Creative charitable strategies for mortgaged real estate

Creative charitable strategies for mortgaged real estate
Published on Nov 9, 2020,03:34pm EST by Bryan K. Clontz, Ph.D., CFP®, CAP® for

Giving real estate is an impactful way support a charity and provide tax benefits to donors. But real estate donations are rarely a simple transaction, often carrying thorny restrictions and issues that have to be resolved. Almost every charity has a major gifts officer with a horror story of a failed gift they cannot get out of their memory.

Most charities will not even entertain an inquiry of a gift of real estate. This is even written into their gift acceptance policy. While real estate can be a tax optimal asset for a donor, it can be a challenge for charities to accept, whether because of risk tolerance, board policy, or practical concerns with the potential for property management burdens and indeterminate sale date.

Add an encumbrance such as a mortgage, and the risk and tax treatment quickly gets more complex. Debt reduces both the donor’s tax benefit and the charitable dollars ultimately realized for charity.

When gifting mortgaged real estate, the donor is relieved of the debt while the encumbered value is treated as a sale to the recipient charity. Also different from mortgage-free gifts of real estate, capital gains realized from debt-financed assets are generally taxable to the charity as unrelated business income (UBTI) unless it meets certain exemptions.

Some of these debt-burdened properties can be very good candidates for charitable giving. However, if it has any debt, most nonprofits will regretfully pass on the proposed donation unless the donor is willing to pay off the debt pre-contribution. Is there a way this could work better for all parties?

There are a few options for many donors who have valuable property with debt under 30- 40% of the fair market value.

Solution #1: The charity accepts the donation as a bargain sale, where the purchase price is equivalent to the debt. Then, upon the sale of the property, the charity calculates unrelated business income tax, if necessary, and uses the net proceeds for the originally intended charitable purposes.

Solution #2: The charity purchases the portion of the property equivalent to the debt, with the donor then making a charitable donation of the remaining interest. The charity, along with the other owner if one exists, would then cooperate in the sales process. As an example, imagine a $2 million vacation home with a $500,000 mortgage that a donor is no longer using and wants to donate. The charity could purchase the mortgaged 25% interest in the property for cash, with which the donor pays off the debt. The donor is free to donate the remaining 75% share to charity or simply keep some proportional amount. The charity (or charities/donor) then sells the entirety of the debt-free property and receive the proceeds appropriately. This can work well for outright major gifts or life-income gifts like charitable remainder trusts or charitable gift annuities.

Beautiful waterfront house on Cape Cod...

Solution #3: A final, higher-risk strategy for mortgaged property is to have the donor simply keep the debt obligation in place. The donor contributes whatever percentage they choose to charity, and signs a side agreement consenting to continued payment of the mortgage. This is a higher-risk proposition for the charity and donor, since the lender could call the loan under the “due on sale” clause. The donor may prefer this approach, since there is arguably no relief of debt from a tax perspective. Clearly, a donor should seek strong financial, tax and legal counsel to explore this solution.

Real estate donations can be difficult to begin with, let alone debt-encumbered property. Many charities will not accept such property. However, it can have significant value for the charity, and meaningful tax advantages for the donor. This is true even when the property has a mortgage on it. In those cases, the donor and charity should work together to determine whether to utilize a strategy for donating the property with the debt continuing to be paid or being paid off by the charity.