CGNA: Appendix A - Valuation, Appraisals, and Substantiation

This article is an excerpt from the 2018 2nd edition of Charitable Gifts of Noncash Assets, a comprehensive guide to illiquid giving by Bryan Clontz, ed. Ryan Raffin. Published by the American College of Financial Services for the Chartered Advisor in Philanthropy Program (CAP), with generous funding from Leon L. Levy. For a free digital copy of the 2nd edition, click here, and to order a bound copy from Amazon, click here.

Appendix A:
Valuation, Appraisals, and Substantiation1

By: Russell James III

To begin the topic of valuing charitable gifts of property, consider why this topic is so important. The vast majority of wealth in this country is not held in cash, savings accounts, checking accounts, or money market accounts. Consequently, if fundraisers wish to ask for gifts of wealth, then, generally they must ask for gifts of property. In other words, if fundraisers want to ask from the “big bucket” of wealth, then they need to ask for gifts of property, meaning any type of noncash asset. A fundamental requirement is an understanding of how such gifts are valued for tax purposes. Correspondingly, donors and their advisors must evaluate whether these gifts will achieve the charitable goals in an optimized way. As described below, this is no small issue.

Different types of assets in various types of transactions may generate dramatically differently values for taxation purposes. To learn how to ask for noncash gifts, it is essential to have a basic understanding of how property gifts are valued. A fundraiser or advisor who suggests a charitable gift of property—while being unaware that the deduction in that particular case would be far less than the value of the property—is creating serious potential problems. For the same reason, the donor will want to know exactly what sort of tax benefit she will receive. This reading reviews the rules for valuing charitable gifts of property.

Charities, donors, and their advisors may only be familiar with cash gifts to charity, so the valuation issues may be new. Cash gifts include all cash equivalent transactions such as checks, currency, or credit cards. Gifts of cash require no valuation. The value is simply the amount of the gift. Because the valuation is simple, calculating the deduction is also simple. Although cash gifts are simple, the donor rarely holds the bulk of her wealth in cash. Understanding gifts of noncash assets opens up the possibility for many more sophisticated and beneficial conversations with donors.

The simplicity of valuation with cash or cash equivalent gifts contrasts with the complexity of valuing several kinds of property gifts. An initial cause of this complexity may come from the difficulty inherent in valuing certain property types. Additionally, there are special tax rules for charitable gifts of certain kinds of property which can themselves alter the valuation of the property for tax purposes.

These rules have at times been put in place to curb abuses of the charitable gift tax deduction. Because Congress and the IRS created many of these rules in a reactive fashion—responding to particular individual abuses—it has resulted in a hodgepodge of rules that are not always consistent. Consequently, because so many specialized exceptions have arisen over the years, it is not always enough to know a single approach to the valuation of charitable gifts of property. Nevertheless, there are some general principles that apply to most gifts of property.

Property Valuation Overview

Despite the variety of rules and exceptions, the most typical valuations fall into three categories.2 With a few exceptions, the value for tax deduction purposes of a charitable gift of property will be (1) the fair market value of the property, (2) the cost basis of the property (only where such basis is less than the fair market value), or (3) nothing. Notice that the most advantageous valuation that a donor can receive under any circumstances is the fair market value of property.

Donors almost universally expect that the charitable gift will generate a charitable deduction equivalent to the value of the property, but those three categories show that is simply not the case. Asking for property gifts that generate no deduction or a much reduced deduction without understanding that reality in advance places the fundraiser or advisor in a highly unfavorable position. Thus, as a prerequisite to suggesting charitable transactions involving property, the fundraiser or advisor must be familiar with the rules for deducting such property gifts to avoid embarrassment, financial loss, and broken relationships.

One of the common valuation options for charitable gifts of property is the property’s “cost basis,” or what tax professionals refer to more technically as “adjusted basis.” The term cost basis is used here because, in most cases, the adjusted basis is simply the amount the donor paid for the item (i.e., its cost to the donor). So, if a donor paid $100 for an item that is now worth $200, the deduction for giving that item to charity will be $100 if the gift’s value is based on its cost basis.

