Charitable donations can be a true win-win: you reduce your tax burden while those who are doing good in the community benefit from your generosity. With the combination of the holiday season and the end of the tax year upon us, this is a good time to consider the ins and outs of the tax regulations that govern charitable giving. Donating is a great thing, but while you’re at it donate tax-smart.
Always Get Written Documentation of the Value of Your Charitable Gifts
When it’s time to record the value of your charitable donations on your tax return, you might be tempted to use “reasonable” (at least to you) values for your gifts. However, should the IRS come calling with an audit—which can happen years after the fact, by the way—the auditing agent will want something rather more concrete than your opinion. The first step is to ask the charity for a written acknowledgment of the gift, describing the item or items you donated. This acknowledgment should also state whether you received anything of value for your donation, even if that is merely confirmation that you received nothing. If you did, the receipt should provide a “good-faith estimate” of what it is worth, and only the portion of your donation in excess of the value of what you received will be deductible.
With a cash donation, this documentation is fairly simple. If you donate some form of property, however, things quickly become more complicated. In some cases a formal appraisal is required; IRS Publication 561 lays out the rather stringent rules on appraisal. For example, a single “household item” or article of clothing that is not in “good used” or better condition for which you take a deduction exceeding $500 must be appraised. (Confused yet?) Moreover, in some cases the appraisal must actually be included with the return on which the deduction is taken.
Arriving at a generally-agreed value for donations like real estate, artwork and collectibles, or various intangibles can be a challenge. Large deductions for donations of this type are also more likely to attract the attention of the IRS, so following the letter of the appraisal rules is very important. If you plan a gift of this type, find a tax professional familiar with this aspect of the tax code to advise you before you make the donation.
By the way, if you think you can call upon your favored charity a year or two down the road should an audit rear its head and get the necessary receipts, you should reconsider. The IRS requires receipts to be issued at the time of the donation, so go ahead and get the necessary paperwork now. You’ll make your tax preparer very happy and could save yourself some future pain.
Vehicle Donations are Popular—but Might Be Worth Less than You Think
From public radio fundraising pitches to roadside billboards, all sorts of organizations are pushing the “donate your old car” method of charitable giving. There is nothing wrong with this sort of donation per se, but before you sign over the title you should understand the rules governing these gifts.
In this case, the IRS is not even concerned with an appraised value. Regardless of what Kelley Blue Book or the NADA guide might say about how much the vehicle you donate is worth, that is not the amount you are permitted to deduct. Rather, the deductible value will be the amount the charitable organization actually receives when it sells the car.
There are a handful of exceptions to this limit, however, which may be worth pursuing when deciding on a recipient organization. The first is when the charity makes a “material improvement” to the vehicle before selling it, bearing in mind that cleaning and even repainting are not “material improvements” under this rule. The second is when the charity makes “significant intervening use” of the donated vehicle before selling it, such as using it to transport goods or meals to the needy. (IRS Notice 2005-44, which outlines these rules, does not specify a minimum duration for this “intervening use.”) The third and final exception is when the charity donates the vehicle in turn (or sells it at a price well below market value) to a needy individual who needs transportation. In these cases you may deduct the fair market value of the vehicle.
Make Your Required Minimum Distribution Your Charitable Gift
Tax-deferred retirement accounts require minimum distributions beginning at age 70-1/2. If you need to reduce your taxable income, you can take your required distribution but transfer it directly to a qualified organization. Technically this is not a charitable donation (in that it will not be considered such on your tax return), but the direct transfer counts toward your required minimum distribution (RMD) while not counting as income, so the net effect of reducing your adjusted gross income is the same.
Perhaps not surprisingly, there are some limits on this practice. For one, such direct transfers can be made only from IRAs, not from 401(k) accounts. For another, not just any charitable organization is eligible, with donor-advised funds (more on those in a moment) excluded. And of course, you must be at least 70-1/2 and therefore subject to RMD rules. Finally, as of this writing the rule is scheduled to expire with the 2013 tax year, and it will take congressional action to extend it to 2014 or beyond. With congressional productivity at mind-numbing lows, the likelihood of an extension is not very promising at the moment. So if you’re eligible, use the RMD direct transfer this year—it may be your last opportunity.
Manage Donations of Securities for Maximum Tax Benefits
Donating stock to charities is old news. However, there are smart ways to make such donations and ways that are…well, less so. Remember that capital gains taxes work differently for securities held more than a year and less than a year—long-term and short-term capital gains respectively. That one-year limit also affects the deductibility of stock donations. Assuming you are donating a stock that has appreciated in value, if you have owned it for more than a year you may deduct the market value of the stock, and you will also avoid any capital gains tax you would have incurred. If it is a stock you have held for less than a year, you will be permitted to deduct only the basis—the cost you originally paid for the stock.
Only donate securities that have risen in value. If you have suffered a loss on one or more stocks (assuming that you sell them, of course, since losses must be realized for tax purposes), you will gain a greater tax benefit from using the capital loss rules than from donating stock itself or even the proceeds of the sale. Your losses can be used to offset any capital gains dollar for dollar, and if your losses are greater than your gains, you can deduct a portion ($1,500 if single or married and filing separately; $3,000 if married and filing jointly) from your gross income and even carry over excess losses to future tax years.
Consider a Donor-Advised Fund for Your Donation
The donor-advised fund has risen in popularity thanks to its convenience and efficiency. Essentially you make a lump-sum donation and can then suggest to the fund what specific causes you would like to see supported with your money immediately or in the future. Regardless of when the funds are actually distributed, the deduction is taken in the year in which you donate to the fund.
The main considerations in choosing a donor-advised fund have less to do with tax rules than with personal preferences. The specific charities that a fund supports, how it makes grant decisions, and the minimum amount required for donations will vary.
The charitable donation is a time-honored means of reducing income tax liability, and it provides real benefits to the community. Maximizing the win-win requires understanding exactly how the charitable deduction rules work, planning your giving in advance, and when necessary seeking professional advice.