Gifting to Donor Advised Funds (DAFs) and investing in real estate 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 can 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 40 or 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.
• Investing in Real Estate Yields Decent Tax Savings Plus Investment Returns: Real estate investments can yield large depreciation deductions, though likely smaller than the upfront charitable deduction generated by a DAF. But real estate also generates investment returns, which DAFs do not.

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:

1. Immediate Tax Deduction: Donors receive a tax deduction in the year the contribution is made, regardless of when the funds are distributed to charities.
2. 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).
3. 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:

1. Irrevocable Contributions: Once assets are donated to a DAF, they cannot be reclaimed by the donor.
2. Fees and Management Costs: DAFs are managed by sponsors, which may charge administrative fees.
3. 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 Real Estate Investments?

This article uses “real estate investment” broadly to mean any investment involving the purchase, sale, management, or leasing of property for profit. Real estate investors can benefit from several tax-saving strategies, but depreciation (specifically accelerated depreciation) is the most important for people looking to reduce their ordinary income taxes. Critically, to offset ordinary income with real estate depreciation, you need to be a real estate professional, which means spending more than 500 or 750 hours in a year on your real estate business. For practical purposes, that means you can’t have another job. But if your spouse doesn’t have a full-time job (and wants to spend 750 hours per year on real estate), or you don’t have a full-time job (and want to spend 750 hours per year on real estate), it can work.

Benefits of Real Estate Investments:

1. Tax Deductions: Investors can deduct a range of expenses, including depreciation, which reduces taxable income.
2. Appreciation Potential: Real estate can appreciate over time, providing both rental income and capital gains.
3. Leverage: Real estate allows investors to use debt to finance purchases, amplifying potential returns and tax savings from depreciation.

Drawbacks of Real Estate Investments:

1. Illiquidity: Real estate investments can be difficult and time-consuming to sell.
2. Management Burden: Owning and managing real estate requires significant time, effort, and expertise.
3. Market Risk: Real estate markets can be volatile, and values may decrease due to economic downturns or other factors.
4. Material Participation Requirements: To use the depreciation to offset ordinary income, real estate has to be your (or your spouse’s) full-time job.

What is an Ideal Use Case?

Kevin, a married New Jersey resident who is a real estate developer, is earning $1,000,000 with a $420,000 annual tax bill. In the past, he has only invested in stock indexes. Tired of paying so much tax on his salary, Kevin buys a $500,000 duplex and rents it out. He deducts 60% of this amount as depreciation in the first year, reducing his taxable income by $300,000 that year. If his marginal tax rate is 50%, that will save him $150,000, effectively reducing his taxes in that year from $420,000 to about $270,000 (not including the income tax generated by the rental). Due to leverage, he may have only had to invest $100,000 in the property upfront, with the rest covered by loans. The loan interest will also be deductible, reducing his taxable income by another $20,000 or so. In future years, he’ll be able to deduct additional depreciation as well as interest on the loan. That said, taking on leverage is risky and means that Kevin will have to cover the interest and principal payments as they come due. Kevin or his spouse will also have to qualify as a real estate professional in order to use the depreciation to offset his ordinary income.

Why Choose One Strategy or the Other?

Gifting to Donor Advised Funds and investing in real estate accomplish different things. DAFs allow donors to support charity while realizing modest tax benefits. Investing in real estate generates higher overall returns, taking into account both the tax savings and the investment returns, but make less sense for people who are focused on charitable giving. When choosing between these two strategies, the key question is: What are you trying to accomplish? If your goal is primarily to support charity, then a DAF may make sense — though Charitable Remainder Unitrusts may be even more attractive. If your goal is simply to maximize returns, then real estate investing is probably a better fit.

Conclusion

Gifting to Donor Advised Funds and investing in real estate are both 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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