Unrecovered Basis
Unrecovered Basis Deduction: An annuitant who passes away before his or her projected life expectancy may be entitled to an income tax deduction for the unrecovered basis in his or her charitable gift annuity.What is Unrecovered Basis? A charitable gift annuity is considered a bargain sale.
Timing of the Deduction: The deduction is taken when the annuitant of a one-life annuity passes away or the second annuitant of a two-life annuity passes away.
The 2% Floor: The deduction for unrecovered basis is not subject to the 2% of adjusted gross income floor like other miscellaneous itemized deductions.
Where to Claim the Deduction the 1040 Tax Return: The deduction for unrecovered basis is claimed on Schedule A, Line 27, titled, "Other Miscellaneous Deductions."
Calculating Unrecovered Basis: Included in the Crescendo proposal is a page titled, "Charitable Gift Annuity - Income Taxation."
Unrecovered Basis Deduction
An annuitant who passes away before his or her projected life expectancy may be entitled to an income tax deduction for the unrecovered basis in his or her charitable gift annuity. Sec. 72(b)(3)(A). This income tax deduction is taken on the annuitant's final income tax return as a miscellaneous itemized deduction (not a charitable deduction). Further, the deduction is not subject to the 2% of adjusted gross income floor.
What is Unrecovered Basis?
A charitable gift annuity is considered a bargain sale. A bargain sale is a sale of an asset to a charity for less than the asset's fair market value. Thus, with a gift annuity, the donor is "selling" an asset to the charity in exchange for a payment stream. The payment stream's value is less than the value of the property the donor is transferring to the charity. As with any other bargain sale, the donor is entitled to a charitable deduction for the difference between the fair market value of the asset transferred and the value that the donor receives in exchange.
Whenever a donor sells an asset, he or she must recognize the gain on any appreciation. The cost basis, or the amount the donor paid for the asset, will escape taxation. Because a gift annuity is a bargain sale, the donor will recognize gain on part of any appreciation and will receive some partially tax-free payments if the basis is greater than zero. The tax-free payments are considered a recovery of the donor's cost basis.
Example 8.1.4A
Mary Smith transfers 1,000 shares of ABC stock to her favorite charity in exchange for a charitable gift annuity. Mary originally paid $10 per share for the ABC stock. On the day Mary transferred the stock, it was worth $50 per share. At Mary's age, she is entitled to a charitable deduction of $25,000. Mary's deduction represents ½ of the stock value given for the gift annuity (1,000 shares at $50 per share is $50,000). The value of Mary's gift is 50% (the value of the charitable deduction divided by the total amount given). Therefore, Mary will recognize $20,000, or 50% of the gain in the stock, over her life expectancy. The other 50% of the gain will be bypassed because it is attributable to the gift portion of the annuity. Note that if Mary purchased the annuity to benefit someone else, Mary would have to recognize the entire gain in the year of the gift. The same calculation is applied to Mary's tax-free payments from the gift annuity. Mary will receive 50% of her cost basis as tax-free payments from the annuity over her life expectancy. The other 50% of Mary's basis will be attributed to the gift she is making to the charity for the gift annuity. Therefore, Mary will receive $5,000 (½ of her $10,000 cost basis) over her life expectancy.If Mary were to pass away before she has received her full $5,000 of tax-free payments from the gift annuity, she would be entitled to a miscellaneous itemized deduction on her final income tax return for the unrecovered basis. If Mary lives past her life expectancy, she will have received all of her tax-free payments, and thus, no deduction is allowed.
Timing of the Deduction
The deduction is taken when the annuitant of a one-life annuity passes away or the second annuitant of a two-life annuity passes away. The annuitant is entitled to claim the deduction even if he or she was not the donor to the annuity contract. Sec. 72(b)(3)(B).
The 2% Floor
The deduction for unrecovered basis is not subject to the 2% of adjusted gross income floor like other miscellaneous itemized deductions. The 2% floor does not allow deductions of a total amount less than 2% of the taxpayer's adjusted gross income.
Where to Claim the Deduction on the 1040 Tax Return
The deduction for unrecovered basis is claimed on Schedule A, Line 27, titled, "Other Miscellaneous Deductions." This form requires the type and amount of the deduction to be listed. The type is "Unrecovered investment in an annuity." The amount is the total of tax-free payments that the annuitant was entitled to receive under the gift annuity contract but did not receive because of the premature death.
Calculating Unrecovered Basis
Included in the Crescendo proposal and Crescendo worksheet is a page titled, "Charitable Gift Annuity - Income Taxation." This page reports to the annuitant the yearly amounts of ordinary income, capital gain and tax-free payments that he or she receives from the charitable gift annuity. The yearly totals on this page should match the 1099R the donor receives from the charity each year.
When an annuitant passes away before his or her projected life expectancy, the charity must report the amount of unrecovered basis to the estate's personal representative. To calculate the unrecovered basis, add together all of the tax-free payments the donor has yet to receive from the annuity. The sum of these payments is the amount of unrecovered basis.
