This is a guest post from LD, a practicing Certified Public Accountant and Certified Financial Planner who blogs about personal finance at Personal Finance Insider.
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Generosity is exactly this: to give that which is dearest to us. It is an act that transforms us. After it, we will be poorer, but we will feel richer. Perhaps we will feel less equipped and secure, but we will be freer. We will have made the world we live in a little kinder. – Piero Ferrucci
Giving selflessly of your time and means to help and serve those who are less fortunate can bring great joy to both the giver and the receiver. It can give life much more meaning.
Most people don’t give to charity solely to receive a tax benefit and rightly so. They do it for much more noble reasons that are beyond a numerical value. However, if you can accomplish the same charitable or philanthropic objective using tax-efficient strategies as you can tax-inefficient ones, it would make sense to use the tax-efficient route.
If you contribute to charity, or plan on doing so in the future, below is a list of some of the important individual income tax issues of which you should be aware.
Basic deductibility rules
There are some basic rules that you should be aware of if you want to receive an income tax deduction for your charitable gifts:
- In order to receive an income tax deduction, money or property must be contributed to a qualified charitable organization (rather than directly to an individual or some other type of organization).
- If you receive a benefit (e.g., you pay $200 to attend a charity fundraiser and you receive a dinner valued at $50), the income tax deduction is limited to the excess of the contribution over the value of the benefit received.
- You generally cannot take a deduction for the value of your time or services contributed to charity.
- You may be able to deduct out-of-pocket expenses incurred in giving services to a qualified organization.
Your Adjusted Gross Income (AGI) is a line on your Form 1040 (bottom of page 1 and top of page 2) that is calculated by taking your income and subtracting certain deductions. Deductions for charitable gifts may be limited to 50, 30, or 20 percent of this number, depending on the property gifted and the type of charity receiving the gift.
Most people don’t contribute enough to charity to have their deduction limited by the applicable thresholds. However, if your deduction is limited, you generally have five years to use the disallowed portion before it is lost.
I once had a client who donated a piece of art valued at $1 million to a museum. I had another client who personally funded the construction of a new building on the campus of his alma mater (guess who they named the building after?). The deductions for both of these gifts were limited in the year the gifts were made but were subsequently fully allowed over the following five years.
Choice of property
Your choice of property that you contribute to charity has important tax consequences. Cash is by far the most common asset that people contribute to charity. While other assets may be more tax advantageous, it is generally the easiest asset to contribute. It may also be the most appropriate asset to use for people who don’t hold appreciated securities in a taxable (non-retirement) account, who plan on contributing very small amounts to many different charities, or whose income is low relative to the amount they are gifting.
It is generally more tax efficient to donate appreciated capital assets (i.e., securities, etc.) that you have owned more than a year than to sell the asset, recognize the capital gain, and then donate the proceeds. The donor avoids having to pay tax on the asset appreciation and generally receives a charitable income tax deduction equal to the fair market value of the asset. Since most charities are tax exempt, the charity doesn’t pay tax on the appreciation either.
It is usually tax inefficient to donate investment assets that have depreciated in value. It is generally more advantageous to sell the security, recognize the capital loss, and then donate the proceeds to charity. The taxpayer would most likely forgo the capital loss if the depreciated asset were contributed directly to charity.
Contributions during life versus at death
From a tax point of view, it is generally more beneficial to contribute to charity while you are alive rather than at death. Not only do you receive the satisfaction of seeing the gift being made, but you may also receive a charitable deduction on your federal individual income tax return.
An individual generally receives no charitable income tax deduction for assets passing to charity at death. The upside to making a charitable bequest, though, is that you have the flexibility to change your mind during your lifetime.
If you do decide to make a charitable bequest, certain retirement assets (and other assets known as Income in Respect of a Decedent, or IRD) such as a traditional IRA are often good assets to use. If you were to leave a traditional IRA to an individual beneficiary, he or she would most likely have to pay taxes on any distributions received. However, since charities are generally tax exempt, the charity would probably be exempt from having to pay any tax on the distributions. Other assets that receive a step up in basis at death could be left to non-charitable beneficiaries and would be taxed more favorably.
Donor advised funds (DAFs) are offered by many community foundations and mutual fund companies and are great for people who want an upfront charitable deduction without the costs and complexities of running a private foundation. Although technically the individual does not control the funds in a DAF, he or she can make recommendations as to how the money is to be disbursed.
Last but not least, it is important to keep good records of your charitable contributions. If you don’t and the IRS audits your tax return, your charitable deductions could be disallowed, and you could be slapped with a stiff penalty.
Giving to charity is about much more than just taxes. However, if you choose to give to charity, it’s important to be aware of the relevant tax rules surrounding charitable giving. I hope that a tax technicality never prevents or discourages you from helping another person in need. However, tax-efficient giving may allow your limited resources to help more people and to achieve your charitable objectives.
Disclaimer: The above article is provided for informational purposes only and should not be construed as professional legal, financial, or tax advice. Should you need such advice, seek out and consult a qualified professional who can give advice on your specific situation.