IRS Section 170 Bargain Sale
What is an IRS Section 170 Bargain Sale?
An IRS Section 170 Bargain Sale transaction is also known as a Bargain Sale. It’s a combination of cash at closing from a buyer, plus cash in the form of tax reduction or rebate from Federal and State governments. The cash portion of the IRS Section 170 Bargain Sale can be anywhere from 5, 6 or even 7 figure cash amounts at closing, depending on the transaction, with the rest of the cash benefit coming from tax savings. Depending on the Seller’s tax liability, it’s not uncommon to get the full tax benefit in as little as 30 days, but the Seller has up to six years to fully utilize the deduction.
First written into law back in 1917 as part of the War Revenue Act, and predating the 1031 Exchange, it uses the tax law to encourage philanthropy. It is estimated that there are over 20,000 of these real estate transactions done annually with an estimated value of $8,000,000,000. To see a partial list of well known entities we have concluded the IRS Section 170 Bargain Sale transactions with, visit this page.
This transaction is regulated by the IRS Code Section 170 because it relates to charitable contributions of non-cash transactions. IRS Publication 526 and 561 are two additional IRS publication guidelines that further help explain the guidelines for this type of transaction.
This transaction is really the same as any other real estate transaction with a buyer or seller and real estate agent. However, with the IRS Section 170 Bargain Sale, the buyer is a tax exempt entity and the seller is desiring to (will) receive a tax deduction on a portion of the transaction. Therefore, special rules apply to this transaction.n. Some of the unique transactions features are the following:
- The buyer must be a qualified tax exempt nonprofit.
- The seller must obtain a qualified appraisal if the asset is valued over $5,000 in value.
- The seller may deduct the difference of the appraised value and the cash amount received, as a charitable contribution. This charitable contribution tax deduction is like any other cash charitable contribution to a church, the Red Cross, etc., and is therefore governed by the standard rules and regulations of charitable contributions.
- The difference is that it’s not cash and therefore requires some sort of valuation mechanism defined by the IRS for charitable contribution purpose. The method valuing the specific assets are further defined in IRS Publication 561.
- Both buyer, seller, and appraiser must sign IRS Form 8283 and seller must submit this form with seller’s tax return.
In order to qualify for the Federal and State tax benefits, the Seller must have sufficient taxable income to utilize the charitable portion of the transaction. The Seller is entitled to write off up to 60% of their annual Adjusted Gross Income (AGI) for charitable purposes.
When it comes to real estate however, there is a caveat. The Seller can deduct up to 50% of their annual AGI only if they use their cost basis for the property (what they paid for it). In the vast majority of cases however, it may be in the Sellers best interest to accept the 30% ceiling for allowable charitable tax deductions in a given year, and use the current Fair Market value of the property based on an independent, certified appraisal.
How do you value the property?
Simply stated… We don’t.
The appraisal is performed by an independent, 3rd party, certified appraiser. We always recommend MAI-designated appraisers. In our estimation, they are the PhD’s of the appraisal world. At the end of the day, the appraisal is what it is. We recommend appraisers who are familiar with Section 170 of the IRS code as it pertains to valuations. Many of the basic guidelines are outlined in IRS Publication 561.
Appraisals for Bargain Sales are determined by IRS Publication 561 guidelines and are different than other appraisal methods. These guidelines were established to assure the full and fair market value of any real estate property. The IRS defines Fair Market Value as “the price that would be agreed on between a willing buyer and a willing seller, with neither being required to act, and both having reasonable knowledge of the relevant facts”. Therefore, distressed sales comparables do not qualify under this scenario. Furthermore, the proper marketing time required to dispose of an asset is determined by the appraiser considering the type, size, and location of the asset. Qualified appraisers often determine that some assets require over three years to liquidate and find the right suitable buyer.
The IRS further recognizes that unlike uniformly minted gold coins for example, all real estate is considered to be non-fungible. In other words, no two properties are the same and each property can and should be valued according to its unique characteristics.
