Rizek Housari, CPA, CFP®
Creating a custom financial model of your future gives you the framework and lens to make important financial decisions.
How to best mitigate and manage your tax burden is just one of the important decisions to consider.
At Divergent Wealth we are state-of-the-art financial planners and investment professionals who specialize in simplifying complicated things.
To create a complimentary customized financial plan, call us at 385-CFP-4000. For information, visit us at www.divergentwealth.com.
There is no feeling like giving to a cause or charity that you care deeply about. Being in a position to help is empowering.
With all that is occurring in the world, many families are looking for opportunities to make a greater impact and leave a lasting legacy. There are numerous methods of donating to your favorite charities that are often overlooked.
This article highlights a few efficient tax planning strategies for maximizing your charitable impact.
Donating Appreciated Assets
While donating cash to qualifying charities is certainly worthwhile, the IRS has provided a way for investors to avoid some tax when donating certain assets other than cash.
Donating appreciated property that has been held for more than one year can often provide extra benefits to you and the charitable organization. This is because the donor obtains a charitable contribution deduction equivalent to the fair market value of the property on the date it was donated.
The real tax benefit comes because the gain on the investment is not recognized, so there is typically no tax to pay. This is extremely effective because the donor avoids the long-term capital gains tax attributable to the increased value of the security. Even more impactful is donating collectibles such as art, antiques, or coin collections as the tax rate of these items is often significantly higher than other property.
Remove the Tax Burden from your Charitable Giving
If you are concerned you are offloading the tax burden onto your favorite charity or church, rest assured. Those entities organized under the Internal Revenue Code’s Section 501(c)(3) are normally exempt from federal income and capital gains tax. Be sure to verify that the organization is eligible for tax-deductible donations by using the Tax Exempt Organization Search (TEOS) tool found at IRS.gov. Let us explain this through an example.
Mrs. Trout Writes a Check
Mrs. Trout is a frugal, charitable person and has saved throughout her life, investing continuously. Each year she writes a check out to her favorite charity. To do this, she sells a portion of her stock for $10,000. She originally purchased the stock for $6,000, resulting in a $4,000 long-term capital gain. As Mrs. Trout knows, long-term capital gains (LTCG) are taxed at preferential tax rates, meaning that she pays far less tax on this form of income than she does on ordinary income from her job. She is initially happy that she only has to pay $800 (at 20% LTCG) in taxes to Uncle Sam. This leaves our friend Mrs. Trout with $9,200 that she uses to write her check and donate to a good cause. However, Mrs. Trout could donate even more by taking advantage of donating her appreciated stock directly to the charity.
Mrs. Trout Donates Stock
After a quick phone call to her charitable organization, Mrs. Trout learns that she can donate her appreciated stock rather than selling it for cash and writing a check. Instead of selling her investments, she avoids the tax altogether and gives the charity the stock valued at $10,000. She is thrilled because her charity gets the full $10,000 in lieu of just the $9,200. It gets better.
Mrs. Trout can take a charitable deduction equal to $10,000 when she itemizes her taxes, as opposed to only $9,200. Her charity, if they choose, can then turn around and immediately sell the appreciated stock for $10,000 cash. The tax is avoided altogether, and Mrs. Trout feels terrific because she was able to donate more to her favorite cause by donating stock rather than cash.
Itemized v. Standard
According to an IRS news release in late 2020, “Nearly 9 in 10 taxpayers now take the standard deduction.” This means that most individuals who donate do not get the tax deduction when they file their federal taxes, as charitable contributions are itemized on their return. For those clients who did take the standard deduction in 2020, The Coronavirus Aid, Relief and Economic Security (CARES) Act included a special temporary tax change that helped charities and donors. In an effort to boost charitable contributions during the COVID-19 pandemic, a special $300 tax deduction was given to those who donated cash to eligible organizations. Interestingly, this special deduction excluded property, household items, or securities that were donated.
