The purpose of estate tax planning is to maximize the assets you pass on to future generations by minimizing gift and estate taxes. Estate-tax strategies revolve around the use of irrevocable trusts. This article discusses the most common types of irrevocable trusts that are used to minimize gift and estate […]
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.
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.
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).
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.
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.
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.
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.
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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