A standard bank valuation for loan purposes leans toward the conservative side to limit their exposure (e.g. liquidation scenario), while an insurance appraisal tends to be the highest due to having to factor in replacement costs. With an IRS Section 170 Bargain Sale valuation, there are five major guidelines that are factored together to achieve the full and fair market value, generally resulting in an appraised value that falls somewhere between a conservative bank appraisal and a replacement cost valuation for insurance purposes depending on the type and location of the asset.
- Fair Market Value: Fair Market Value is greatly affected by the law of supply and demand. Greater demand usually means a higher valuation. Yet many property resellers spend the minimal amount on marketing to create demand and their advertising often fails to communicate a property’s full value. IRS valuation rules assume a reasonable marketing budget, that expertly conveys the full and fair market value of a property, which tends to stimulate more demand and potentially, higher valuation. Furthermore, marketing time period is another important factor as stated above.
- Highest and Best Use: When determining fair market value for an IRS Section 170 Bargain Sale, the appraiser may factor in highest and best use. So for example, if zoning allows, an old warehouse could be valued as office condos or a commercial restaurant such as with the popular Old Spaghetti Factory chain. Another example: If valued as a package, three homes clustered together in the old town center, may bring a higher valuation than the total of their separate valuations, especially if the highest and best use could be for a CVS or Walgreens.
- Comparable Sales Method: The comparable sales method compares the subject property with several similar sold properties. Whereas banks typically only want sold comps from the last six months, finding a sold comp for a large industrial property may require a much broader look back in history, along with a broader geographic search area, resulting in a more accurate and potentially higher valuation. Distressed sales assume the seller was under compulsion to sell, and therefore are disqualified or adjusted upwards to account for the distressed sale nature as determined by the appraiser in each individual case.
- Capitalization of Income: This method capitalizes the net income from the property at a rate representing a fair return on investment at the current time, considering the risks involved. Often the capitalization of income value approach is higher because it accounts for the discrepancy of market rate rents vs. available inventory for sale, as well as the opportunity of utilizing the asset as an investment property after being fully developed as an investment property.
- Replacement Cost Minus Observed Depreciation: Replacement cost is figured by considering the materials, labor, overhead, quality of workmanship, building size and profit. With historical properties, reproduction costs may be used instead of replacement costs and result in higher valuation. Valuation is then adjusted to allow for the current condition and remaining useful life of the structure.
The combination of these and other factors and others, which is accounted for in the final value of the 561 Appraisal, may result in a higher valuation than what the Seller is willing to accept in a quick sale to get out of high carrying costs and escape the nuisance factor of owning a vacant building.
How is this different from a donation?
Unlike a standard donation, the IRS Section 170 Bargain Sale is a combination of cash from the Buyer at closing (or possibly over time, if terms are agreed to) and a cash benefit derived from tax savings in the form of reduction or rebate, depending on the Sellers specific tax liability. It is defined in IRC 170 of the IRS code as a “Bargain Sale”, because it is in fact, a sale, but has a charitable component to it.
A straight donation has no cash component and is often not valued for its full and fair market value due to the Seller either not being informed about IRS approved valuation guidelines or not caring enough about the deduction.
In short, the IRS Section 170 Bargain Sale delivers the best of both worlds to a Seller. They typically get cash at closing or possibly the assumption of debt, PLUS they get a valuable tax deduction to reduce or eliminate other tax liabilities.
Who pays for the appraisal?
It is widely reported by many legal tax authorities that the Seller must pay for the appraisal. Although we cannot find that specific wording in the tax code, it is generally accepted as best practice to avoid the appearance of conflict of interest for the Buyer.
For the protection of the Seller we always recommend the Seller pay for the appraisal.
Doesn’t the charity have to have a related use for the property?
