608 / How are payments received under a charitable gift annuity agreement taxed?
(1) A charitable contribution is made in the amount by which cash or the fair market value of property transferred to the charity exceeds the present value of the annuity. The American Council on Gift Annuities, a voluntary group sponsored by charitable organizations, recommends uniform annuity rates based on the annuitant’s age at the date of the gift. See American Council on Gift Annuities’ Uniform Gift Annuity Rates (https://www.acga-web.org/current-gift-annuity-rates). The uniform annuity rate is applied to the transfer and determines the amount of the annuity paid to the annuitant each year. The present value of a charitable gift annuity when issued is determined under Estate and Gift Tax Tables ( Q 921).(2) When an annuitant receives annuity payments, a percentage of each payment reflects a return of principal. This percentage (the “exclusion ratio”) is determined by the basic annuity rule, that is, by dividing the investment in the contract by the expected return. The investment in the contract in the charitable annuity situation is the lesser of the present value of the annuity or the fair market value of the property transferred to the charity. The expected return is the annual annuity amount multiplied by the years of life expectancy of the donor at the time of the gift. If the annuity starting date is after December 31, 1986, the return of principal portion is excludable only until the investment in the contract is fully recovered. Thereafter, that portion is included in income as ordinary income.2
If, however, the donor has transferred appreciated property to the charity, the donor has a gain (either a capital gain or an ordinary gain depending on the property) to the extent the fair market value of the property exceeds the donor’s adjusted basis. In this situation, the bargain sale rules apply. Under these rules, proportionate portions of the donor’s basis are considered part of the charitable gift and part of the investment in the annuity contract. Thus, the donor’s return of principal element of each payment consists of two segments: one represents return of gain that is taxed as capital or ordinary gain, and the other represents return of the donor’s adjusted basis and is excluded from the donor’s income.
The portion of the gain that is taxed is the percentage that the investment in the contract bears to the total amount transferred. As long as the annuity is nonassignable, the donor may take the gain into income ratably over the donor’s life expectancy. After all the gain is reported, that portion of the donor’s annuity payment is excluded from income as well as the return of basis portion, if the donor’s annuity starting date was before January 1, 1987. If the annuity starting date is after December 31, 1986, the IRC provides that amounts are not excludable after the investment in the contract has been recovered. Thus, it appears that once the annuitant has outlived his or her life expectancy, and recovered his or her investment in the contract, the entire payment is included in income as ordinary income.