Note that the cost basis valuation of charitable gifts of property is not used when the cost basis is greater than the property’s fair market value. Cost basis valuation of gifts of property can only lower the gift’s value compared with its fair market value, not raise it. The property’s cost basis can include other items besides the initial purchase price. For example, if a person purchases a house for $100,000 and then spends $30,000 on an addition to the house, his basis in the home is $130,000. So, the basis of a property includes both its initial purchase price and any subsequent capital expenditures.

Calculating the basis of property becomes more complex if it involves depreciation deductions. Not all property is subject to depreciation deductions. However, this is common with property the donor used for business purposes. A depreciation deduction allows a person to claim that the property has become less valuable, because it is wearing out. For example, if someone purchases a $5,000 computer for her business, she can claim that after one year of use the computer is worth $4,000. Consequently, she will have a depreciation deduction of $1,000. She can do this for each of the first five years that she uses the computer in her business until, after five years, she has completely depreciated it. If after five years she has taken depreciation deductions of $5,000, her basis is $0.

Depreciation deductions affect charitable deductions for gifts of property, because a taxpayer cannot deduct the same item twice. So, if a $5,000 computer purchase has already generated $5,000 of depreciation deductions, the taxpayer cannot then give it to charity and generate another $2,000 deduction (even if it is truly worth $2,000). As a result, any depreciation deductions that the donor has already taken may reduce the value of property for purposes of determining the charitable deduction. If it is real property, however, the donor still may take a fair market value deduction even if the property has been depreciated, assuming a straight line schedule. Of course, donors cannot depreciate all property—it is not a concern in most property gift transactions. But, it is an important concept to keep in mind for those cases when it does arise (primarily physical items used in business operations).

Charitable gifts of property can also be given their current “fair market value.” The IRS indicates that fair market value is the price that property would sell for on the open market. It is the price that a willing buyer and a willing seller would agree on, with neither being required to act, and both having reasonable knowledge of the relevant facts. It is easiest to think of fair market value as simply the answer to the question, “What could you normally sell it for?” or, “What is it worth?”

When valuing an item of property to be given as a charitable gift, the initial issue is, for almost all transactions, “Which of these three valuation approaches apply?” How will the item be valued for purposes of the charitable tax deduction? Will the donor be able to deduct its fair market value, its basis, or nothing at all? The next section reviews the basic framework that determines which of these deduction amounts the donor can use.

Determining Deduction Amounts

When property sales proceeds would be ordinary income if the donor had sold the property (rather than given it to a charity), then the donor may deduct only his or her basis in the property. For example, if a cobbler received $100 for selling a pair of his shoes, this money is ordinary income. Selling shoes is his ordinary business. If the cobbler gave a pair of shoes that normally sells for $100 to a charity, the IRS limits his deduction to his cost basis in the shoes (i.e., cost of materials). Simi- larly, if an artist painted a painting and gave it to a charity, her deduction would be the cost of the canvas and paint she used in the painting. Just as with the cobbler selling shoes, if the artist had sold the painting, the IRS would tax the money from the sale as ordinary income to the artist.

The cost basis valuation also applies to any property the donor held for one year or less. If the donor sold this property for a profit, that profit would have been short-term capital gain. The IRS values all such short-term capital gain property at its basis for purposes of the charitable deduction. Any property that generates a loss on sale would not be valued at its basis because, in that case, the basis would be higher than the fair market value. The IRS never allows the donor to use basis for valuation if it is higher than fair market value.

The only type of noncash property that may receive fair market value for a charitable deduction is long-term capital gain property. Start with the assumption that long-term capital gain property can be valued at its fair market value for charitable tax deduction purposes. However, several circumstances can cause long-term capital gain property to instead have cost basis valuation.

The first scenario where long-term capital gain property would be subject to cost basis deduction is if the property is given to a private foundation, rather than to a public charity. Although here there is an exception to the exception, because if the gift is “qualified stock,” defined as publicly traded stock, then the donor can still deduct it at fair market value. Another reason that long-term capital gain property does not receive fair market value treatment for tax deduction purposes is if the donor has made a “special election” to accept the lower valuation in exchange for a higher charitable deduction income limitation.

