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Monday July 28, 2014

Case of the Week

Baroness Edna and the Depreciation Dilemma, Part II

Case:

Will Rogers has been credited with saying "Buy land. They ain't making any more of the stuff." These words were not lost on Edna Appleby. Edna began purchasing parcels of land around her southern California home many years ago. She purchased only investment properties and these properties have paid off handsomely over the years. It was not long before Edna became known in her community as "Baroness Edna."

One property Edna owns is a large office building. The building was purchased years ago for $200,000 and is now valued at $1,000,000. Edna, who has learned a thing or two about owning investment properties, has depreciated the building. The basis in Edna's building has been depreciated by $100,000 ($60,000 of which is attributable to the straight-line method of depreciation and $40,000 of which is attributable to the accelerated method).

Although the office building has been profitable for Edna, she decided to diversify her holdings. Edna approached her accountant and asked about the feasibility of donating the office building to Favorite Charity, the nonprofit school her boys attended some many years ago.

Question:

Edna met with Kate, her CPA, and said, "We spoke last week about selling my office building. I would now like to hear about the ramifications of donating the building to Favorite Charity."

Solution:

“Now, Edna," Kate said, "You have taken some depreciation on the building. This was a good plan in order to get you a deduction on your taxes in previous years. However, because accelerated depreciation was taken on the building, there will be some recapture issues." Edna smiled at Kate and asked about the tax consequences and what impact the recapture would have. Kate explained to Edna that when a property on which accelerated depreciation has been taken is used to fund a charitable gift annuity, the difference between accelerated depreciation and straight-line depreciation is taxed to the seller as ordinary income.

"Kate," asked Edna, "how exactly would this apply to my situation?"

"Last time we met we discussed that your building has a fair market value (FMV) of $1,000,000 and an original cost basis of $200,000," Kate said. "You have taken $100,000 in depreciation and $40,000 of that was accelerated depreciation. In total, your new basis in the property is $100,000."

Kate went on to discuss the aspects of a charitable gift annuity (CGA) funded with Edna's building. "If you use the building to fund a charitable gift annuity with Favorite Charity you will receive a tax deduction and a stream of income for the remainder of your life."

"That sounds great!" said Edna, "What's the catch?"

"When a CGA is funded with property on which accelerated depreciation has been taken, the amount of the deduction is reduced." Kate explained. "In your case the situation is this: you have a $1,000,000 property depreciated by $100,000, $40,000 of which is accelerated depreciation. If you donate the property to Favorite Charity your deduction will be based on $960,000, not the full $1,000,000 ($1,000,000 - $40,000 of accelerated depreciation). This is because of that pesky recapture issue I mentioned."

Edna thought for a minute and said, "Well, that’s not so bad. But what about the income from the CGA? Is that affected by the depreciation I have taken?"

"A good question Edna," said the CPA. "As a matter of fact, depreciated property exchanged for a CGA does have an effect on the payments." Kate went on to explain that payments from the CGA would be taxed as part long-term capital gain taxed at 23.8%, part capital gain attributable to straight-line depreciation taxed at 28.8%, part ordinary gain due to the accelerated depreciation taxable at up to 43.4% and part tax-free return of basis. "In addition," Kate told Edna, "the portion of capital gains, both long-term and the amount attributable to depreciation, allocated to the gift portion of the contribution is bypassed." Remembering that Edna prefers numbers to theory, Kate quickly wrote down some figures and passed a notepad to her.

Property Information

  • $1,000,000 - FMV
  • $200,000 - Original Cost Basis
  • $100,000 - Total Depreciation
  • $60,000 - Straight-Line Depreciation
  • $40,000 - Accelerated Depreciation

Funding a Charitable Gift Annuity

  • $1,000,000 - Annuity Funding Amount
  • $960,000 - Charitable Deduction Is Based On This Amount
  • Capital Gain Attributable to the Annuity Portion (both the long term and the amount attributable to depreciation) Spread Over the Lifetime of the Donor.
  • Capital Gain Attributable to the Gift Portion (both the long term and the amount attributable to depreciation) Bypassed.
  • Basis Attributable To Annuity Portion Spread Over Donor's Lifetime

"I hope this explains the tax issues associated with the sale of your building," Kate said.

"Think about the annuity option this week and on Monday we will discuss funding a charitable remainder trust with your building."

Published July 25, 2014

Previous Articles

Baroness Edna and the Depreciation Dilemma

Refund Due for Termination of “Single” Status – Part 3 of 3

Refund Due for Termination of “Single” Status – Part 2 of 3

Refund Due for Termination of “Single” Status – Part 1 of 3

Swenson "Early" Retirement

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