The Background
The transfer of American production and manufacturing operations to emerging markets in Asia and South America has changed the face of corporate real estate disposition. This shift is responsible for an abundant supply of commercial properties in the North American market. As a result, the quantity of vacant and underutilized commercial buildings is escalating. Few attractive options exist for corporations seeking to dispose of surplus properties other than waiting, often years for a buyer.
Increasingly, real estate professionals have been touting charitable donation as a viable solution for the divestment of surplus property. However, the overwhelming impression is that a charitable donation is not a rewarding financial alternative. On the contrary, close examination of the existing federal income tax rules for the charitable donation of real estate reveals a potential economic advantage in certain circumstances. The rules are contained in Internal Revenue Code Section 170 and summarized in IRS Publication 561, which is the basis for a transaction called the 561 Exchange. Unlike the IRC Section 1031 Exchange, the 561 Exchange is not an exchange of properties, but rather, it is a transfer of property in exchange for a federal charitable tax deduction, generally rendering a better financial alternative – even if the property were able to sell at the current list price.
The 561 Exchange may provide an exit strategy for corporations who own negative cash flow properties and at the same time create major funding for the needed programs of nonprofit organizations. Unlike a typical charitable donation, which usually returns the donor a net value reduction, this real estate transaction often provides a value added financial benefit to a property owner.
Concerns Surrounding the Donation of Real Estate to a Normal Non Profit
Navigating real estate donations can be a tedious and expensive process for charities not proficient with the ins-and-outs of real estate acquisition and management. The fact is that nonprofits often lack the expertise necessary to facilitate a desirable outcome. In addition, many charities may not be interested in receiving commercial real estate when they take into account the liabilities associated with the acquisition of a donated property. Concerns over environmental issues, maintenance, repair, and other legal restraints often create enough anxiety to discourage any nonprofit from even considering a viable donation.
Likewise, many charities that are not adverse to the risks associated with receiving real estate often do not have the capacity or interest in carrying the property.
Since the charity has no intended use for the building, they tend to unload the property as fast as possible to receive quick cash to reinvest. Property is sold for amounts considerably below market value by means of an auction or fire sale. These transactions pose a real risk to the integrity of the donor’s charitable contribution at fair market value, since the auction or fire sale transaction must be reported to the IRS if made within 36 months of the donation.
In these cases, the donor could receive a poor financial return because the IRS adopts the auction or fire sale price as the contribution value for tax deduction purposes and it’s not unusual for that value to be 30 to 40% below fair market value.
The Differences of the 561 Exchange
To be clear, the 561 Exchange is still a charitable donation of real estate. The organization that is given the real estate still must be a charity organized under Section 501(c)(3) of the Internal Revenue Code. However, the 561 Exchange can provide a property owner with the most appealing real estate solution when the right property and right charity is employed.
First, there are nonprofits that possess expertise and interest in real property acquisition and real property management. Giving consideration to these organizations may offer the most secure and financially attractive disposition opportunity for a property owner.
Second, if the nonprofit has a plan to hold and manage, rather than sell the property, then an attractive financial option may be feasible since the fair market value utilized for the charitable deduction will be maintained. The key is that the nonprofit must be able to make this hold and manage commitment.
To put it in dollar terms, if a property owner were to contribute a real estate asset with a fair market value of $2,000,000, that amount can be deducted from their taxable income. Assume an average corporate income tax rate (federal, state & local) of 40%, that translates into a financial gain of $800,000 or the equivalent amount the owner doesn’t pay in taxes. The 561 Exchange is quickly becoming known as a fast and safe donation that provides a cash benefit that often exceeds any conventional real estate sale transaction – even when sold at the current list price.
Case Study
As an example of a successful 561 Exchange, ConAgra Foods, Omaha, Nebraska transferred real estate it owned in Ashland, Ohio to the SeedAmerica Foundation1. For decades, a division of ConAgra had operated in a 165,000 sq. ft. brick building that dated back to 1896. The building became vacant after ConAgra sold the division. Not only did ConAgra receive a valuable charitable contribution deduction, but they also removed the burden of unrecoverable carrying costs that were draining their monthly cash flow.