A third circumstance when long-term capital gain property receives cost basis treatment is when it is “unrelated use” tangible personal property.3 “Unrelated use” tangible personal property is property that the charity does not intend to use in furtherance of its charitable purposes. If, for example, the charity intends to simply sell the gifted item, then the item is “unrelated use” property. Note that this is true even though the charity will use cash from the sale of the item to further the charitable purposes of the organization.

Capital Loss Property

Capital loss property is property that is worth less at its sale than the owner originally paid for it. In that case, the fair market value would be less than the cost basis of the property. If the fair market value is less than the cost basis of the property, then the donor cannot deduct the fair market value regardless of what kind of property he gives. If the donor is contributing loss property, short-term or long-term makes no difference for gift valuation.

In practice, donors should likely never give capital loss property. Instead they should realize the loss and deduct it upon the sale of the property. For example, if a donor bought a share of stock for $110 and it is now worth $10, it is better for the donor to sell the share and then give the proceeds to charity, rather than to give the share directly to the charity. If he sells the share, he will recognize a loss of $100 ($110 purchase price less the $10 sale price). This loss can offset other gains that he might otherwise have to recognize. But if he gives the share directly to a charity, he loses the ability to recognize that loss, and so he loses a valuable tax benefit. The charitable tax deduction is the same whether he gives the share directly to the charity or sells the share and then gives the proceeds to the charity (i.e., $10).

Appraisal Considerations4

The best way to minimize valuation problems is to employ a professional appraiser who follows guidelines set forth in IRS Publication 561, “Determining the Value of Donated Property.” These guidelines require appraisals to include references to sales of comparable items, such as other works by the same artist, as well as some statement regarding the present market in the type of item being appraised. They also limit who can act as an appraiser in this context. The first requirement is that the appraiser must have an appraisal designation from a recognized professional appraiser organization, or otherwise must have met certain minimum education and experience requirements. The second requirement is that they must have demonstrated verifiable education and experience in valuing specific type of property in question.

A dealer from whom a collector purchased the item in question, any expert who derives 50 percent of his appraisal income from appraisals for the collector or the charity, and any family member of such persons cannot perform appraisals for tax purposes. Make sure the appraiser applies USPAP, the Uniform Standards of Professional Appraisal Practice. Under IRS Notice 2006-96, the IRS recognizes this standard, “...[t]he Appraisal will be treated as satisfying generally accepted appraisal standards if, for example, the appraisal is consistent with substance and principles of USPAP.”5 Additionally, the appraiser must also be aware of the extra IRS requirements for charitable contribution appraisal reports that are required in addition to the USPAP requirements.

Applications

Consider some examples that demonstrate how these rules function with specific gifts:

Stock: Suppose that a donor owns a share of closely held C corporation stock that he paid one dollar for in 1990, which today is worth $25. He gives that share of stock to a public charity. How much could he deduct for that charitable gift? Notice that the stock is long-term capital gain property. Why? First, it has appreciated in value, therefore, so it is gain property. Second, the donor has owned it since 1990. This means he has owned it for more than 12 months and, therefore, it is long-term capital property.

Because it is long-term capital gain property, this means that the donor can deduct its fair market value (in this case, $25), unless one of the three exceptions applies. In this case, none of the three exceptions apply. The donor is not giving the property to a private foundation, but instead is giving it to a public charity. The donor has not made a special election to reduce the valuation, so that exception does not apply. And finally, this is intangible personal property, therefore, the third exception, which relates to tangible personal property, does not apply. Because none of the three exceptions apply, the donor can deduct this gift at its fair market value of $25.

Farmland: Now suppose the donor has farmland that he purchased for $600 an acre in 1990, which is now worth $1,800 an acre. He contributes this farmland as a gift to a private foundation. How much per acre can he deduct for this gift? As before, we begin by recognizing that this is long-term capital gain property. First, it has enjoyed capital appreciation. Second, the donor has owned it for more than 12 months.

