By Kathryn Tong, Senior Aquisition Manager – CRE Western Region
Ever been forced to sell a stock in a sinking market or pressured to trade a car for less than it’s worth? Anyone who has experienced these disappointing financial transactions has felt the sting of sacrificing an asset for less than its true value. No one wants to sell at a loss; indeed, everyone expects to gain from a sale. Yet “selling for less than full value” is the very essence of a 170 bargain sale of real estate.
What is an IRS Section 170 Bargain Sale?
An IRS Section 170 Bargain Sale transaction is also known as a Bargain Sale. It’s a combination of cash at closing from a buyer plus cash in the form of tax reduction or rebate from Federal and State governments. The cash portion of the IRS Section 170 Bargain Sale can be anywhere from 5-, 6- or even 7-figurcash amounts at closing, depending on the transaction, with the rest of the cash benefit coming from tax savings. Depending on the seller’s tax liability, it’s not uncommon to get the full tax benefit in as little as 30 days, but the seller has up to six years to fully utilize the deduction.
First written into law back in 1917 as part of the War Revenue Act, and predating the 1031 Exchange, it uses the tax law to encourage philanthropy. It is estimated that there are over 20,000 of these real estate transactions done annually, with an estimated value of $8,000,000,000.
This transaction is regulated by the IRS Code Section 170 because it relates to charitable contributions of non-cash transactions. IRS Publication 526 and 561 are two additional IRS publication guidelines that further help explain the guidelines for this type of transaction.
This transaction is really the same as any other real estate transaction with a buyer or seller and real estate agent. However, with the IRS Section 170 Bargain Sale, the buyer is a tax-exempt entity and the seller is desiring to receive a tax deduction on a portion of the transaction. Therefore, special rules apply to this transaction. Some of the unique transaction’s features are the following:
- The buyer must be a qualified tax- exempt nonprofit.
- The seller must obtain a qualified appraisal if the asset is valued over $5,000.
- The seller may deduct the difference of the appraised value and the cash amount received as a charitable contribution. This charitable-contribution tax deduction is like any other cash charitable contribution to a church, the Red Cross, etc., and is therefore governed by the standard rules and regulations of charitable contributions.
- The difference is that it’s not cash and therefore requires some sort of valuation mechanism defined by the IRS for charitable-contribution purpose. The method valuing the specific assets are further defined in IRS Publication 561.
- Buyer, seller, and appraiser must sign IRS Form 8283, and seller must submit this form with seller’s tax return.
- In order to qualify for the Federal and State tax benefits, the seller must have sufficient taxable income to utilize the charitable portion of the transaction. The seller is entitled to write off up to 50% of their annual Adjusted Gross Income (AGI) for charitable purposes.
- When it comes to real estate, however, there is a caveat. The seller can deduct up to 50% of their annual AGI only if they use their cost basis for the property (what they paid for it). In the vast majority of cases, however, it is in the sellers best interest to accept the 30% ceiling for allowable charitable tax deductions in a given year and use the current Fair Market value of the property based on an independent, certified appraisal.
How is this different from a donation?
Unlike a standard donation, the IRS Section 170 Bargain Sale is a combination of cash from the buyer at closing (or possibly over time, if terms are agreed to) and a cash benefit derived from tax savings in the form of reduction or rebate, depending on the sellers specific tax liability. It is defined in IRC 170 of the IRS code as a “Bargain Sale” because it is in fact a sale but has a charitable component to it.
A straight donation has no cash component and is often not valued for its full and fair market value, due to the seller either not being informed about IRS approved valuation guidelines or not caring enough about the deduction.
In short, the IRS Section 170 Bargain Sale delivers the best of both worlds to a seller. They typically get cash at closing or possibly the assumption of debt, PLUS they get a valuable tax deduction to reduce or eliminate other tax liabilities.
Property Appraisal for an IRS Section 170 Bargain Sale Transaction is a Game Changer
Why? Because the size of a tax deduction from the Bargain Sale can be significant. The large deductions afford the right seller tax savings that could exceed the amount donated. The tax benefits from the transaction apply for up to 5 more years for the seller.
