The Option to Purchase/ Deferred Bargain Sale is an extension of a standard bargain sale arrangement with a donor. It is a contingent agreement that grants the charity time to market the proposed real estate gift and identify a third-party buyer. The option to purchase is a standard form of agreement in the real estate industry.
When used in a philanthropic context, it reduces the risk that a charity is exposed to.
The charity has no obligation whatsoever to exercise its option to purchase the proposed real estate gift. The charity will only close on the option to purchase when it has entered into an irrevocable, binding agreement of sale with a third-party buyer. The option to purchase is exercised immediately before close of escrow with the third-party buyer. The donor receives the bargain sale cash portion from the sale of the property to the third-party buyer. At the time the charity exercises its option to purchase, the donor receives a charitable income tax deduction for the difference between the appraised fair market value and the bargain sale cash proceeds. This is the same result that would occur in a standard bargain sale arrangement. The charity avoids any risk exposure to a downturn in property values while the gifted real estate is on the market. In addition, the charity assumes no responsibility for holding costs that may apply to the gifted property, including property taxes, maintenance, insurance, etc. This enables charities to accept a much broader range of gifts and helps maximize the donor’s tax deduction.
How it works
Underlying each Option to Purchase/ Deferred Bargain Sale transaction is a legally-binding gift agreement, or contract, in which the donor makes an irrevocable commitment granting an option to the charity to purchase the gifted piece of property, subject to an “option to purchase period” for a stated period. During this period, the charity inspects and markets the property and attempts to identify a third-party purchaser. Throughout the option to purchase period, the donor remains responsible for all holding costs associated with the gifted property, including maintenance, taxes, and insurance.
If a third-party purchaser is identified, a closing settlement is scheduled. The sale to the third-party purchaser is contingent upon the charity taking title to the property from the donor/seller. Immediately prior to closing, the charity exercises its option to purchase with the donor/seller. The donor receives a charitable income tax deduction equivalent to the difference between the appraised fair market value of the property and the bargain sale cash proceeds that the donor receives at closing. The appraised fair market value is based on an independent qualified appraisal secured by the donor.
If a third-party purchaser is not identified, then one of three things will happen:
- The charity and donor may choose to negotiate a new Option to Purchase/ Deferred Bargain Sale agreement, perhaps with different terms;
- The charity may choose to finish accepting the gift and take possession of the property; or
- The charity may let the contract expire/terminate, so that full control of the property reverts to the donor.
The Legal Underpinning
The legal authority for a bargain sale is very well established and does not need to be discussed here. The intriguing, unique aspect to the gift arrangement outlined above is the option to purchase. This is a common technique in the proprietary real estate sector. It is an uncommon and underutilized method to minimize and avoid risk in the philanthropic community. There is no Tax Court case or Revenue Ruling directly on point regarding an option to purchase real property in a bargain sale setting. However, there is a Revenue Ruling that is significantly instructive with an option to purchase stock. The Revenue Ruling below clearly addresses the option to purchase as a valid technique in a charitable bargain sale gift arrangement.
Appendix: The legal precedent that underlies the option to purchase/ deferred bargain sale technique
In Rev. Rul. 75-348, a publicly traded corporation made a pledge to a 501(c)(3) tax exempt, charitable educational institution in which the charitable institution could purchase a specified number of shares of the corporation at any time during a specified period at a price set forth in the pledge agreement. It was anticipated that if the price of the stock grew beyond the strike price, the charitable institution would exercise its purchase option.
The Service ruled that the corporation would be entitled to a charitable income tax deduction in the year that the charitable institution exercised the option in an amount equal to the difference between the strike price and the fair market value of the stock on the date of exercise. Thus, there is clear legal precedent upholding the option to purchase in the case of a bargain sale gift arrangement.
It is the harmonious blending of an option to purchase and a bargain sale that may seem somewhat perplexing at the onset. However, once the complexity of the gift arrangement is analyzed in separate components, the true benefits of the overall charitable transaction can be appreciated. Under this gift arrangement, the charity knows with certainty what the net proceeds will be to fund the bargain sale purchase.
