Charitable Planning – Leveraging Those Gains

There are few things more rewarding than giving your resources in a way that has a positive and profound impact on the lives of others. Fortunately, the IRS encourages this type of generosity by classifying donations to qualified charities as tax-deductible. As a result, it’s possible to “do good while doing well.”

But what if you could do good while doing really well? Rather than simply writing a check to your favorite charity, one approach to leveraging your charitable intent is to donate appreciated securities.

But What About the Taxes?

If you’re a long-term investor, you likely have (or hopefully have) some positions with embedded unrealized capital gains. Unrealized gains (a.k.a. “paper profits”) are wonderful ego boosters, but once we realize those gains, Uncle Sam wants his pound of flesh.

Fortunately, gains realized in a tax-qualified account (e.g., IRA, Roth, 529, 403b, 401k, or other pre-tax retirement accounts) are not taxed. Those accounts are tax-deferred until you withdraw the funds. However, if your gains are realized in a non-qualified taxable account (e.g., individual, joint, trust, UTMA), you’ll be forking over something to the IRS in the year of sale. So, from a tax perspective, non-qualified investment holdings with unrealized capital gains can be accurately described as a future tax liability.

Isn’t There Some Kind of Loophole?

If you’re a creative thinker, you might be wondering, “Couldn’t I get around the gains by gifting the shares to my deadbeat brother-in-law? Since he’s in a low tax bracket, he could sell them, pay little or no tax, then gift the proceeds back to me?” At first blush, it sounds plausible. But the IRS would consider this to be a “step transaction.”

Basically, you’ve circumvented the tax law by stringing together several “steps” that, on their own, are perfectly legal but, in combination, result in an overall transaction that breaks the law. Nice try, though.

The Beauty of Donating Securities

Here’s where the charitable donation strategy comes into play. Qualified charities are tax-exempt, meaning they don’t have to pay capital gains. Ever. So, any securities that are donated to them can be sold by the charity with zero tax impact.

Here’s a hypothetical:

$40K = Current value of XYZ mutual fund
($10K) = Tax cost basis of those shares of XYZ (purchased more than a year ago)
$30K  = Unrealized long-term capital gains

If you sold the shares of XYZ and donated the $40K proceeds to a charity, you’d be looking at $30K of realized capital gains. For those in the 20% capital gains bracket and exposed to the 3.8% net investment income tax (NIIT), you would likely be paying at least $7,140 in taxes to realize those gains ($30K x 23.8%). Even those in the 15% capital gains bracket would be looking at a $4,500 tax bill.

By choosing to gift the shares to the charity before the sale, you get the same $40K tax deduction, but you avoid a tax bill of thousands on the gains. It's not a bad paycheck for a little bit of planning.

When you donate appreciated securities to a charity, you walk away with the following benefits:

• You receive the tax deduction for the full, current value of the securities (just like if it were cash)
• That whopping unrealized gain that you’ve been bragging about – you know, the one that I just described as a tax liability? – You just nuked it. Gone. You legally removed it from your portfolio in such a way that no one will ever have to pay tax on it.

For those who are charitably inclined, considering a charitable donation of securities could minimize your taxes and maximize your donations.