Charitable giving is a powerful way to create a lasting legacy, embodying the age-old questions of purpose and remembrance. For many, the act of giving answers the profound inquiry, “Have I made a difference?” The desire to contribute positively to society often motivates individuals to support causes close to their hearts, fostering a sense of camaraderie and purpose.
Many real estate investors own properties that have appreciated significantly since acquisition or inheritance. While converting this appreciation into charitable donations is indeed a blessing, it comes with potential tax costs. Selling appreciated properties can trigger federal capital gains taxes, depreciation recapture, and various state and local taxes, which can aggregate to as much as 35%. Alternatively, donating the entire property may materially impair an investor’s overall net worth and present challenges for both donors and charity.
Fortunately, a viable solution for accredited investors [1] combines the benefits of an Internal Revenue Code (IRC) Section 1031 like-kind exchange with the Delaware Statutory Trust (DST) structure, allowing for tax-free donations of appreciated real estate of any amount. If structured properly, this method provides an option for future charitable giving and future tax deductions based on the fair market value of the donated asset.
IRC Section 1031 has been a cornerstone of real estate investment strategy for over a century. By adhering to specific criteria—such as reinvesting all cash, assuming equal or greater debt, and acquiring property of equal or greater value—investors can defer taxes on the sale of appreciated investment real estate. This nonrecognition of gain allows for a seamless transition into a tax-advantaged structure.
A DST is a legal entity established under Delaware law that permits the pooling of capital from multiple investors, offering a flexible framework for real estate investment. Since 2004, the IRS has recognized DSTs as eligible for Section 1031 exchanges, provided they comply with established guidelines.[2] With investment minimums as low as $25,000, DSTs allow investors access to stabilized, institutional-grade properties often valued over $100 million.
Within the context of forward-looking tax planning, when the time comes to sell an appreciated property and contribute to a public charity (qualifying charity), utilizing a Section 1031 exchange with a DST replacement property can yield numerous benefits:
Tax Shelter: Investors can defer capital gains and other taxes on the appreciated value of their properties.
Tax-Free Exchanges: The process allows for a fully tax-free exchange into a DST, which may later be gifted to a qualifying charity without depreciation recapture. [3]
Flexible Gifting: Investors can choose to donate any portion of the sale proceeds rather than the entire property.
Portfolio Diversification: The non-donated portion can be reinvested into a diversified DST investment portfolio or traditional real estate investment, maintaining tax-deferred status.
Tax Deduction Opportunities: Investors may receive an income tax deduction for the fair market value of the DST real estate contribution, documented by appraisal.
Institutional-quality Gifts: Gifting a share in stable, cash-flowing real estate diversifies the qualifying charity’s investment portfolio.
Passive Management: Qualifying charities receive a professionally managed real estate interest, reducing operational burdens.
Conversely, contributing traditionally held appreciated real estate presents several challenges, including:
All-or-nothing Approach: Donors may have to contribute the entire property instead of a portion of the sales proceeds.
Title Complications: Adding a charity to the title or as a co-equity owner of a property may present additional costs and complications, and it must be done before the property is under contract.
Management Challenges: If the charity is unable to manage or accept complex properties, it hinders the property’s performance or causes the charity to lose focus on its nonprofit activity.
Liability Exposure: Donating property can expose charities to liabilities, such as environmental issues or injuries.
Maintenance Costs: The gifted property may incur repair expenses, management fees, and other carrying costs that diminish its benefits to the charity.
To enhance the charitable giving process, investors can sell appreciated real estate at fair market value and reinvest the proceeds into multiple DSTs under the tax deferral provisions of Section 1031 exchange. As demonstrated in Figure 1 below, this approach allows for any portion of the equity to be invested into a DST for a potential future charitable contribution option while the remaining proceeds are reinvested into a diversified DST real estate investment portfolio.
Adhering to a fact pattern that demonstrates an intent to hold the asset as an investment or for use in a trade or business is crucial to ensuring compliance with IRS regulations and a fully tax-free transaction.
Not a Binding Obligation: The investor’s future contribution of the DST is not a binding obligation or commitment. Rather, the investor simply has knowledge of various options following the exchange, including the donation of the DST interest to a qualifying charity.[4]
Not a Prearranged Plan: Investors may not have a prearranged plan to gift the DST interest, but they are free to structure the DST investment transaction in a way that provides for the best future tax planning option for charitable giving.[5]
Must Have Beneficial Ownership: This strategy provides for the investor to be the beneficial owner of the DST interest with all the burdens and benefits, including the risk of loss and the receipt and recognition of investment rental income, before a potential gift of the DST interest to a qualifying charity. [6] If desired, this income may be offset with independent annual cash donations to the qualifying charity[7], creating a win-win scenario.
Shorter Hold Period: If the exchange transaction is structured to ensure the DST interest is held for investment, a shorter hold period may be sufficient if, in the normal course of tax planning, the investor decides to take the option to gift the DST interest to the qualifying charity.[8] However, it should be noted that the DST interest must be held of a least one year in order to qualify as a long-term asset and allow for a fair market value property contribution deduction.[9] Once the hold period is completed, the DST investor could then assess his or her tax planning strategy and potentially contribute the DST interest to a chosen charity.
