Gifting to Donor Advised Funds (DAFs) and entering into conservation easements are two popular strategies for offsetting ordinary income tax. How do you know which one is right for you? This article explains what these strategies are and when they make sense.
Key Highlights and Takeaways
- Two Ordinary Income Tax Strategies: Both strategies offset ordinary income tax at least to some extent.
- DAFs are a Charitable Giving Strategy with Ancillary Tax Benefits: People often think of DAFs as a tax-saving strategy. While gifting to a DAF can reduce your tax bill, you won’t come out ahead personally by doing so. You might get back 50 cents for every dollar you put in a DAF. But that’s okay, because DAFs are vehicles for charitable giving. Assuming you’re looking to support charity in a significant way, DAFs can make a lot of sense. The tax benefits just aren’t that large.
- Conservation Easements are Risky but Can Yield Large Tax Savings: A conservation easement is a legal arrangement in which a landowner agrees to restrict the use of a piece of land. Conservation easements are a type of charitable gift and yield similar deductions. Donors often claim very aggressive valuations for the land over which the easement is being granted. The resulting tax savings can be quite large, but it is an aggressive tax strategy that involves significant legal risk to the donor.
What are Donor Advised Funds (DAFs)?
A Donor Advised Fund (DAF) is a charitable giving account. When a donor contributes cash, securities, or other assets to a DAF, the donor receives an immediate tax deduction. That deduction can offset capital gains or ordinary income. The donor can then recommend grants to charities from the fund. DAFs are popular because they provide immediate tax benefits while allowing for strategic charitable giving at the donor’s leisure.
What are a DAF’s Tax Consequences?
While a DAF is a relatively tax-efficient and flexible way of supporting charity, it is not a pure tax play. If your goal is just to save taxes, giving to a DAF will not make sense. Someone in the 40% marginal tax bracket who gives $100 to a DAF will only receive $40 in tax savings. The charity will get the full $100, but the taxpayer will be out, on net, $60 (perhaps a little less if the asset was appreciated and would have generated capital gain on a sale).
Benefits of DAFs:
- Immediate Tax Deduction: Donors receive a tax deduction in the year the contribution is made, regardless of when the funds are distributed to charities.
- Tax-Free Growth: Contributions to a DAF can grow tax-free, allowing for potentially larger future charitable donations (though you do not receive an additional charitable deduction for this growth).
- Flexibility in Giving: Donors have the flexibility to make grants to multiple charities over time and don’t need to decide which charities to support until at some point after the assets have been contributed to the DAF.
Drawbacks of DAFs:
- Irrevocable Contributions: Once assets are donated to a DAF, they cannot be reclaimed by the donor.
- Fees and Management Costs: DAFs are managed by sponsors, which may charge administrative fees.
- Negative Financial Transaction: The assets you give away will be worth more than the tax benefits you receive in return, which is why you need to be philanthropically minded for this to make sense!
What is an Ideal Use Case?
Astrid is a married New Yorker earning $1,200,000 per year. Her annual tax bill is $550,000. She isn’t particularly focused on tax mitigation, but she’s passionate about her favorite charity: the Boys & Girls Club. Astrid wants to give six figures to charity each year, ideally in a relatively tax-efficient way. Astrid could sell $250,000 of her appreciated investments, pay $50,000 in taxes and donate the remaining $200,000, or she could directly donate $200,000 of stock to the DAF, have the DAF sell the stock tax free, and then the DAF could donate the money to the Boys & Girls Club! Using the DAF allows Astrid to avoid capital gains taxes. Of course, Astrid would have been better off personally if she had just kept the stock for herself. But given her philanthropic goals, gifting to a DAF may make sense for her.
What are Conservation Easements?
A conservation easement is a legal agreement between a landowner and a qualified organization, such as a land trust or a government agency, that restricts the development of the land in perpetuity, protecting wildlife habitats or preserving historic sites even if the property is later sold or passed down to future generations. Conservation easements, in short, are a way for landowners to protect property from future development, no matter who ends up in control of the land in the future.
Conservation easements are also a tax tool. When you agree to restrict the use of your land for conservation reasons, the government considers that a type of charitable donation, and you get a charitable deduction based on the lost value of the land. In practice, taxpayers often claim a value that is a multiple of the value at which the land was purchased. This deduction can be used to offset ordinary income up to 30% of the donor’s adjusted gross income (AGI), with any excess carried forward for up to five years.
Because a number of players in the space are unscrupulous, the IRS has become concerned in recent years that the tax code’s conservation easement rules are being exploited. Certain types of conservation easements are now considered “listed transactions” that must be flagged for the IRS. Sen. Ron Wyden, chair of the Senate Finance Committee, has been consistently critical of conservation easements, which he describes as “a tax shelter gold mine.”
Benefits of Conservation Easements:
- Tax Benefits: A donor can receive a charitable deduction for the value of the easement, which can significantly reduce the donor’s taxes. The resulting deduction may exceed the initial cost of the land.
- Preservation of Land: The easement permanently protects the land from development, preserving its historical or environmental value.
Drawbacks of Conservation Easements:
- Permanent Restrictions: Once granted, the easement permanently restricts development of the land.
- Complex Valuation Process: Determining the value of a conservation easement can be complex and may require an expensive appraisal.
- Legal Risk: The IRS has been scrutinizing conservation easements very closely, so there is substantial risk that an aggressive deduction will be disallowed.
What is an Ideal Use Case?
Gabriel, a single New Jersey resident, earns $1,200,000 per year. His annual tax bill is $550,000. Gabriel happens to be an avid conservationist with an appetite for risk. Tired of paying so much tax on his salary, Gabriel purchased a $100,000 property fours years ago and this year he put a conservation easement on the land to protect it from future development. The easement is valued at $350,000 and he is allowed to deduct this entire amount from his income, reducing his taxable income by $350,000 this year. If his marginal tax rate is 50%, that will save him close to $175,000, effectively reducing his taxes this year from $550,000 to under $375,000.
Why Choose One Strategy or the Other?
Gifting to Donor Advised Funds and entering into conservation easements accomplish different things. DAFs allow donors to support charity while realizing modest tax benefits. Conservation easements may yield somewhat larger tax benefits, but they expose the donor to legal risk as the conservation easement projects that yield large tax savings tend to rely on aggressive interpretations of the tax code. When choosing between these two strategies, the key question is: What are you trying to accomplish? If your goal is primarily to support charity without taking undue legal risks, then a DAF may make sense — though Charitable Remainder Unitrusts may be even more attractive. If your goal is to maximize tax savings, then a conservation easement may be more appealing.
Conclusion
Gifting to Donor Advised Funds (DAFs) and entering into conservation easements are both potentially viable tax strategies, but they serve different objectives. Hopefully this article has given you a better idea of what each strategy entails, and whether one or the other might be a better fit.
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