Every now and then, someone asks an obvious question – one staring us right in the face – and then we realize that we don’t really understand the concept.
This really basic, but really good, question came from a client this morning.
Could you please explain the following statement that begins with “The charitable deduction displayed…” and how the tax-free portion and ordinary income are calculated?
Here is the statement that he quoted:
The charitable deduction displayed above is based on an IRS discount rate for a month prior to the month of gift. To take your deduction based on this rate, you must specify it in an election statement that you file with your tax return.
Answer (in two parts):
The charitable deduction is basically the present value of the remainder interest to the charity – which is calculated by first figuring out what the present value of the income stream to the donor is (and then simply subtracting the present value of the income stream from the gross gift amount). To do a present value of an income stream calculation – which is basically how much money you need in the bank TODAY to make the income stream payments over the time period, ie the life expectancy – you need an investment assumption. The AFR (Applicable Federal rate – also called the mid-term or IRS discount rate of the month) is the investment assumption rate used for that calculation.
Donors are allowed to choose a more favorable AFR rate of the month for either of the two previous months, if either one is more favorable. If the AFR is higher in one of the two prior months, than the value of the income stream to donor is less and therefore the remainder to charity higher. The donor must make this election – PGCalc provides a form for the donor to give to his or her accountant along with the deduction pages for this election.
Here is another way to understand this:
In your first example, your donor is giving $80,000 for a 5.8% annuity. The fixed 5.8% payments are $4,640 a year and the period is his life expectancy – 14.5 years.
How much money do you need today – earning the AFR of 3.6% – to pay exactly $4,640, broken into quarterly payments, to your donor for exactly 14.5 years?
Answer: $45,301.60 That amount is what the IRS considers as the value of the income stream your donor is keeping for himself. Subtract that amount from the total gift amount of $80,000 and you get $34,698.40 – the charitable deduction.
If you put $45,301.60 in the bank today earning exactly 3.6% and paying the $4,640 annuity in quarterly installments over exactly 14.5 years – you will have $0.00 left upon the last payment.
Does this answer your questions?
Sorry, I forgot the second half of your question – how do the tax-free and ordinary income parts work!
Basically, I told you already about the present value of the income stream (calculated by taking the term/life expectancy and AFR/investment assumption and figuring out how much you theoretically need to pay the annuity for the rest of the life expectancy). Once we know that amount, we also know what ratio of the CGA is gift vs. retained income stream (hold that thought for now). Now, divide the present value of the income stream in the case I gave you earlier – $45,301.60 – by 14.5 years (the life expectancy in that illustration). That comes out to $3,124.25. If you look at the first PGCalc chart you showed me, it says that the annual tax free is $3,122.72 for 14.5 years. I am off by less than $2.50 – not bad for someone who can’t help his children with math once they get past 6th grade.
In other words, we are assuming that the donor is getting back $45,301.60 over his life expectancy – really return of principal since he never gave it away in the first place and didn’t get a deduction for it either. Return of principal is not taxable – it’s your money. The CGA just divides it equally over the life expectancy.
Once we know the annual return of principal/tax-free part, then we simply assume the rest is ordinary income. If some capital gains were avoided when the gift was funded, the non-charitable ratio of that avoided capital gains would be spread out over the life expectancy, annually reducing the tax-free return of principal.
That is it! Any questions?