Fair Market Value Tax Deduction: In the tax year the option to gift the DST interest is exercised, the donor may take a federal tax deduction equal to the current market value of the DST interest. The tax deduction is allowed up to 30% of the donor’s adjusted gross income (AGI).[10] If the DST value exceeds 30% of the donor’s AGI in a given year, then any excess contribution deduction may be carried over for five years for more efficient tax planning.[11] The fair market value of the DST interest at the time of the tax deduction must be documented by a qualified appraisal.
No Depreciation Recapture: In addition to the federal charitable tax deduction, when a donor contributes their DST interest to a qualifying charity as a gift, the depreciation recapture provisions of Section 1250 should not apply to such disposition. [12]
No Debt DST Donation: It should be emphasized that donating a property encumbered with a mortgage may expose both the donor [13] and the charity [14] to tax liability. Therefore, donating unencumbered property to charity for tax purposes is preferable. With DSTs, any debt on the relinquished property may be allocated to the other DSTs in the investment portfolio, providing for an all-cash (no debt) DST for potential future charitable donations.
Donor-advised Fund (DAF)
As an alternative to a direct gift to a qualifying charity, the donor may choose to gift the DST interest to a DAF sponsored by a qualifying charity.[15] A DAF is a separately identified fund or account maintained and operated by a qualifying charity. Once the donor makes the contribution, the organization has legal control over it. However, the donor retains advisory privileges with respect to the distribution of funds and investment of assets in the account.
The DST structure has gained traction in the investment world, with over $50 billion in private equity investment since its inception (Figure 2). This vehicle serves as an efficient means to donate appreciated real estate, offering access to institutional-quality properties across the United States.
Key advantages of donating a DST property interest includes:
Diversified Asset Classes: DST offerings encompass various real estate sectors, such as multifamily housing, retail properties, senior care facilities, and more.
Professional Management: DST properties are managed by experienced sponsors, ensuring a passive investment for charities while providing consistent cash flow.
Limited Liability: Under Delaware law, donors and charities enjoy limited liability protections equivalent to those of a Delaware corporation.
Ease of Transfer: Ease of transfer of title through change in registration with the trustee with no lender approval.
By collaborating with Cornerstone, donors can align their charitable intentions with investment strategies, choosing DST properties that enhance the charity’s portfolio while maximizing tax benefits.
When and if the donor has elected the option to gift a DST interest, Cornerstone will work with the charity of your planned giving personnel to facilitate the transfer of the ownership interest to the qualifying charity and assist in the building of a diversified portfolio of professionally managed, institutional-quality real estate to help fund the charity’s activities.
In conclusion, utilizing DSTs for charitable giving presents an innovative pathway for real estate investors to maximize their philanthropic efforts while minimizing tax implications. By strategically leveraging Section 1031 exchanges, investors can contribute to their favorite charities without compromising their financial well-being. This approach empowers donors to create lasting legacies, ensuring that their contributions make a meaningful difference in the communities they care about most.
Cornerstone has obtained a legal opinion from a leading international law firm to ensure compliance with various tax rules. If you’re ready to explore how DSTs can enhance your charitable giving strategy, contact us today to discuss your options and start making a significant impact!
[1] An accredited investor is defined in Rule 501 of Regulation D and includes any individual with a net worth of at least $1 million, not including the value of his or her primary residence, or an individual with income exceeding $200,000 in each of the two most recent calendar years, or joint income with a spouse exceeding $300,000 for those years, and a reasonable expectation of the same income level in the current year. The accreditation standard is met for most business entities and trusts with total assets in excess of $5 million. [2] IRS Revenue Ruling 2004-86 [3] IRC Section 1250(b); Treas. Reg. Section 1.1245-4(a); Cornerstone-Baker McKenzie legal opinion, Issue 2, page17. [4] Other options include but are not limited to, cashing out of the investment, future Section 1031 like-kind exchanges, and Section 721 UPREIT exchanges. Cornerstone-Baker McKenzie legal opinion, Issue 1, page 15. [5] Gregory v. Helvering, 293 U.S. 465 (1935), Judge Learned Hand; Rice’s Toyota World, 81 T.C. at 196; Cornerstone-Baker Mckenzie legal opinion Issue 1, page 8. [6] The Grodt test and “the upside/downside” test, See Grodt & McKay Realty, Inc v. Commissioner, 77 T.C. 1221 (1981); Cornerstone-Baker McKenzie legal opinion, Issue 1, page 10. [7] Limited to 50% of the donor’s adjusted gross income (AGI). [8] Wagensen v. Commissioner, 74 T.C. 653 (1980); Compare PLR 8429039 (1984); Cornerstone-Baker McKenzie legal opinion, Issue 1, Page 13. [9] IRC § 170 and Sec. 170(e)(1). [10] IRC § 170 (b)(1)(C)(i) [11] IRS Publication 526 (2022), Page 18. [12] See Section 1250(d); see also PLR 201318003; Cornerstone-Baker McKenzie legal opinion, Issue 2, page 18. [13] Per 26 CFR § 1.1011-2 (a)(3)- Bargain sale to a charitable organization, a taxpayer that transfers encumbered property is treated as receiving additional consideration equal to indebtedness, regardless of whether the charity assumes or agrees to pay the indebtedness or takes the property subject to the indebtedness. [14] See IRS Publication 598 (03/2021), Tax on Unrelated Business Income of Exempt Organizations [15] Cornerstone-Baker McKenzie legal opinion, Issue 3, page 18.