Because this is long-term capital gain property, the donor can normally deduct its fair market value, unless one of the exceptions applies. The donor has not made a special election to lower his gift’s valuation, so that exception does not apply. Similarly, this is not tangible personal property—it is real property. Therefore, the tangible personal property exception does not apply either. However, the donor has made this gift to a private foundation. Consequently, he will not be able to deduct its fair market value, unless it is “qualified stock.” Clearly, this is not stock, it is real property. So, this exception to the exception is not relevant. As a result of making this gift to a private foundation (since it is not “qualified stock”), the donor’s deduction for the charitable gift of land will be statutorily limited to cost basis. In this case, that means that the donor’s deduction will be limited to $600 per acre.

Antique Toy Car, Part I: Next, consider an example involving a different kind of property. Suppose a donor purchased an antique toy car six weeks ago for $1. This was quite a good purchase, because today the value of the antique toy car is $25. The donor’s plan is to give the toy car to a toy museum that is recognized as a public charity. The charity is interested in the car for its historical value and intends to display the car in its museum collection. How much can the donor deduct for the gift of the antique toy car she gives to the public charity?

The answer to this question is actually simpler than it may seem at first. Since the donor has owned the antique toy car for only six weeks, it is short-term capital gain. Because it is short-term capital gain, the rules concerning “related use” or “unrelated use” tangible personal property become irrelevant. The gift’s value is the lower of fair market value or basis regardless of the charity’s use. These exceptions are irrelevant because, as short-term capital gain property, the donor may value this item only at cost basis. As always, valuing at cost basis assumes that the cost basis is less than fair market value. Here, the cost basis of $1 is less than the fair market value of $25.

Antique Toy Car, Part II: Now consider a slightly different example. Suppose that the donor pur- chased the antique toy car, not six weeks ago, but in 1990. How does this change the result? Since the donor has owned the property for more than 12 months and it has appreciated in value, this property is long-term capital gain.

Because this is long-term capital gain property, there is the potential to deduct the full fair market value of the gifted property, rather than only its cost basis. Of course, this is true only if none of the exceptions apply. The first exception does not apply, because this is not a gift to a private foundation. It is a gift to a public charity—a toy museum. Next, there was no mention of a special election, so this exception does not apply either. Finally, this is tangible personal property and consequently the unrelated use exception could apply. However, in this case, the charity will actually be using the gifted item in furtherance of its charitable purposes. Thus, this property is related use property, not unrelated use property.

As none of the exceptions apply, the IRS allows the donor to deduct the full fair market value of the property donated to the charity. In this case, it is important that the charity “intended” to use the item in its charitable operations by displaying the toy in its collection. How can the IRS prevent abuse of this rule by charities that might say they “intend” to use gifts of property, but then simply sell the gifted property?

Recapture Rule

The recapture rule limits abuse of the related use regulations. If a charity sells (or otherwise transfers) the property item within three years, the valuation could change from fair market value to cost basis. Such a change of valuation would require the donor to amend his or her tax return to reflect the lower deduction. This recapture rule applies only to tangible personal property worth more than $5,000. For these larger gifts, the charity’s transfer or sale of the property within three years will lead to the donor reducing the charitable deduction. This occurs unless the charity certifies that it made substantial related use of the property prior to sale or that the intended use became impossible.

For example, if the donor’s toy car was worth $25,000 (instead of $25) and the charity sold the toy three months later, then the original deduction would be subject to recapture. However, if the reason the charity sold the car was because their museum location was destroyed, making it impossible to display the car as the organization originally intended, then the IRS would likely not require recapture (assuming that the charity certified that the original intended use became impossible). Alternatively, if the charity had displayed the car for 21⁄2 years in its collection prior to the sale of the item and was willing to certify this substantial related use, this certification could also prevent recapture.

Obviously, the simplest and cleanest way to avoid recapture is to make sure the charity does not sell the item for at least three years. If the charity does sell within three years, but it also certifies that one of these two exceptions applies, that will also avoid recapture. However, this certification must be accurate. The charity must sign under penalty of perjury, and there is a $10,000 fine if the charity provides false information.

