It's the Capital Gains, Stupid!
We hope that you’ll pardon the title of this article, which is a modification of the infamous James Carville campaign mantra in 1992 – “it’s the economy, stupid!” As was the case with the original phrase, this expression is meant to be tongue-in-cheek and self-directed. The tax legislation passed by Congress and signed by the President last December seems to have rendered the itemizing of personal deductions much less beneficial for large numbers of Americans. There has been considerable discussion among fundraising professionals that the result will be a dramatic decrease in charitable contributions. Whether or not you agree with that assertion, this article is about something else - the realization that the possible benefits of reducing taxes on realized capital gains by contributing appreciated securities for split-interest gift arrangements remain as powerful as ever.
The Tax Cut and Jobs Act – and Capital Gains
The Tax Cuts and Jobs Act of 2017 (TCJA) – technically known as “An Act to provide for reconciliation pursuant to titles II and V of the concurrent resolution on the budget for fiscal year 2018” – represented a significant number of revisions to the federal tax code. Major elements included the following:
- reducing tax rates for businesses and individuals
- limiting the mortgage interest deduction
- reducing the number of estates impacted by the estate tax
- reducing the alternative minimum tax for individuals and eliminating it for corporations
- repealing the individual mandate of the Affordable Care Act
The Act also addressed tax simplification by increasing the standard deduction, while eliminating personal exemptions and limiting deductions for state and local taxes (thereby making it less beneficial to itemize deductions).
One very basic premise of our federal tax code that has not changed, however, is the nearly inevitable tax on the realization of capital gains. The realization of capital gains – when the asset is sold - is essentially the recognition of the profit-taking on the increase in the market value of an asset over the original cost paid by the owner (or in the case of inherited assets, the increase in market value over the fair market value on the decedent’s date of passing). Realized capital gains are categorized either as short-term – resulting from the sale of assets that have been held less than a year – or as long-term – resulting from the sale of assets held more than a year. Short-term gains are typically taxed at the owner’s highest marginal income tax bracket, whereas long-term gains are generally taxed at 15% for most individuals, or 20% for those in the highest marginal tax bracket.
In addition to the taxes mentioned above, for individuals with income above certain thresholds, there is the 3.8% net investment income tax (NIIT), also known as the Medicare surtax. Currently this additional tax applies to single taxpayers whose modified adjusted gross income (MAGI) exceeds $200,000, and to married taxpayers filing jointly whose MAGI exceeds $250,000. The actual effect of this tax is more complicated, but suffice to say, it does apply to certain taxpayers. And on top of federal taxes on realized capital gains, for many individuals, there are state taxes on their gains as well. For this discussion, however, we will focus mainly on federal taxes.
In a simple example, we can see how this plays out: Let’s say that Mary purchased 1,000 shares of stock 20 years ago for $25,000, so her cost basis on the stock is $25,000. Over the years, the value of the stock has fluctuated, no doubt, but over the long run, the stock has increased to a current market value of $75,000. If Mary sells her stock today, she has realized $50,000 of long-term capital gains. Under the federal tax code, if she is in the highest marginal income tax bracket, her tax on those gains will be $50,000 x 20% = $10,000. If she ends up being subject to the additional 3.8% NIIT, her federal tax will be $50,000 x 23.8% = $11,900. State taxes could easily add a few thousand dollars to her total tax bill.
Tax Savings on Long Term Capital Gains
This brings us to a basic and fundamental dynamic in fundraising and planned giving – potential donors may be sitting on holdings of appreciated assets outside of a retirement account – especially appreciated stock – and they may be reluctant to sell the assets because of the likely capital gains taxes. It would be swell, of course, if Mary simply contributed the stock to her favorite charity as an outright gift. All the inherent capital gains in the stock would be transferred to the organization, and there would be no tax on the realization of the gains when the stock is sold by the charity. Mary would get an income tax deduction for the entire value of the stock. Given the amount of the deduction, Mary may be able to use it over several years; this would make it advantageous for her to itemize her deductions, as opposed to taking the higher standard deduction under the new tax law. But Mary might not be able or willing to make such a large outright gift.
What happens if Mary uses the stock instead to establish a charitable gift annuity? If she is 72 years old, and we are using the new rates recommended by the American Council on Gift Annuities (ACGA) for gift annuities issued after June 30, 2018, Mary would receive a gift annuity with a payout rate of 5.8%. Mary’s charitable deduction would be $31,913.25 (based on July's IRS discount rate of 3.4%) and her annuity of $4,350 would be paid in quarterly installments of $1,087.50 each (based on a gift date of July 1, 2018).
But here is the big deal: Mary’s capital gains would be reported in conjunction with the gift annuity arrangement. According to federal tax rules, the gift annuity would have reportable capital gains of only $28,724.50, meaning that the other $21,275.50 of capital gains allocated to the gift portion of the gift annuity would be permanently forgiven. Mary would never have to pay tax on that other portion – the non-reportable portion – of her capital gains. That is a huge savings of actual tax liability.
Making the gift annuity arrangement even sweeter, Mary gets another significant tax break: As long as she is establishing the CGA for her own benefit (she will be the annuitant), the IRS allows Mary to spread the reportable capital gains ratably over her remaining life expectancy, as determined by the 2010 U.S. census. In the first year, she will receive prorated payments of $2,175.00 and report $990.35 as capital gains and $689.47 as ordinary income (the remaining annuity payment is tax-free). Beginning in 2019, and through 2032, she will receive $4,350 in payments and report $1,980.70 as capital gains and $1,378.95 as ordinary income. The remaining reportable capital gains of $4.35 will be reported in 2033, totaling the $28,724.50 mentioned above.
In summary, there are 2 significant tax savings for Mary if she uses the appreciated stock to establish a charitable gift annuity for herself rather than selling the stocks. The total amount of gains subject to tax is dramatically reduced, saving Mary thousands of dollars, and the amount of gain that is reportable is divided into smaller amounts and spread over many years. In basic economic theory, any tax delayed is a tax lessened. The time value of money theory says that the longer Mary delays tax on the gains, the lower the real cost of those taxes will be.
Potential donors like Mary may be considering fewer charitable donations since the passage of the 2017 tax act, due to the diminishing need to itemize deductions. We will never know for sure, but the legislation is likely to have a dampening effect on at least some portion of a charity’s base of supporters. The benefits of lessening the taxes on long-term capital gains, however, is as potent as ever. Nothing in the legislation takes away the potential tax efficiencies of using appreciated assets to make charitable contributions through split-interest gift arrangements. Perhaps a gentler way to say it would be “It’s the capital gains, silly!” but we hope you’ve gotten the point we were trying to make.
Please feel free to contact us if you have any questions about this article or would like to explore the issues further.