“Related Use” rules are important to understand because they can affect the amount of deduction a Seller can get from the charitable portion of a Bargain Sale. The rules typically use donated artwork for an example. It may be appraised at $10,000 but the Seller only paid $2,000 for it five years earlier. In this illustration, the Seller donates it to a nonprofit and receives a $10,000 tax deduction. However, if the nonprofit Buyer does not have a charitable use (related to its mission) for the painting, the Seller may only claim their original cost basis ($2,000) for a tax deduction. If, on the other hand, the Seller was for example, a nonprofit art gallery, and they gave written assurances that the painting was going to be put to a “related use” such as being on display in the art gallery, the full $10,000 tax deduction would apply.
Real Estate is Different
Related Use rules apply to tangible personal property which is defined by the IRS in Publication 526 (page 10, column 1) as “any property, other than land or buildings, that can be seen or touched. It includes furniture, books, jewelry, paintings, and cars.” Real estate on the other hand, is defined by the IRS as “capital gain property if you would have recognized long-term capital gain had you sold it at fair market value on the date of contribution. Capital gain property includes capital assets held more than 1 year.” It is not subject to the same “related use” rules that “tangible personal property” is.
When figuring your deduction for a contribution of capital gain property, you generally can use the fair market value of the property. However, in certain situations, you must reduce the fair market value by any amount that would have been long-term capital gain if you had sold the property for its fair market value. Generally, this means reducing the fair market value to the property’s cost or other basis. You must do this if:
- The property (other than qualified appreciated stock) is contributed to certain private non-operating foundations, (not applicable with our clients)
- You choose the 50% limit instead of the special 30% limit for capital gain property, (not recommend in most cases)
- The contributed property is intellectual property (not applicable with our offers),
- The contributed property is certain taxidermy property (not applicable with our offers), or
- The contributed property is tangible personal property and is either put to an unrelated use or has a claimed value of more than $5,000 and is sold, traded, or other- wise disposed of by the qualified organization during the year in which you made the contribution, and the qualified organization has not made the required certification of exempt use (such as on Form 8282, Donee Information Return, Part IV). (Real estate is not considered tangible personal property, so this is not applicable)
Related Use rules that can limit the deduction amount on certain assets, do not apply to land or buildings, UNLESS the donor chooses to deduct 50% of their AGI instead of 30% typically used for appreciated real estate. This is preferable when:
- Current value is close to, or less than original cost basis, and the donor (seller) has sufficient income for the deduction. This is more likely to occur when seller has held property for a relatively short period of time (1 – 5 years) or bought at an inflated price, or the market is experiencing a serious down turn.
- Donor knows they don’t (and won’t) have sufficient AGI to deduct the full amount at the 30% rate, so they would rather deduct at 50% for a shorter time, while income is high and they can do it.
Why should I go through Welfont when I can just donate the property to a nonprofit I know?
The Seller is quite welcome to go that route if they would like. It is absolutely their choice. However, the vast majority of non-cash contributions offered to nonprofits are turned down – especially these kind of properties – due to the illiquid nature of the gift, the cost of carrying it until sold and the difficulty in managing an asset that they have little or no experience in.
The acquisition, management and disposition of the asset is a service Welfont provides to our clients to facilitate the whole transaction and bring it to a successful conclusion.
Furthermore, when a Seller donates directly to a charity, without the benefit of professional assistance, they typically get a less than favorable valuation on the donated property. This is because they often settle for a modest market valuation based on a quick sale, instead of following the provisions of Section 170 of the tax code that allow for several other factors and valuation methods to determine the full and fair market value.
The bottom line in that case, is that the Seller either gets a lesser charitable deduction than they could have qualified for, or worse yet, if the appraisal does not meet IRS guidelines for this type of transaction, their deduction may be disallowed.
Lastly, if the Seller does find a nonprofit who would assume the cost and risk of ownership, they then have to either ask the nonprofit to come up with the cash portion similar to the offer our client brought, or forego the cash portion and receive an even smaller overall cash benefit.