So, what happens if the charity does not use the item, but instead simply sells it soon after receiving it? In this case the donor gives his antique toy car to a public charity that displays toys in its museum, but the charity does not want to display the donor’s toy. The charity just wants to sell it. So, after the donor has given the toy to the charity, the charity sells the toy at its annual benefit auction. What happens then?

Once again, this is still long-term appreciated capital gain property because the donor has owned it since 1990, so there is the possibility that it could receive fair market value treatment unless one of the exceptions applies. In this case, one of the exceptions does indeed apply, because this is unrelated use tangible personal property. It is unrelated use property, because the charity did not use it. Instead, the charity simply sold the car. It is tangible personal property because it is a moveable physical item. Thus, since the charity is selling this tangible personal property instead of using it, the exception to fair market valuation does apply. Because one of the exceptions applies, the donor cannot use the fair market value for calculating the deduction. Instead, the valuation must drop down to the cost basis valuation. So, the gift of an item worth $25 generates a deduction of only $1.

Qualified Stock

An exception to the exception is the rule on “qualified stock.” Qualified stock is typically publicly traded stock but usually does not include other publicly traded securities like bonds or publicly traded partnerships. That is, stocks that trade on an exchange such that market quotations are regularly available. For example, any stock traded on the New York Stock Exchange can be qualified stock. In addition to being a publicly traded stock, the private foundation cannot have more than ten percent of the entire company when counting all family member transfers together.

The intent is to avoid giving special benefit to large, closely held, insider transactions. Consider the case of a family-owned business where family members transfer most shares of the business to their own private family foundation. This transaction has some potential for abuse. The family members controlled the asset before the gift. And now, as board members of the private family foundation, they control the asset after the gift (at least until the foundation sells it). Determining the fair market value of shares in a family-owned business may be quite difficult. This is especially true for closely held corporations where other investors may be uninterested in owning a minority share when the family still controls all aspects of the business. Because the donor or the donor’s family often control private family foundations, these transfers are generally less desirable, from a policy-makers perspective, than gifts to traditional public charities

The exception is allowed for cases in which the property given is almost like cash. It is almost like cash because the shares are regularly traded and have an easily identifiable value. It is also like cash because it is not a very large share of the total ownership of the corporation (even when considering all family members’ transfers together). Given the cash-like nature of the transfer, there is less concern about inappropriate or abusive transactions, making a fair market value deduction more appropriate. Consider an example of the mechanics of this kind of transaction.

Suppose a donor owns 10,000 shares of Microsoft Corporation (a publicly traded corporation), which she originally paid $1 per share for and is today worth $25 per share. The donor gives these 10,000 shares to a private foundation. What is her deduction for this gift?

Initially, it is useful to note that this is long-term capital gain property. This is true because the donor has owned it for more than 12 months and it has appreciated. Since it is long-term capital gain, there is at least the potential that the donor can deduct its fair market value, unless one of the exceptions apply. In this case, the donor is giving the property to a private foundation, so one of the exceptions to a fair market value deduction does apply, unless the donor qualifies for the exception to the exception.

Because the donor is giving qualified stock, the normal rule for private foundations does not apply. As a result, the IRS allows the donor to deduct the fair market value of the shares of stock. Thus, the donor’s deduction is $25 per share ($250,000) rather than $1 per share ($10,000). The property is “qualified stock” because it was publicly traded (meaning that market quotations are available) and because 10,000 shares is nowhere close to a ten percent ownership interest in the corporation (given that it has billions of shares).

Special Cases: Taxpayer Abuses and Congressional Responses

From time to time there have been special kinds of property that have been used in significant tax abuses. As a result, Congress has acted to create special rules that apply only to specific types of property, usually in response to these tax abuses. For these special kinds of property, it modifies the normal rules. Special charitable donation rules apply to clothing, household items, cars, boats, airplanes, taxidermy, inventory, patents, and other intellectual property.

Considering the complexity of the “standard” rules reviewed above, why would Congress add these special rules for specific assets? The answer is that Congress reacted to ongoing abuses that fit the normal rules, but which it still considered to be inappropriate.