SeedAmerica put the building back into service. They found tenants to revive the building into a working asset for the community. New businesses were presented affordable space to expand operations, jobs were created, and tax revenue grew in the local township. Civic leaders took notice and recognized the benevolent effort of ConAgra. Thus, ConAgra was able to obtain positive public relations, focus on their core business by removing a corporate headache, and they collected an attractive financial benefit from the 561 Exchange transaction.
The Catch of the 561 Exchange
The property owner must be a profitable individual, partnership, company, or corporation. If you pay federal income taxes, then the 561 Exchange may work for you. The actual amount of the tax deductions varies depending upon the type of organization, the tax rates applicable, and the depreciation methods that have been utilized. However, all entities whether individual, LLC, S-Corporation, C-Corporation, or their shareholders, partners or members are able to potentially benefit from the 561 Exchange. Additionally, the timeframe is flexible – if the current federal income tax liability is high enough, one can take the entire charitable contribution deduction in one year or stretch the deduction out over as many as five future taxable years.
Measuring the Worth of the Property
A key component to the 561 Exchange is the approved IRC method used to value charitable contributions of real estate. The rules and regulations used are found in IRC Section 170, and the regulations are condensed in IRS Publication 561. In a conventional real estate transaction, external influencers often can be a deterrent to the ultimate amount a seller may receive. A slow economy, scarce demand, functional obsolescence, environmental issues or being located in a depressed community all can reduce the amount a seller can receive for a property – as well as being an influence to the selling price that a broker recommends to the owner. In other words, the property owner is under “a compulsion to sell.”
The tax guidelines used for determining the fair market value of real estate utilizes a definition that includes an assumption that neither party is under “a compulsion to buy or sell.” Meaning, if the seller is not motivated by duress of market conditions or financial pressures and if the buyer has no allure or inducement to acquire, this is the legitimate method to determine the real fair market value of a property.
Other tax requirements include the type of appraiser used, the timeframe of the appraisal, as well as the consideration of multiple appraisal approaches. Only taking into account recent sales comparables is not adequate, but this is the common technique used to determine market price or broker opinion of value. Other appraisal methods must be considered when determining fair market value, which ultimately is determined by an independent appraiser. Ideally, using an MAI-qualified appraiser with commercial and industrial appraisal experience will render the best results.
Remember, if the property is sold in an auction or fire sale for a quick capital return by the done within 36 months of the transfer of title, then the value of the appraisal is overridden by the cash value of the quick sale because the federal government now adopts the auction or fire sale price as the charitable tax deduction value. Thus, a charity that has a long-term plan to hold and manage the property will allow the owner of the property to use the total appraisal amount for the charitable tax deduction. The charity is required to give the owner a gift receipt, IRS Form 8283. Finally, the owner is required to obtain and pay for the qualified appraisal of the real estate, which ultimately determines the worth of the real estate in a 561 Exchange.
Summary
Rather than accepting a low cash offer or negotiating repeated counter offers, enduring lengthy environmental studies, or having to wait while the buyer acquires adequate financing for the purchase to be completed in a conventional sale of real estate, a 561 Exchange may be a better alternative, especially for hard to move properties.
When partnering with an experienced nonprofit who specializes in these transactions, the entire process can occur in weeks after signing a Letter of Intent.
Companies across the country are recognizing the merits of the 561 Exchange, which is a quick and safe method for the disposition of under producing real estate assets. Instead of waiting years to find a suitable buyer of a property, companies like FMC, Murray Corporation, GEM Industries, ConAgra Foods, AAF McQuay, Rockbestos, Quebecor Printing, A.O. Smith, Kaydon Corporation, and others have found the speed and merits of the 561 Exchange to be more advantageous.
Perhaps that is why the 561 Exchange has been referred as “the next revolution in real estate.” The 561 Exchange certainly provides realistic hope once vibrant commercial properties.