Example 8.1.4B
When Mary Smith established her gift annuity, she had a life expectancy of 10.2 years. Mary, however, passed away after receiving payments for only two years. Because Mary died before her projected 10.2-year life expectancy, Mary will be entitled to a deduction for her unrecovered basis. Using the example above, Mary should have received $5,000 of tax-free payments over her life expectancy. However, Mary received only $500 of tax-free payments. Therefore, Mary will be entitled to a $4,500 deduction on her final income tax return.Case Studies on Unrecovered Basis
An Income Tax Deduction when a Gift Annuitant Dies Early: Barbara Holmes had been a longtime volunteer and financial supporter of a national charity. She believed that whenever you can assist someone less fortunate with a "helping hand" it is your responsibility to do so. Because of her belief, she gave her time, love, and money whenever possible. In fact, she established a gift annuity with the charity many years ago.Dying to Deduct, Part 1: Abigail was a wonderful and spirited 80-year-old woman. She worked in her garden, handled all her finances and played golf each weekend. In addition to her busy schedule, she also made time to help at a local shelter. She believed that whenever you can lend assistance to your fellow neighbor, it is your responsibility to do so. Because of this belief, she gave her time, love and money to the shelter. Abigail's normal practice was to give the shelter $5,000 each year. However, she wanted to make a more significant gift to the shelter this year.
In January, she decided to establish a $100,000 charitable gift annuity. She liked the fixed payments, the approximate $46,000 tax deduction and the simplicity of the arrangement. Because Abigail funded the CGA with cash, a large portion of each payment was tax-free. What she loved most though was the eventual gift to the shelter.
Sadly, Abigail suffered a heart attack a few weeks later and died soon after. It was a terrible loss to the community. Now several months have passed and Abigail's family and CPA are winding up Abigail's financial affairs. At the time she passed away, Abigail had $100,000 of income (mainly from an IRA distribution in January). Her CPA knew he could deduct the $46,000 charitable tax deduction on Abigail's final tax return. However, he wondered if she was entitled to any other deductions since she passed away prematurely.
In looking for this answer, the CPA contacted the shelter to inquire about the gift annuity. The shelter informed the CPA that Abigail never received a payment since she passed away prior to the first payment.
Since Abigail died prematurely, is there an additional tax deduction? If so, what type of deduction is available and how is it reported?
Dying to Deduct, Part 2: Abigail was a wonderful and spirited 80-year-old woman. She worked in her garden, handled all her finances and played golf each weekend. In addition to her busy schedule, she also made time to help at a local shelter. She believed that whenever you can lend assistance to your fellow neighbor, it is your responsibility to do so. Because of this belief, she gave her time, love and money to the local homeless shelter. Abigail’s normal practice was to give the shelter $5,000 each year. However, she wanted to make a more significant gift this year.
In January, she decided to establish a $100,000 charitable gift annuity for herself and her sister. The payments would go to Abigail for life, then to her sister for life. Abigail liked the fixed payments, large tax deduction and simplicity of the arrangement. Because Abigail funded the CGA with cash, a large portion of each payment was tax-free. What she loved most though was the eventual gift to the shelter.
Sadly, Abigail suffered a heart attack a few weeks later and died. It was a terrible loss to the community. Now several months have passed and Abigail’s family and CPA are winding up Abigail’s financial affairs. The CPA knew he could deduct Abigail’s charitable tax deduction on Abigail’s final income tax return. He also knew if a person who funds a gift annuity dies prematurely, he or she may claim an additional tax deduction for any unrecovered investment (See “Dying to Deduct, Part 1”). However, Abigail’s sister is remaining on the gift annuity contract. Thus, the CPA wonders how this affects the unrecovered investment issue.
Since Abigail died earlier than expected, does she get another tax deduction? Does the fact that this is a two-life gift annuity affect the outcome?
Dying to Deduct, Part 3: Abigail was a wonderful and spirited 80-year-old woman. She worked in her garden, handled all her finances and played golf each weekend. In addition to her busy schedule, she also made time to help at a local shelter. She believed that whenever you can lend assistance to your fellow neighbor, it is your responsibility to do so. Because of this belief, she gave her time, love and money to the local homeless shelter. Abigail’s normal practice was to give the shelter $5,000 each year. However, she wanted to make a more significant gift this year.
In January, she decided to establish a $100,000 charitable gift annuity for herself and her sister, Mandy. The payments would go to Abigail for life, then to her sister for life. Abigail liked the fixed payments, large tax deduction and simplicity of the arrangement. Because Abigail funded the CGA with cash, a large portion of each payment was tax-free. What she loved most though was the eventual gift to the shelter.
Sadly, Abigail suffered a heart attack a few weeks later and died. To make matters worse, Mandy died the following year in a tragic automobile accident. It was a terrible loss to the family, friends and community. Now several months have passed and Mandy’s CPA is winding up Mandy’s financial affairs. Mandy’s CPA recalls that if a person who funds a gift annuity dies prematurely, he or she may claim an additional tax deduction for any unrecovered investment (See “Dying to Deduct, Part 1”). However, in this case, Mandy is not the donor but just an annuitant. Thus, the CPA wonders if there is a tax deduction for the unrecovered investment on Mandy’s final income tax return?
Who gets the “unrecovered investment” tax deduction since both Abigail and Mandy died prematurely?