There is always a special potential for abuse in the area of deductions for gifts of property when the property has an uncertain valuation. Consider a taxpayer at the top federal tax rate of 37 percent, and at the top state tax rate in a state like California, where the top rate is 13.3 percent. A deduction for this taxpayer is worth more than half of the value of the gifted property, considering that the donor will likely already have reached the cap for federal deductions of state and local taxes. A property may be difficult to value or difficult to sell, but the donor can immediately convert it into a tax benefit worth nearly fifty cents of every appraised dollar. This can make such transfers highly attractive, even to those with little or no charitable intent. If a difficult-to-value item of property can be appraised for two or three times what the owner could actually sell it for in an immediate sale, it may be more profitable to donate the property, rather than to sell it. Such financial incentives make gifts of difficult-to-value assets ripe for abuse.

Taxpayer Abuses

What do the abuses that led to special rules look like? For example, a person might have old clothes that she would otherwise throw in the trash, because they have little or no resale value. Instead of throwing them away, the person could give them away and generate a charitable deduction. Perhaps the person may attempt to value the deduction based on the original cost of the clothing or some “estimated” value based on a percentage of the original cost, when in reality the poor quality clothing has little or no resale value.

Another abuse could result from gifts of automobiles where the automobile has some defect that reduces its value below the normal resale value for that model and year of car. Even though in reality the automobile may be worth nothing, except in a junkyard, taxpayers may be tempted to donate the vehicle and deduct the standard value for a vehicle of that age, make and model (i.e., the “blue book” value). For an in-depth discussion of vehicle valuation issues, see Chapter 9.

A particularly egregious abuse occurred in the area of donating stuffed animals to a wildlife museum. In this scheme, the taxpayer would go on safari to hunt exotic animals, have a taxidermist stuff the animals, and then donate the animals to a wildlife museum. An appraisal firm would provide a high valuation for exotic stuffed animals (a valuation which might be difficult to disprove given the rarity of transactions and the high cost of acquiring new exotic stuffed animals). A few small wildlife museums were willing to accept these donations (often taking in thousands of animals). The donor would then deduct his cost basis in the stuffed animal, including all of the costs of acquiring the animal, such as the entire expense of the safari travel. Thus, the tax code was essentially funding a substantial portion of safari tourism intended to kill exotic animals.

A different problem arose with copyrights and other intellectual property not simply because of the risk of fraud, but also because of the enormous difficulty in valuing such intellectual property in advance. If a best-selling author wrote a new book and immediately donated the copyright of the book to charity, such a donation would be enormously valuable. If a less well-known author did the same, the donation could be highly valuable or it could be worth nothing. The difficulty is that it may be impossible to tell at the time of the donation how much the gift is worth. No amount of sophistication, education, experience, or integrity of any appraiser will be able to correct that problem.

Congressional Responses

Because of the wide variety of problems and issues with these special kinds of property, each of them has their own special rule.

Clothing and household items typically get no deduction unless they are in “good used condition or better.” The purpose of requiring “good used condition” is to exclude worn out clothes. An exception to this rule is if the donor gives more than $500 of clothing and the donor includes a qualified appraisal of the clothing with the tax return. Thus, small donations of clothing in poor condition are not deductible. Large donations of such clothing may be deductible, but only if there is a qualified appraisal.

This same rule applies not only to clothing, but to other household items. The term “household items” does not include art, antiques, jewelry or collections. Instead, it refers to items like furniture, electronics, appliances, linens and the like. The donor may not deduct these household items unless they are in “good used condition or better,” or where there is an accompanying qualified appraisal indicating a value in excess of $500 for the entire donation. To address the problem of taxpayer financed safari trips, Congress limited deductions for taxidermy property to the cost of stuffing the animal only. Thus, none of the other costs of acquiring the animal may be deducted.