The true Fair Market Value assessment makes the Bargain Sale amazing!
The Fair Market Value is a significant contributing factor to why the Bargain Sale is an amazing opportunity. Before we look at this appraisal closely, let’s examine a few more appraisal types and compare them to the FMV.
- Liquidation Value (aka the fire sale)
- Tax Assessment Appraisal
- Bank Appraisal (conservative market value)
- Comparable Sales (excluding distressed sales)
- Income approach (based on optimal NOI)
- Replacement Cost (insurance appraisal)
Now, let’s give a more concrete definition of what this means and entails.
The Higher Value IRS 561 Appraisal differs from the Bank Appraisal and other types of appraisals. The 561 appraisal specifically evaluates donated property. The IRS defines Fair Market Value as a price that would be agreed on between a willing buyer and a willing seller. Neither party is under any compulsion to buy or sell. Both have reasonable knowledge of the relevant facts. Essentially, the Bargain Sale raises the Fair Market Value, while most other transactions decrease the value. Based on IRS Publication 561 appraisal guidelines, the higher FMV attracts buyers. The value of donated property dictates the amount of the tax deduction the seller receives. The higher the property is appraised, the more tax deductions sellers receive.
What is the difference between a 1031 Exchange and a Bargain Sale?
The 1031 Exchange is an excellent vehicle to build up wealth in a tax-free environment. However, when you want to cash in your 1031 Exchange, the total accumulated profits become taxable. That’s because the 1031 Exchange is a tax-deferment vehicle while the IRS Section 170 Bargain Sale is a tax-reduction strategy.
With the Bargain Sale, the seller can enjoy immediate cash at closing PLUS an immediate tax deduction that in many cases can significantly reduce taxes due by the seller. In short, the IRS Section 170 Bargain Sale eliminates taxes, while the 1031 Exchange merely delays taxes, which may have to be paid at an even higher rate in the future, depending on prevailing tax law at the time.
Can I use a Bargain Sale to cash out of my 1031 Exchange tax free?
When you cash out of your 1031 Exchange, there is typically a big tax bill due. You can offset some or all of that tax liability with IRS Section 170 Bargain Sale, which, in effect, absorbs the brunt of the tax liability with the charitable portion of IRS Section 170 Bargain Sale. You can accomplish this a couple ways:
- Sell the property coming out of the 1031 Exchange using IRS Section 170 Bargain Sale. This assures that the bulk of the funds you ultimately receive will be tax free. It also greatly reduces taxes due on the cash portion of the transaction.
- If you have already been cashed out of your 1031 Exchange and are facing a big tax bill, you can do IRS Section 170 Bargain Sale on a different piece of property and use those tax savings to offset some or all of your gains from the 1031 Exchange.
2018 vs 2017: The Real Estate Bargain Sale Got Better!
Before 2018 when you sold real estate, your state taxes for proceeds were deductible from your federal taxes; as of 2018, these taxes are no longer deductible. Obviously, you should confirm your situation with your CPA, but this is the essence.
Subsequently, the proceeds from a traditional cash transaction from a real estate sale are subject to that additional portion of taxes that were previously deductible from federal taxes (i.e. state taxes). Depending on where you live, that can vary from a couple of percentage points up to 5 or 6% in states like California. Again, check with your CPA for your situation. The benefit here is that if you sell your asset via a Bargain Sale, you can still use the charitable deduction portion against your federal taxes, thereby avoiding state taxes and any lack of state tax “deductibility.”
For more information about 170 Bargain Sale real estate transactions, please contact Joseph Brady of the Bradco Companies at (760) 954-4567.
The posts focus on creating a win-win-win situation within the world of commercial real estate transactions. The content found on this page, however, is for educational purposes only and is not intended to constitute legal, financial, or tax advice. Please consult your attorney, accountant, tax or other adviser before acting on any information found here.