Case of the Week

Case:

Abigail Green was a wonderful and spirited 80-year-old woman. Even in her advanced age, she worked in her garden, handled all of her finances and played golf each weekend. In addition to her busy schedule, she also made time to help at a local homeless shelter. She believed that whenever you can lend assistance to your fellow neighbor it is your responsibility to do so. Because of this belief, she gave her time, love and money to the local homeless shelter. Abigail's normal practice was to give $5,000 each year to the homeless shelter. However, she wanted to make a more significant gift this year.

So, in January of this year, she decided to establish a $100,000 charitable gift annuity. She liked the high fixed payments, $49,000 tax deduction and simplicity of the arrangement. Because Abigail funded the CGA with cash, a large portion of each payment was tax-free. But of course, what she loved most was the eventual gift to the shelter.

Sadly, Abigail suffered a heart attack a few weeks later and died soon after. It was a terrible loss to the community. Now several months have passed and Abigail's family and CPA are winding up Abigail's financial affairs. At the time she passed away, Abigail had $100,000 of income (mainly from an IRA distribution in January). Her CPA knew he could deduct the $49,000 charitable tax deduction on Abigail's final tax return. However, he wondered if she was entitled to any other deductions since she passed away prematurely.

In looking for this answer, the CPA contacted the shelter to inquire about the gift annuity. The shelter informed the CPA that Abigail never received a payment. The payments were quarterly; however, she passed away prior to the first payment.

Question:

Since Abigail died prematurely, does she get another tax deduction? If so, what type of deduction is available and how is it reported?

Solution:

Abigail's income from her gift annuity, as mentioned above, was partially tax-free. This tax-free component is essentially a return of principal that lasts until the end of her life expectancy. Because Abigail passed away before the end of her life expectancy (and before even one payment), she did not receive any of her tax-free income. "Unrecovered investment" is the term for this shortfall of tax-free payments. Fortunately, the amount of unrecovered investment may be claimed as a deduction on Abigail's final income tax return.

With a $100,000 charitable gift annuity and charitable tax deduction of $49,000, Abigail's total investment in the annuity contract was $51,000. Because Abigail died prior to even one payment, she did not receive any tax-free income. Thus, Abigail had $51,000 of unrecovered investment in the annuity contract. See Section 72(b)(4).

The CPA was very pleased with this news. However, he wondered how to deduct the $51,000. If the $51,000 is an additional charitable tax deduction, a portion of it could be lost due to the 60% AGI limitation rules for charitable income tax deductions. Abigail's AGI for this year is $100,000. As a result, $60,000 is the deduction limit for her cash gifts. She already has a $49,000 charitable deduction which resulted from creating the CGA. As such, any additional charitable income tax deductions in excess of $11,000 would be unusable on her final income tax return.

To the CPA's great surprise, the $51,000 amount is not deducted as a charitable tax deduction or impacted by the repeal of miscellaneous deductions. Rather, the unrecovered basis is reported as a "net operating loss deduction." This deduction can be claimed on Schedule A of Form 1040. Moreover, it is not subject to the 60% AGI limitation on charitable deductions. So, the CPA can claim a $49,000 charitable tax deduction and a $51,000 NOL deduction all in the same year. Abigail's death, for tax purposes, transformed the unrecovered basis into a deductible item. Accordingly, these two deductions can effectively wipe out any taxable income on Abigail's final income tax return! This is a nice benefit - especially since the shelter will receive a major part of Abigail's estate.