Charitable contribution of mortgaged property

[appelman]

I have a client who has for many years owned a rental property now valued at $1.5M. He has a mortgage of 1M on it. His basis is about 200K, and he has claimed about 60K of depreciation. He wants to donate this property to a private school for use in its educational activities. The school will assume the mortgage. I see two possibilities:

a) He simply claims 500K charitable deduction, subject to the 30%-of-AGI limit, or

b) He has to treat this as a bargain sale, claiming the 500K charitable deduction, but also reporting the gain on a sale price equal to the mortgage.

Obviously Option a) would be much to my client's advantage.

From p. 8 of Pub. 526:

"Property Subject to a Debt

...If the debt is assumed by the recipient (or another person), you must also reduce the fair market value of the property by the amount of the outstanding debt assumed.

If you sold the property to a qualified organization at a bargain price, the amount of the debt is also treated as an amount realized on the sale or exchange of property. For more information, see Bargain Sales under Giving Property That Has Increased in Value, later."

The "If" at the beginning of the 2nd paragraph seems to make a distinction between a gift of property subject to debt and a bargain sale of such property. It does not imply that having the recipient assume the debt automatically converts the transaction into a bargain sale. But this interpretation seems to lead to a reductio ad absurdum. Selling the property to the school for as little as $1 would drastically alter the tax consequences!

I would appreciate any help anyone can offer on this. There is obviously a lot at stake for my client.

[appelman]

Since nobody picked up on this, I'll answer it myself.

Since nobody picked up on this, I'll answer it myself. The answer is b). A contribution of property subject to a debt almost always, if not always, involves a "bargain sale." It is one of the relatively few cases where a Pub is misleading. That last "If" really shouldn't be there. For chapter and verse, there is an excellent example in Rev. Rule 81-163:

FACTS
During the taxable year, an individual taxpayer transferred unimproved real property subject to an outstanding mortgage of 10x dollars to an organization described in section 170(c) of the Internal Revenue Code. On the date of transfer the fair market value of the property was 25x dollars, and the taxpayer's adjusted basis in the property was 15x dollars. The taxpayer had held the property for more than one year and made no other charitable contributions during the taxable year. The property was a capital asset in the taxpayer's hands. Thus, under the provisions of section 170 the taxpayer made a charitable contribution to the organization of 15x dollars (25x dollars fair market value less 10x dollars mortgage).

LAW AND ANALYSIS
Section 1011(b) of the Code and section 1.1011-2(b) of the Income Tax Regulations provide that, if a deduction is allowable under section 170 (relating to charitable contributions) by reason of a sale, the adjusted basis for determining the gain from the sale is the portion of the adjusted basis of the entire property that bears the same ratio to the adjusted basis as the amount realized bears to the fair market value of the entire property.

Section 1.1011-2(a)(3) of the regulations provides that, if property is transferred subject to an indebtedness, the amount of the indebtedness must be treated as an amount realized for purposes of determining whether there is a sale or exchange to which section 1011(b) of the Code and section 1.1011-2 apply, even though the transferee does not agree to assume or pay the indebtedness.

Because the outstanding mortgage of 10x dollars is treated as an amount realized, the taxpayer's adjusted basis for determining gain on the bargain sale is 6x dollars (15x dollars adjusted basis of the entire property X 10x dollars amount realized 25x dollars fair market value of the entire property).

HOLDING
The taxpayer recognizes long-term capital gain of 4x dollars (10x dollars amount realized less 6x dollars adjusted basis) on the bargain sale of the property to the charitable organization.