Wealthy individuals often have the bulk of their net worth tied up in highly-appreciated, illiquid assets such as real estate or privately-held businesses. This lack of liquidity can make charitable planning quite challenging, as few charities are adequately prepared to accept donations of such illiquid assets directly, and if the donor chooses to sell the often highly-appreciated asset in order to donate the sale proceeds, the gift is significantly diminished by the steep tax rate these low-basis assets are subject to.
Fortunately, there are a variety of tools and techniques that enable real estate investors to tax-efficiently monetize their business and real estate holdings, and one that can be particularly useful when an individual is charitably inclined: a donor advised fund.
From a tax perspective, the strategy allows for a realization event (the asset is ultimately sold) that is a non-recognition event (no taxable event is triggered on the sale). The strategy allows real estate and interests in limited partnerships to be sold tax-free with 100% of the sales proceeds re-invested in publicly-traded securities within the DAF where those proceeds can grow tax-free for years.
The donor also qualifies for an immediate charitable contribution deduction for the fair market value of the asset (worth 35% at today’s top marginal tax rate) that can be carried forward for an additional five years, irrespective of when the actual grant is made which may be years after the contribution of the real estate to the DAF.
Finally, many wealthy investors consider the possibility of creating their own private foundation which qualifies as a charity if certain conditions are met. It’s worth noting that if appreciated real estate is contributed to a private foundation the investor qualifies for a charitable deduction equal to the tax cost basis (not fair market value) of the property which is typically very low.
Furthermore, there is no requirement that the donor make a minimum annual grant (such as required of private foundations). The proceeds in the account can grow tax-free for years before any grant is made.
For all of these reasons, if a client would like to build a significant endowment fund over the next few years and allow the assets to grow tax-free until grants are made, but has the bulk of their net worth tied up in real estate or a privately-held business, the client might consider contributing all or a portion of these illiquid assets to a donor advised fund (DAF) account.
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