By: Russell N. James III, J.D., Ph.D., CFP
Many have worried about the negative impact of the new tax law on charitable giving. A higher standard deduction means fewer itemizers. Non-itemizers can’t use charitable tax deductions. But, as I pointed out here, the new tax law makes charitable giving more attractive for many high wealth and high income donors. For those still using them, charitable deductions became more valuable because: (1) effective combined income tax rates rose for many in higher tax states due to the cap on state tax deductions, (2) marginal federal income tax rates rose for those in the bubble range of $200,000 to $416,700 for individuals, (3) Pease amendment cuts to charitable deductions were eliminated, and (4) income limitations on charitable deductions for gifts of cash were raised from 50% to 60%. Beyond this, other changes have made gifts of appreciated assets – and all the planned giving vehicles using appreciated assets – much more attractive than last year.
Gifts of appreciated assets
One of the biggest tax advantages in charitable giving is the double benefit donors get when donating appreciated assets instead of cash. By giving appreciated assets, like stocks, held for more than one year, the donor (1) gets a charitable tax deduction for the full value of the asset, and (2) avoids all capital gains taxes. If the donor’s favorite local charity doesn’t know how to deal with gifts of stock, no problem. The donor simply transfers the stock to a donor advised fund and then has the fund write a check to the charity.
A donor can even do a “charitable swap” to keep an identical portfolio after the gift. For example, instead of giving $10,000 cash to a charity, the donor gives $10,000 of stock that he originally purchased for $5,000. The donor then takes the $10,000 cash he would have donated to charity and instead uses it to immediately purchase identical stock replacing the donated shares. The donor not only gets a $10,000 tax deduction, but he now owns stock with a $10,000 basis instead of a $5,000 basis. The charitable swap wipes out all capital gains taxes on the appreciated stock. The new tax law didn’t change the rules for avoiding capital gains taxes by giving appreciated assets, but it did substantially change the capital gains tax rates.
Capital gains tax rates just increased
Did you miss that headline? Under the new tax law, capital gains tax rates went up. A lot. “But, wait,” you say, “federal capital gains taxes didn’t change in the new law.” No, but if you don’t live in one of the nine states (Alaska, Florida, Nevada, New Hampshire, South Dakota, Tennessee, Texas, Washington, and Wyoming) that have no state capital gains taxes, then your capital gains tax rates almost certainly went up. Last year if you paid state taxes on a capital gain, you probably got a break on your federal taxes. This year, you almost certainly won’t. This is either because you are already over your $10,000 deduction limit for state and local taxes or because, unlike last year, you can’t use the deduction for paying state capital gains taxes because you will now be using the new higher standard deduction. Either way, the federal tax benefits for paying state capital gains taxes have disappeared. This means your effective combined federal and state capital gains tax rate went up substantially.
For example, if you were living in California paying top rates, selling a $1 million zero basis asset last year would have netted you $681,688. You pay $133,000 to the state of California, $238,000 to the federal government, and get a federal tax deduction worth $52,688 ($133,000 x 39.6%). That same sale today nets you $629,000, because the old federal tax deduction disappeared. The bottom line is that your effective combined capital gains tax rate went from 31.8% in December to 37.1% in January. Of course, avoiding this – now higher – tax becomes even more important, making gifts of assets even more attractive.
Income from gifts of appreciated assets
Beyond just avoiding these higher capital gains taxes, sophisticated planned giving allows donors to both avoid the capital gains taxes and take income from those assets for life. Using the previous example, selling the asset yields $629,000 after taxes. But, you could instead gift the asset to a charitable remainder trust, sell it with no capital gains taxes, and earn income off of the entire $1,000,000, undiminished by capital gains taxes. If you don’t want the hassle of setting up a charitable remainder trust, you could give the asset to a charity in exchange for a charitable gift annuity to get a similar result. Earning income from $1,000,000 instead of $629,000 with planned giving is a good deal. More to the point, it is even better than last year’s deal of earning income from $1,000,000 instead of $681,688. And, because these extra benefits come from tax avoidance and not from the charity, the ultimate charitable impact of the donation stays the same.
The new power of bunching charitable deductions
The biggest downside for charitable giving in the new tax law is that a higher standard deduction means fewer itemizers, and fewer itemizers means fewer people who can use a charitable tax deduction. But, donor advised funds can change this calculus. Donors with sufficient flexibility can now pick a target year to itemize, transfer several years’ worth of charitable giving to a donor advised fund in advance and take a big deduction only in the target year. During off years, the donor’s favorite charities still receive checks from the donor advised fund. In this way, no charitable deductions are wasted during the off years when the donor is taking the standard deduction. (There is also a way to bunch deductions by temporarily placing an income-producing asset into a grantor charitable lead trust, but these are rare.)
The power of deduction bunching also makes large planned giving arrangements more attractive because these tend to produce a single, large initial charitable deduction. Using a charitable remainder trust (or charitable gift annuity) in the previous example to earn lifetime income from the full $1 million also generates an immediate tax deduction of over $100,000. Although the planning giving arrangement lasts as long as the donor, all the charitable deductions arrive up front in one lump sum. Under the old tax law, we might have preferred these deductions to be spread out, anticipating regular annual itemizing. But, under the new law, bunching the deductions up front in the target year, and opting for the higher standard deductions afterwards, will be more valuable for many donors.
Capital gains increased, too
You may not have noticed this, but corporate stock just got a lot more valuable. Whether you agree or disagree with cutting the corporate tax rate, there is no doubt that a lower corporate tax rate increases profits and makes stocks more valuable. This tax cut made small businesses more valuable too, cutting the rates for getting profits out of those businesses as well. For this reason, when those shares or businesses are sold, they will now be worth more money. This increase in the value of stocks and closely held businesses means more people with more highly appreciated assets. Avoiding the, now larger, capital gains taxes on these, now larger, capital gains just got more important. Planned giving, anyone?