Deducting charitable gifts of copyright (or other intellectual property, such as patents and trademarks) is not simply a problem of fraud or abuse, but is fundamentally a problem of accurately valuing the property in advance. To resolve this issue, Congress allowed for special deduction rules, discussed in depth in Chapter 11. However, note that, as in all other forms of charitable property deductions, the cost basis is deductible only if such basis is less than fair market value. Thus conceptually, it may still be necessary to estimate the fair market value of an intellectual property right in advance. However, in practice, many such rights have little or no cost basis. For example, an author’s cost basis would include only some paper and ink, and would not take into account his or her time spent in producing the work.6

Another exception to the standard valuation rules involves an unusual compromise. The normal rule for gifts of inventory is that only the cost basis of inventory is deductible. However, the tax code provides a special increase in the deduction for specific types of inventory gifts. If the donor is a standard corporation (a C corporation, as opposed to an S corporation), it can receive a higher deduction. To do so, it must be giving inventory to a public charity for care of ill individuals, needy individuals, or infants, or it is giving qualified research materials to an institution of higher education or other scientific institution. This higher deduction will be the average of basis and fair market value.

Thus, the Corporation receives neither the most favored status (which would be fair market value) nor the less favored status (which would be cost basis), but instead receives something in the middle. However, regulations still limit this deduction to no more than double the cost basis in the gifted items. This is to prevent a scenario where the deduction was worth more than the cost of manufacturing the property.

General Reporting Requirements7

The burden of defending the value claimed for a deduction rests with the donor. In order to claim a charitable deduction over $5,000 for any noncash asset other than publicly traded stock, the donor must secure a qualified independent appraisal, with a qualified appraiser completing a qualified appraisal under IRC 170(f )(11).8 The appraisal must be dated within sixty days of the gift, or by the donor’s tax return filing date for the year of the gift. Further, in order to claim the deduction, the donor must file IRS Form 8283, and for any noncash asset gift over $5,000, the Form must be signed by the appraiser, as well as a representative of the charitable organization. Failure to follow these appraisal rules can result in denial of the charitable deduction.9

If the charity sells or disposes of the donated asset within three years, then it must file IRS Form 8282 reporting the sale price. If there is a significant discrepancy between the sale price it lists on Form 8282 and the original deduction claimed by the donor as reported on the Form 8283, then this could trigger an IRS audit review. There is no “bright line” standard of how much difference between the deduction and a reduced sale price would threaten the claim of a deduction, but tax counsel should be aware of the discrepancy.

Special Valuation Requirements

Although not exceptions to the general rules, some items can be hard to value and consequently, the IRS requires a special kind of valuation for these items. For example, when valuing gifts of clothing, the valuation must be what the used clothing would sell for in a consignment or thrift shop, not what it sells for new in a retail environment. Of course, the difference between what an Armani suit sells for in an upscale retail environment and what a used Armani suit would sell for in a thrift shop is dramatic.

Finally, for gifts of large quantities of individual items, donors must determine the valuation from the value of the entire lot of items. The IRS does not permit donors to estimate the value of a single item and multiply that by the total number of items gifted. For example, suppose a donor found a box of 1,000 beanie babies on sale online for $1,000. If the donor purchased these, then gave them to an orphanage over a year later for use in their charitable activities, the donor could be legally entitled to a deduction of fair market value (long-term capital gain related use personal property). However, even if the fair market value for a single beanie baby toy was $5, the donor could not claim a fair market value for the gift of $5,000 ($5 x 1,000). Instead, the fair market value would be the value of the entire lot of 1,000 such beanie babies in a single lot sale.

If, during an audit, the IRS determines that the taxpayer overvalued a charitable gift, there will be distinctly adverse results. First, the donor must reduce the deduction to an appropriate value, and consequently will need to pay for additional taxes and any interest accrued since the due date for those taxes. In addition to this repayment and interest, there can be penalties for over- valuing a charitable gift. Those penalties depend upon the amount of the gift and the degree of overvaluation. If the taxpayer valued the gift at greater than 50 percent of its true value and, as a result, there was more than $5,000 in underpayment of tax, then the taxpayer must pay not only the taxes due, but also an additional 20 percent of the unpaid taxes. If in the previous case, the valuation was more than double the item’s true value, then the penalty would be an additional 40 percent of the unpaid taxes. Finally, if the misstatement of value was due to fraud, the penalty would be an additional 75 percent of the unpaid taxes, regardless of the amount of underpayment or the degree of over valuation.10

The IRS often requires the donor to obtain an appraisal to deduct gifts of property. Can the taxpayer avoid the penalties discussed above if the taxpayer had a qualified appraisal for the amounts reported? The answer is: it depends.

