Gifts of Appreciated Assets - Be Careful!

I have written many times about gifting to charity using appreciated assets. Done correctly, this can increase the value of giving to both the receiving charity and the donor as well. I say "done correctly" because we are often asked by investors to make these gifts in incorrect fashion. Accordingly, it is clear that many investors don't fully understand the issues in play.

Segment Wealth Management Blog Open-ended mutual funds

As a refresher, the basic strategy is to donate to charity those assets with the largest untaxed gain, not the one with the greatest increase in value. Tax exempt recipients (501c3 organizations) are also exempt from capital gains taxes. Gifting a current position worth $50,000 for which an investor paid $10,000 would normally be an excellent choice. I say "normally" because not all vehicles have the same tax treatment and some positions with $40,000 gains are better than others. This is particularly true with open-ended mutual funds, such as most Fidelity funds or American Funds.

Open-ended mutual funds often make a very poor choice for a gift because they have an inherent quirk in them that causes the embedded profits to mostly get taxed every year. Read my musings on the inherent tax disadvantages of open ended funds here.

Most open ended funds have individual security activity inside the fund that flows through to investors each year. This often appears on a 1099 as "reinvested capital gains distributions". This is the printing of taxable profits that are attributable to an investor's holdings in a fund. This taxable capital gain activity generally occurs from two sources in a fund: 1) The manager's activity of buying and selling the stocks inside the fund or 2) Purchase and sale activity of other investors entering and leaving the fund. Other investors crowding in or out of the fund can cause purchase and sale activity of stock holdings inside the fund to meet those requests. This is manager activity in dealing with liquidity that he or she would not have otherwise chosen to do as part of the strategy. Existing shareholders often have their most profitable stock shares shed in these two sources of perpetual activity.

So here is an example of how it plays out. We have an open-end mutual fund on our firm's books that was purchased in July 2004. The investor paid $29,574 for his shares. He has received dividends and capital gains reinvestments, all of which were taxable in the year they occurred. The investor's current value is $93,581; generating a gross profit of $64,007, or a little more than 200% in gains. When I review the tax basis info on this investment I find the investor has already paid tax on all but $1571 of the $64,007 in profits. This means that 97.5% of all the profits have already been taxed. Using this fund as a gift would be silly since it contains large profits, but almost no untaxed profits. The same investor also owns shares of Wal-Mart bought in 1996. Those shares still have untaxed profits of thirteen times the original cost; a much better choice as a gift.

Segment Wealth Management Blog never use short term gains.png

Remember also that short term gain items should never be used as a gift. The charity will receive full value for the gift, but the donor can only deduct the original cost if not held for a full year. Plain old cash would be a better choice.

So keep these issues in mind for your next gift, and continue to be generous!

  • Main 713.800.7150
  • Toll Free 877.499.7150
  • Fax 713.800.7066

Segment Wealth Management