However, just because someone is taking the standard deduction does not mean they cannot benefit from donating appreciated assets. Quite the opposite. If Mrs. Trout in our example was taking the standard deduction, she would still benefit from donating appreciated stock. Just after she donates that stock, she can then turn around and use the cash that she would have otherwise donated and purchase the same security thus, keeping her asset allocation the same. On top of that, she gets a stepped-up basis in the sense that her cost basis is now higher than it was in the donated stock, all while avoiding the tax on the gain in the appreciated stock.
Why is this important? In the future when Mrs. Trout needs to sell some well-performing stock to go on that Alaskan cruise, her basis in the stock will be higher, meaning that her gain will be smaller. Ultimately, a smaller realized gain means she can get a room with a view of the ocean instead of paying increased taxes.
A Word of Caution
While donating appreciated assets can be an excellent strategy, donating assets that have gone down in value is not strategic. The benefit comes by avoiding paying taxes on the gains. Oftentimes, harvesting losses on their own is a more efficient strategy.
Frontloading the Donation
You may be thinking at this point, is there a way I can get the full benefit of charitable giving by itemizing this contribution next year? The answer is (drumroll please) YES! Donor-Advised Funds (DAFs) may be the answer.
This dedicated charitable account is used for the sole purpose of endorsing those causes that mean the most to you. DAFs allow you to frontload your charitable contribution and take an increased deduction this year while postponing the actual disbursement of funds until a future date.
This separately identified fund is held by a sponsoring organization that has legal control over the funds, however, the donor retains the privilege of advising the distribution of the funds.
Even better, prior to the distribution of the funds from a DAF, the donor may choose to invest the principal amount contributed. This means that the account can grow over time protected from taxes. By frontloading the contributions to a DAF, you can offset high-income years by using this time-tested strategy.
This could be highly productive in several situations. Here are just a few instances when this approach may be beneficial to consider:
·Your final few years of working when your income is typically the highest
·Selling a privately held business
·During years of ROTH conversions
·Receiving an Inherited IRA
·Selling a vacation home or rental property
This approach to donating gives clients the opportunity to lower their tax liability today, and pre-fund their charitable giving in the future during retirement when realized income is typically lower. While there are no time requirements to distribute funds from a DAF to a charity, some sponsors have policies that require donors to make a gift from the DAF every few years. You will want to consider this before making a contribution to a DAF.
Charitable Remainder Trusts
A Charitable Remainder Trust (CRT) can be a phenomenal vehicle designed to reduce taxable income and leave a legacy to your favorite charity. While these types of trusts can be customized and sometimes complex, in essence, the donor contributes assets to a tax-exempt irrevocable trust with two beneficiaries. This is often why CRTs are referred to as “split-interest.” The trust pays the beneficiary you designate for a specified period of time. After which, the estate gives the remainder to the charity you determined upon the creation of the CRT. Another example helps illustrate this.
Mr. Bass creates a CRT
Mr. Bass contributes assets to a CRT. This is when things get exciting. The CRT names Mr. Bass as the beneficiary for 20 years or his remaining life, and then names a charity to receive the remaining assets of the CRT. He is now eligible for a partial tax deduction because he has given to charity.
This enables Mr. Bass to receive an income stream in the future and a partial tax deduction today, all while ensuring his assets go to his designated charity in the end. Further, if Mr. Bass contributes highly appreciated property such as publicly-traded securities or real estate into the CRT, he can avoid having his assets eroded by large capital gains taxes. This allows for more assets to be distributed as income and a greater remainder for the charitable organizations named as beneficiaries.
You have some excellent opportunities to maximize your charitable giving. Proactive tax planning will empower you to support charitable organizations in an efficient manner. Consider donating appreciated securities, using a Donor-Advised Fund, or a Charitable Remainder Trust as part of your financial plan.
Creating a custom financial model of your future gives you the framework and lens to make important financial decisions. Tax Planning is just one of the important decisions. At DivergentWealth®we are state-of-the-art financial planners and investment professionals who specialize in simplifying complicated things. To create a customized complimentary financial plan, call us at 385-CFP-4000. For information, visit us at www.divergentwealth.com.
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