Note#1: Basis Allocation Rules and Deductions
Some of the discussion that follows will be “old news” to readers. But the idea here is really to lay the foundation for a discussion of the “basis allocation” rules, which are frequently unknown, ignored, or misunderstood. One or more future “Notes” will take the basis allocation rules a few steps further.
The discussion below also assumes that the conservation easement deduction rules that apply are those that apply when this Note is written. That is, the deduction can be taken up to 30% of adjusted gross income with a five-year carryforward of any remaining amount. The enhanced easement deduction incentives, which expired at the end of 2013, allowed the deduction to be taken up to 50% of adjusted gross income (for farmers and ranchers up to 100% of adjusted gross income), with a fifteen-year carryforward. Those incentives might become law again, so stay tuned.
Gift of the property. Aunt Sally has a farm. The value of the farm is $1,000,000. Aunt Sally gives the farm to the land trust. Aunt Sally can take an income tax deduction for the value of the farm, $1,000,000, and she can generally take that deduction up to 30% of her adjusted gross income for the year of the gift, with a five-year carryforward of any unused amount of the deduction. Aunt Sally needs a “qualified appraisal” to substantiate the value of her charitable gift. Future Notes will cover some
qualified appraisal issues. In all examples below where Aunt Sally makes a charitable contribution, she will need a “qualified appraisal.”
Sale of the property at full fair market value. Aunt Sally has a farm. She purchased the farm in 1978 and her cost or “basis” of the farm is $100,000. (“Basis” is a tax concept that often means the same as “cost” but in many situations cost and basis are different. For purposes of this Note, I will assume Aunt Sally’s cost and her basis are the same.) The farm is now worth $1,000,000. She sells it for $1,000,000. She has $900,000 of long-term capital gain from the sale.
Sale of the property at less than full fair market value, also known as a “bargain sale” or “part-sale part-gift.” Aunt Sally has a farm. She purchased the farm in 1978 and her cost or “basis” of the farm is $100,000. The value of the farm today is $1,000,000. Aunt Sally sells her farm to the land trust for $600,000. On these facts, since the sale price is 60% of the value of the farm, the tax rules require that 60% of the basis of the farm be allocated to the “sale” portion and 40% of the basis be allocated to the “gift” portion. The basis is $100,000; 60% of that is $60,000, which means that the “sale” portion has a basis of $60,000. Sally has long-term capital gain of $540,000 (the $600,000 sale price minus $60,000 of basis). Sally also has a charitable contribution deduction of $400,000, the amount of value she gave up by selling the farm to the land trust for less than its fair market value. The “basis” of the charitable gift turns out to be $40,000, but in this particular situation the basis of the “gift” has no tax consequence.
Now, some readers might think, and Aunt Sally might think, “that’s not a bad deal. I have $540,000 of long-term capital gain and a charitable contribution of $400,000, so I can ‘shelter’ most of the gain with the deduction.” However, note that the charitable deduction rules allow Sally to use the charitable contribution only up to 30% of her adjusted gross income for the year (with a five-year carryforward). If Sally has no other income, this year she can deduction $180,000 of her charitable contribution (30% of $540,000), with the remaining $220,000 of her $400,000 deduction available as a carryforward.
Gift of an easement. Aunt Sally’s farm has a basis of $100,000 and is worth $1,000,000. An easement on the farm is worth $300,000. Sally sells an easement to the land trust for $300,000. Under the conservation easement regulations, a portion of the basis of the farm must be allocated to the easement. Many landowners and many advisors to landowners are not aware of this rule. Because the easement is worth 30% of the value of the entire farm, 30% of the farm’s $100,000 basis, or $30,000, is allocated to the easement. In this case, and in almost every other case, the “basis” of the easement will have no tax consequences.
However, because $30,000 of the basis of the property has now been allocated to the easement, the basis of the farm is now reduced to $70,000 ($100,000 minus $30,000). If Aunt Sally sells the farm tomorrow, she will have more tax to pay. If Aunt Sally sells the farm in ten years, she will have more tax to pay, although on these facts that probably won’t bother her very much. This rule isn’t really unfair or illogical, but easement donors and their advisors should be aware of it.
Sale of an easement at full fair market value. Aunt Sally’s farm has a basis of $100,000 and is worth $1,000,000. An easement on the farm is worth $300,000. Sally sells an easement to the land trust for $300,000. Under the conservation easement regulations, a portion of the basis of the farm must be allocated to the easement. Since the easement is worth 30% of the value of the entire farm, 30% of the farm’s $100,000 basis, or $30,000, is allocated to the easement. Accordingly, Aunt Sally has long-term capital gain of $270,000 (the $300,000 sale price minus $30,000 of basis).
Sale of an easement at less than full fair market value: a “bargain sale” of an easement. Aunt Sally’s farm has a basis of $100,000 and is worth $1,000,000. An easement on the farm is valued at $300,000. Sally sells the easement to the land trust for $200,000. This gets a little complicated.
On these facts we have determined that the basis of the easement is $30,000. Now, under the bargain sale rules (discussed above), we know that the basis of the easement must be allocated between the sale portion and the gift portion. Since the sale price of $200,000 represents two-thirds of the $300,000 total value of the easement, two-thirds of the $30,000 basis of the easement, or $20,000, is allocated to the sale portion and $10,000 of the basis of the easement is allocated to the gift portion. This means that Aunt Sally has $180,000 of long-term capital gain (the sale price of $200,000 minus the $20,000 basis of the sale portion). Sally also has a charitable contribution deduction of $100,000, the amount of the value of the easement she gave away by selling it to the land trust for less than its full fair market value. The basis of the easement is $10,000, but that has no tax consequences here.
Sale of a conservation easement: “Do I have to pay tax?” Let’s say the land trust is willing to pay $300,000 for Sally’s easement, as in the prior example, but Sally doesn’t want to pay tax on the money she receives.
Do you have any advice for her? See Note #2, coming soon.
Sale of a conservation easement: “Do I have to pay tax? And, I’m a generous person.”
Sally still wants some money for her conservation easement. But can you combine Sally’s desire to avoid tax (legally…) and her kind and philanthropic nature?
Do you have any advice for her? See Note #2, coming soon.
SJS
8/27/2014
This is not legal advice. This is not advertising. The Notes are not intended to be definitive or “the” answer.
Copyright 2014 by Stephen J. Small. All rights reserved
