Part III – Life Estates and Pooled Income Funds

VI. Gifts From Life Estates

Under Sec. 170(f)(3)(B)(i) of the Internal Revenue Code, a person may give a remainder interest in a personal residence or farm to a charity and reserve the right to live there for one or two lives. But what if circumstances change and the donor no longer desires to live in the home? Or perhaps mother and father created a two-life estate and father passes away? Are there options that mother should now consider? Fortunately, there are several potential flexibility options for a life estate donor.

Life Estate With A Surviving Spouse

Assume that John and Mary Jones, both age 75, transfer the remainder interest in their $300,000 home to charity. As owners, they agree to be responsible for the maintenance, insurance and taxes. To make certain that both John and Mary understand their obligations, they sign a Maintenance, Insurance and Taxes (M.I.T.) agreement with the charity.

One caution must be emphasized with respect to the "M.I.T." agreement - the charity must have a remainder interest subject to the donors' life estate in the home and there can be no prearranged obligation to select any of the possible flexibility options. The IRS will deny the charitable income tax deduction if any binding obligation exists. In any case, the purpose of having flexibility options is enhanced by not choosing one until a future time.

Under the Applicable Federal Rate (AFR) at that time, John and Mary receive an income tax deduction of $109,245. In effect, they give this remainder value to the charity and the remaining, $190,755 represents the value of their life estate. As John and Mary grow older, the life estate value declines and the remainder value of the charity increases.

Assume that five years after creating the life estate, John passes away. Mary decides at that time that she would rather live in Happy Acres Retirement Community. What are her possible options? Fortunately, she is not required to keep the life estate interest. She and the charity have several attractive potential options.

Joint Sale

Mary Jones and the charity can enter into a joint sale. The home is now owned in part by Mary Jones and in part by the charity. Just as with any other type of ownership, they can agree together to sell and divide the proceeds.

Based on an Applicable Federal Rate on the date of sale, the home worth $350,000 at that time would have a remainder value to the charity of $204,130 and a life interest value to Mary Jones of $145,870. Charity and Mary Jones could agree jointly to sell the property and divide the proceeds accordingly. Mary Jones would have a very substantial capital gain, but she could use her $250,000 capital gains tax exclusion to eliminate the capital gains tax.

Gift of Life Estate

Mary could decide to give her life estate, valued at $145,870, to the charity. The charity would then own both the remainder value and the life estate and could sell the home. Mary would receive an income tax deduction for the value of the life estate she had transferred to charity.

Remainder Unitrust

If Mary desires to receive income, she could contribute her life interest to a charitable remainder unitrust. Since the life interest under state law is a valid property interest and she transfers her entire retained ownership into the trust, she should receive a deduction for a gift of appreciated property.

Alternatively, if she has available the $250,000 exclusion, the gain on the $145,870 may be offset and it may be preferable to sell for cash and then contribute the sales proceeds to a gift annuity or unitrust. This latter course results in a cash-type deduction usable to 50% of adjusted gross income. In either case, Mary can receive the income from the $145,870 for life.

Conversion to Gift Annuity

With the home sale exclusion of up to $250,000 of long-term capital gain, it may be possible to exchange the life interest in the home for a gift annuity income. In this circumstance, it would be important that the gift annuity based upon the value of the life interest has at least a 10% charitable interest, since that is the minimum requirement for a qualified gift annuity under Section 514(c)(5) of the Internal Revenue Code. If Mary is able to elect the use of the exclusion for the transfer of the life estate, as was permitted by Revenue Ruling 84-43, then the gift annuity could be treated as though Mary contributed cash. Therefore, she would receive both a charitable deduction and substantial tax-free return from the annuity.

Combination Plan

In Revenue Ruling 87-37, the IRS acquiesced in a plan that involved a gift in 1/10th of a remainder interest. So long as the interest transferred was an undivided percentage of the qualified gift plan, the gift was permissible and entitled to a charitable deduction. In essence, this Revenue Ruling is authority for the concept of dividing the remainder and income interests and transferring undivided percentages of those interests into another plan.

For example, Mary might choose to sell 1/2 of the value of her life interest and transfer the balance into either the unitrust or gift annuity rollover plan. This flexibility enables use of combination interests and is very helpful in crafting a rollover solution that optimizes benefits and achieves the goals of Mary Jones.

Benefits of Flexibility

Flexibility is a wonderful tool. Very few tax advisors are fully aware of opportunities for flexibility with life estate agreements. If more gift planners and counsel understood the inherent flexibility of this plan, friends of charities would create far more life estates.

VII. Gifts From Pooled Income Funds

Gift of an Income Interest to Charity

An income interest is a property right under state law. An individual who owns a property right may transfer that property to a charity. The Service has permitted the transfer of an annuity interest or a charitable remainder unitrust interest to charity. See PLR 9550026. When the donor irrevocably transfers the income interest to the charity, he or she has made a gift and should receive a charitable income tax deduction for the value transferred.

Gift of PIF Income Interests

The pooled income fund is an irrevocable agreement between the charity and the donor. The donor retains the life interest and the charity irrevocably receives the remainder. After the interest has been created, the pooled income fund donor may no longer need the income. He or she may then transfer the income interest to the charity. At that time, the charity owns both the income and the remainder interest in those units and may convert that portion of the pooled fund into a current gift to charity.

If the pooled income interest is held by a husband and wife, then it will be necessary for them to give to the charity irrevocably both their current income interest and their contingent income interest in the one-half interest owned by the other spouse. See PLR 9721014. While gifts of income interests have more frequently occurred with charitable remainder unitrusts or charitable gift annuities, a PIF income recipient should be able to make a comparable gift and receive an income tax deduction.

Terminating or Modifying a Pooled Income Fund

Due to low returns during the past several years, many pooled income funds have not been very popular with donors. Some charitable organizations have not had any new donors to pooled income funds in several years. Given the cost of administering the fund, these charities have considered the possibility of converting the pooled income fund to another gift plan.

Charitable Gift Annuity Conversion Option

While there is no specific provision for doing so in the Code, it may be possible to convert a pooled income fund into charitable gift annuities. If all donors agree, they could exchange their respective income interests in the pooled income fund for charitable gift annuities. In effect, they would be transferring irrevocably all of their income interests to the charity and receiving charitable gift annuities in return.

Since the income interest is a valid state law property right, there is no reason why a PIF income recipient should not be permitted to make such a lawful transfer. While the federal tax consequences are not certain, it is reasonable to claim that the property interest should be valued and treated like other capital-gain-type property interests transferred in exchange for gift annuities.

The income interests are valued using Treasury tables and the Applicable Federal Rate under Sec. 7520. Gift annuities could be issued for the value of the income interests. Income interests are considered by the IRS to be capital assets with zero basis. The gain will be recognized over the life expectancy of the donor or donors. All of the gift annuities would need to qualify under federal rules by producing at least a minimum 10% additional charitable deduction. Sec. 514(c)(5).

In some regulated states, it may be necessary to pay only the American Council on Gift Annuities rates (or the rates filed with that state insurance commissioner) on the income interest value. This could mean that pooled income fund beneficiaries would receive lower income from the new gift annuity. However, they also would receive a charitable income tax deduction.

While this is a rather creative solution that may be permissible. Counsel for charities contemplating this course of action should carefully examine the various tax ramifications of a PIF to CGA conversion.