There will be no penalty if the taxpayer’s valuation was based upon a qualified appraisal, the donor made a good-faith investigation of value, and the valuation was less than double the actual value of the item. This exception would not apply if the appraisal was not a qualified appraisal under IRS guidelines. Even if the appraisal was a qualified appraisal, the IRS still requires the donor to have made a good-faith investigation of the value of the item, besides simply relying upon the appraisal. But if both of those conditions apply, and the appraised value was less than double the actual value, then no penalty will apply. However, the donor still must remit any unpaid tax resulting from the overvaluation and any interest due.

What are the penalties to the appraiser for making an excessive appraisal of an item of property gifted to a charity? If the valuation was more than 50 percent greater than the actual value of the item, the appraiser’s penalty will be the greater of $1,000 or 10 percent of the tax underpayment. This penalty could be potentially catastrophic for appraisers who appraise items of extremely high value. Recognizing that such a rule would prevent even legitimate appraisers from functioning, the tax code limits the penalty for appraisers to 125 percent of the appraiser’s fee for making the appraisal. For example, an appraiser charges $1,000 and values a piece of artwork at $10 million when it was actually worth only $5 million and this error results in a $1.5 million tax underpay- ment. The appraiser’s penalty will therefore not be $150,000 (10 percent of the tax underpayment), but instead would be 125 percent of the appraisal fee, or $1,250.

One interesting case that illustrates the sometimes unusual results from property valuation is that involving a work of art called “Canyon.” This work of art was a bequest to the heirs of an estate. The IRS appraised the value of the artwork at $65 million and charged $29.2 million in estate taxes on the item. The IRS based this valuation upon its definition of fair market value, which is the price that property would sell for on the open market.

The problem in this case was not the valuation in itself, but that the artwork incorporated the use of a taxidermied eagle. Federal law prohibits the sale of such taxidermied eagle feathers or parts. Consequently, the IRS required the estate to pay a large tax on an item that it could not sell. This is an interesting example of what could happen with items where the law restricts sale, but the valuation is the price that the item would sell for on the open market. In this case, the heirs would have been much better off if the decedent had gifted the artwork to a charity, rather than left it to them. In the final settlement, the IRS allowed the heirs to retroactively donate the artwork, treating it as if the estate made the gift, thus generating no net estate taxes on the donated artwork.

• 1. This reading is an adaptation of James III, R. (October 7, 2015), “Visual Planned Giving: An Introduction to the Law and Taxation of Charitable Gift Planning,” Chp. 5: Valuing Charitable Gifts of Property, parts 1 and 2, http://www.pgdc.com/pgdc/5-valuing-charitable-gifts-property-part-1-2; http://www.pgdc.com/pgdc/5-valuing-charitable-gifts-property-part-2-2.
• 2. For a general guide to IRS valuation and appraisal rules, see IRS Publication 561 (April 2007), Determining the Value of Donated Property, https://www.irs.gov/publications/p561/index.html.
• 3. It is easiest to think of tangible personal property as movable physical property. This would not include immovable real estate such as land or anything permanently attached to the land, like a building, or intangible personal property, such as shares of stock or bonds.
• 4. This section was written by Armen Vartian (“Charitable Donations of Art and Collectibles” (2016) (on file with author)).
• 5. Notice 2006-96, 2006-46 I.R.B. 902.
• 6. Note that time and effort are excluded from cost basis in other areas as well. For example, if a taxpayer purchases a dirty car for $5,000 and then spends three months cleaning and detailing it, his basis in the car is still only $5,000.
• 7. This section was written by Phil Purcell.
• 8. See IRS Publication 561, “Determining the Value of Donated Property,” for a helpful summary of IRS appraisal requirements.
• 9. See Mohamed v. Commissioner, T.C. Memo. 2012-152 (May 29, 2012). A.15
• 10. Tax fraud can lead not only to financial penalties, but also to imprisonment.