Charitable Giving… Sensibly
Posted by Frank Napolitano on November 29, 2015
If you make, or are planning to make, a charitable gift, and you have a brokerage account with appreciated securities, you might be better off donating those securities directly to your charity than making a cash gift of the same amount. In this article, I’ll describe how a charitable gift reduces taxable income. Then I’ll show how a specific type of gift (“capital gain property”) can save you taxes – you’ll be able to give the same amount and reduce your end of year tax bill.
What are the tax advantages of making a charitable contribution?
There are lots of good reasons to give to a charity. Perhaps you feel strongly about your alma mater. Perhaps you want to support a charity in your community. Perhaps you view giving as an important part of your duty as a citizen. Whatever the reason, should you choose to make a charitable gift that meets certain conditions, your gift may have the added benefit of reducing your overall tax bill. Let’s go over the mechanics of how a charitable gift reduces taxes.
Here is my greatly overly-simplified formula for calculating taxable income:
- Minus Deductions for Adjusted Gross Income (AGI)
= Adjusted Gross Income
- Minus Greater of Total itemized deductions or Standard deduction
- Minus Personal Exemptions
= Taxable Income
Broadly speaking, there are three ways to reduce taxable income: 1. Deductions for AGI (“above-the-line deductions”), 2. Itemized or standard deductions (“below-the-line deductions”), and 3. Personal exemptions.
When you make a gift to a qualified charity, you add the fair market value of that gift to your itemized deductions (if you take the standard deduction, you will not receive a tax benefit). A qualified charitable gift therefore will reduce your taxable income by the amount of the gift.
Take a simple example: assume Sophia has taxable income of $200,000. Before the end of the year, she makes a $20,000 cash gift to her favorite charity. Assuming Sophia itemizes her deductions, the result of the gift is to lower her taxable income to $180,000. (NOTE – this does not reduce her taxes, i.e., the amount she owes Uncle Sam, by $20,000. It reduces her tax base by $20,000.).
You must satisfy a number of other rules to claim the tax deduction. For example, gifts must be to a “qualified charity” (you can use this free tool from the IRS to check if an organization qualifies). Also, large gifts (relative to your income) might limit the amount of the deduction you can take in a given year. IRS Publication 526 provides a detailed explanation of these rules. Of course, if you have any questions, you should consult a CPA or qualified tax accountant before making a charitable gift.
Making a gift from appreciated securities vs cash
There is another interesting tax benefit when it comes to making charitable gifts of “capital gain property”. Capital gain property includes securities, such as a stock mutual fund, held in a brokerage account for more than 365 days. When calculating the amount of the tax deduction for this type of property, the IRS allows you to use the “fair market value of the property.” Why is this important? Let’s look at an example.
Suppose that instead of donating $20,000 in cash, Sophia identifies a highly-appreciated stock fund worth $20,000 in her brokerage account. She’s held the fund for several years and the basis (the amount she paid for it) is $10,000.
Option 1 – Sell the stock and gift the proceeds
Sophia could sell the stock and give the cash proceeds to the charity. When she sells the stock, she will have to report a long-term capital gain of $10,000 ($20,000 minus what she paid for the stock). This gain will be taxed at the federal and, if applicable, state levels. Assuming for simplicity’s sake that her combined (federal and state) long-term capital gains tax rate is 20%, Sophia will owe the government $2,000 ($10,000 x 20%) for selling her stock.
Option 2 – Gift the stock directly to the charity
Now suppose that instead of selling the stock, Sophia transfers the appreciated shares directly to her charity of choice. Because the IRS considers the stock “capital gain property”, Sophia takes the deduction for $20,000, the fair market value of the stock, and because there was no sale, she does not have to report the gain on her tax return.
The charity receives a $20,000 gift in either scenario. From Sophia’s standpoint, however, she is $2,000 wealthier if she donates the securities directly to her charity (option 2). Making a qualified charitable gift using “capital gain property” effectively eliminates the security’s unrealized gain.
In general, if you itemize your deductions and your charitable gift satisfies IRS requirements, you will be able to reduce your taxable income by the amount of the gift. If you plan to make a charitable gift and if you have appreciated securities in a brokerage account, you would probably be better off donating appreciated securities directly to your charity rather than making a cash gift because of the added benefit of gifting “capital gain property.”