sale. For example, assume that a charity pays $12,000 to a donor for stock worth $20,000. The donor is allowed an income tax charitable deduction for the difference between the $12,000 bargain sale price of the property and its $20,000 fair market value. In this example, there would be an $8,000 income tax charitable deduction.

If the donor sells appreciated property to a charity, the donor may allocate her cost basis between the sale and gift portions on the transaction.

Let’s say the donor’s cost basis in the stock in this example was $4,000. If the donor sold the stock at fair market value, she would trigger a capital gain of $16,000, the difference between her purchase price and the sale price. If the donor sold the stock to a charity for $12,000, the $16,000 of reportable capital gain would be reduced by the ratio that the bargain sale price bears to the fair market value. The donor would have to report $9,600 in capital gain instead of $16,000 ($16,000 total gain x ($12,000 bargain sale price /$20,000 FMV) = $9,600). 

Installment Sales Method
Normally, a seller must recognize gain or loss on the sold property in the year of the sale. When property is transferred subject to installment payments, however, the seller can report gain as she receives payments in the proportion that her gain on the transaction bears to the sales price. This is the installment sales method and applies whenever a seller receives a payment in a year after the sale. IRC. Sec. 453(b)(1).

Here is how the installment sales method works. Martha has property worth $100,000 and a cost basis of $20,000. She sells the property for its fair market value of $100,000 in five annual installments of $20,000. Instead of reporting $80,000 of gain in the year of the sale, $16,000 of each $20,000 installment would be taxed as capital gain ($80,000 gain / $100,000 sale price) x $20,000 annual installment = $16,000 reportable capital gain).

Charitable Installment Bargain Sale
The bargain sale and installment sale concepts can be combined to create a charitable installment bargain sale. This arrangement can be attractive when a charity doesn’t have the current cash flow to purchase the donor's property in one payment or the donor prefers to receive cash flow over a term of years.

The charitable installment bargain sale incorporates some of the features of a gift annuity and a bargain sale. The bargain sale can spread payments over a term of years, provide an income tax charitable deduction, reduce reportable capital gain, and allow the donor to report this capital gain over the term of the installment sale. 

When the bargain sale price is paid in installments, the deduction, as with a gift annuity, is equal to the fair market value of the donated asset minus the present value of the payment stream to the donor. Since the charity receives the property right away, but the donor receives payments over time, the value of the charity's portion is greater than when the charity makes a single lump sum payment.

Let’s assume that Martha sells the property described earlier with an appraised fair market value of $100,000 and a cost basis of $20,000 to charity for $40,000. If paid in one installment, Martha’s income tax charitable deduction would be $60,000, the difference between the fair market value of the property and the bargain sale price. If the bargain sale price is paid in five equal installments of $8,000 per year, however, Martha’s deduction would be the fair market value of $100,000 minus the present value of the $8,000 installments spread over five years. The IRS requires that interest be imputed to such a transaction. Assuming the January 2010 discount rate of 3%, the present value of $8,000 per year for five years is $36,637.66. Martha’s income tax charitable deduction would be $100,000 - $36,637.66 = $63,362.34.

What about the capital gain on the transaction? Since Martha’s bargain sale price is being paid in the installment sales method, her gain would be spread out over the five-year term of the contract. The capital gain income, ordinary income (i.e., interest), and tax-free return of principal are spread out in equal installments when paid from a gift annuity. When paid from an installment bargain sale, the capital gain income and the tax-free return of principal are amortized over the term of the payments like a mortgage. Therefore, more of the taxable ordinary and capital gain income is distributed in the early years than the tax-free return of principal.

This is how Martha's payments would be taxed:

Pitfalls
If the installment bargain sale is looking pretty good right now, hold on. An installment bargain sale could cause property to be treated as “debt-financed property” in the hands of the charity. IRC. Sec. 514. Income from debt-financed property unrelated to an organization's exempt purposes is taxable as unrelated business taxable income ("UBTI"). "Debt-financed property" is any property that is subject to acquisition indebtedness and is held to produce income.

This means that in our example, Martha’s gift could be characterized as taxable income to the charity to the extent that the value of the property exceeds the value of the bargain sale payments. Therefore, property received in an installment bargain sale should be put to a use related to your organization’s exempt purpose.

Conclusion
The installment bargain sale can be a unique solution when a donor and charity agree on a bargain sale of property but want to spread the payments over time. The technique works best when the property is related to the charity’s tax-exempt purpose, such as a building into which the charity would like to expand. However, there can be situations where this technique creates substantial benefits for the charity, even when the charity needs to pay some tax.