Nonetheless, the choice is always theirs, and we wish them the best in their philanthropic decision-making process.
Isn’t there tax due on the cash portion?
Surprising to many is the fact that the IRS does have a formula for taxing the cash portion of the IRS Section 170 Bargain Sale. It is found in IRS Publication 544 and is easy to calculate. It is arrived at by dividing the cash amount by the Fair Market Value, then multiplying that number times the Adjusted Basis. Subtract that number from the cash amount and multiply what’s left by the applicable tax rate. It looks like this… Cash – (Adjusted Basis X (cash / FMV)).
So even if you paid $500,000 for the building ten years ago and it is now valued at $1,000,000, and your adjusted basis after depreciation is $400,000 here’s how you would calculate your applicable tax on the transaction, assuming you only received $100,000 cash and accepted a $900,000 tax deduction for the balance of cash benefit.
$100,000 – ($400,000 X ($100,000 / $1,000,000) = $60,000 multiplied by tax rate (i.e. 20% capital gains = $12,000 tax)
Are the tax savings guaranteed?
We are sometimes asked if the tax savings are guaranteed. What we can tell you is this… The Federal and State governments have this provision written into their respective tax codes to reduce the Seller’s tax burden by 39.6% federally and up to 12% from the state (depending on which state – some states have no income tax) if their AGI warrants the deduction.
When Federal and State governments relinquish a tax debt that is otherwise owed, we consider it a contribution they wouldn’t otherwise be making. It is generally believed and accepted that this is the governments way of encouraging shared, social responsibility within corporate America.
We also believe that if those contributions are encoded into the respective tax codes, as indeed they are, (and are therefore not arbitrary), that is as good of a guarantee of commitment that is available from any source. Any resulting financial benefit the Seller derives from the charitable portion of this transaction is in fact tax free. If financial refunds came to the Seller from any other source besides the government, they would most likely, if not certainly, be taxable.
We also believe that the governments commitment to provide tax savings is a more sure form of cash commitment than accepting payment terms from a Buyer the Seller has little or no prior knowledge of.
What is the difference between a 1031 Exchange and a Bargain Sale?
The 1031 Exchange is an excellent vehicle to build up wealth in a tax free environment. However, when you want to cash in your 1031 Exchange, the total accumulated profits become taxable. That’s because the 1031 Exchange is a tax deferment vehicle while the IRS Section 170 Bargain Sale is a tax reduction strategy.
With the Bargain Sale, the Seller can enjoy immediate cash at closing, PLUS an immediate tax deduction that in many cases can significantly reduce taxes due by the Seller. In short, the IRS Section 170 Bargain Sale eliminates taxes, while the 1031 Exchange merely delays taxes which may have to be paid at an even higher rate in the future, depending on prevailing tax law at the time.
Can I use a Bargain Sale to cash out of my 1031 Exchange tax free?
We don’t know enough about your tax liability to make that judgment, but what we can tell you is this… When you cash out of your 1031 Exchange, there is typically a big tax bill due. You can offset some or all of that tax liability with IRS Section 170 Bargain Sale which in effect, absorbs the brunt of the tax liability with the charitable portion of IRS Section 170 Bargain Sale.
You can accomplish this a couple ways…
- Sell the property coming out of the 1031 Exchange using IRS Section 170 Bargain Sale. This assures that the bulk of the funds you ultimately receive will be tax free. It also greatly reduces taxes due on the cash portion of the transaction.
- If you have already been cashed out of your 1031 Exchange and are facing a big tax bill, you can do IRS Section 170 Bargain Sale on a different piece of property and use those tax savings to offset some or all of your gains from the 1031 Exchange.
The amount of tax reduction is dependent on your tax liability, income and other factors. If you have a specific property in mind, give us a call and we’ll most likely be able to match it up with one of our buyers and get an offer back to you fairly quickly.