Want Big Profits Guaranteed? Give Away Your Stock
Donating stock to charity might be the surest investment you can make.
Psst! Want a hot stock tip that will yield a guaranteed 52% return? Give your equities away.
If you're still reading, thanks for providing me with a little more time to prove that I'm not delusional. My reasoning has to do with an underused nuance of the U.S. tax code: equity donations. Handing over your stock certificates to your favorite charity not only helps fund the good work they do but can also provide a lucrative way to lower your tax bill. This is a win-win scenario. It works because of the structure of tax law: The IRS allows investors to write off the current market value of any stock held for at least a year, not the price investors originally paid for the shares. (Short-term holdings don't receive this favorable tax treatment.)
Before we get into the nuts and bolts of giving away your equities, there are a few key points to consider. First, the maneuvers I describe below work only for stock held in taxable accounts; 401(k)s and IRAs need not apply.
Second, the stock you're giving away should almost never have an unrealized capital loss; if it does, you're probably better off selling it and using the losses to offset gains on other investments.
Third, investors will need to make sure that they thoroughly document the transaction by obtaining records from their broker as well as the charity receiving the stock. It also would be wise to consult a financial planner or tax advisor before making the donation.
As I'll illustrate, this nexus of the tax code and stock investing should be attractive to two types of benevolent investors: 1) Those who are sitting on long-term holdings that have appreciated greatly over the years, and 2) Those who own securities that are substantially overvalued on a fundamental basis.
But first, let's consider the basic math behind charitable giving. Suppose out of your annual income, you typically budget $5,000 in charitable donations. Also suppose that your combined state and federal marginal income tax rate is 35%. Because of taxes, it really costs you only $3,250 to give away $5,000 in cash, because if you didn't give it away (and take the itemized deduction), you would pay $1,750 in tax on the income ($5,000 * the 35% tax rate).
Now, let's muddy the waters a bit by layering in an issue many of us face--selling stocks in taxable accounts and getting socked with the capital gains tax bill. Suppose for the sake of our example that you own 100 shares of a $50 stock that you bought years ago for $10 per share, and you're planning to sell it this year. Assuming that your long-term capital gains tax rate is 15%, you would owe the government $600 in taxes on the $4,000 worth of capital gains (100 shares * $40 per-share gain * 15% capital gains tax).
Now, we'll consider the net impact of these two transactions on your tax bill. To do this, we subtract the $600 in capital gains taxes from the $1,750 in charitable tax benefit. This leaves us with a net tax benefit of $1,150. However, if you just give the $5,000 worth of stock directly to the charity, you receive the full $1,750 in charitable tax benefit without worrying about the detriment of capital gains taxes. Why? Because you can write off the $5,000 worth of stock as a charitable donation--just as you would have if you gave cash--and you eliminate your long-term capital gains tax bill in the process.
As a result, you're 52% better off--($1,750 - $1,150) / $1,150--by combining the two transactions into one, rather than by selling the securities and giving away cash separately. Additionally, the charity is just as well off as before. It can, and probably will, immediately sell the donated shares.
Do you want to know what the best part of this guaranteed return is? The benefit will remain available as long as the government continues to levy a capital gains tax--no matter what the rate--and allows itemized deductions to charities. (No offense to flat-taxers such as Steve Forbes, but I'm betting both of these tax code provisions will hang around for decades to come.)
Despite the clear-cut advantages of donating stock--in lieu of cash--to charities, there are potentially millions of investors leaving money on the table by not taking advantage of this maneuver. Among tax filers in 2003 with an adjusted gross income (AGI) between $50,000 and $200,000, 4.3 million people reported capital gains on securities, with an average reported gain of about $13,200, according to IRS data. Additionally, it's a safe bet that many of these same people also donated to nonprofit organizations, since two thirds of all tax filers in this income group itemized charitable deductions, with an average reported gift of $4,800.
The Best Way to Give
So if you've made up your mind to donate stock to your favorite charity, a second decision needs to be made: What stock to give? If you're a diversified long-term investor, chances are you probably have a number of possible candidates. However, in my opinion, investors should focus exclusively on two types: 1) stocks that have appreciated substantially since being purchased, and 2) stocks that are overvalued on a fundamental basis.
Let's consider the first point. While the tax implications should be pretty clear by now, the one hang-up investors still might have is that they don't want to give away a stock if they still like the investment's prospects. But this is a non-issue, and it's easy to see why. When investors donate shares of a company, they deduct the market value of those shares at the time they're given, but they can also immediately turn around and repurchase new shares in the same company, potentially even at the same price. The wash-sale rule--which forbids investors from selling stock for a loss and buying it back within 30 days--doesn't apply to the shares you gave away. After all, you didn't sell them; the charity did--and they were presumably sold at a gain to their original cost anyway. Thus investors can eliminate the deferred tax liability they've built up with Uncle Sam, create a new cost basis in the stock for themselves (if they repurchase it), and help out a good cause in the process. Because of this loophole, there's a strong case in favor of equity donations being the primary way stock investors give to charity.
It's a little trickier proposition to see why overvalued stocks are an even better donation. The primary reason has to do with market inefficiencies created by the capital gains tax, a topic I'll explore in a future column.
For the time being, though, let's consider an example. Suppose the $50 stock we considered above is actually worth only $40 per share, and because you're a fundamental investor, you believe the stock will eventually trade at this level. However, because of frictions created by the capital gains tax, you might be compelled by two factors to hold off on selling and banking the ill-gotten gains that Mr. Market is offering you. First, you'd need sell the stock for far enough above its intrinsic worth to make up for the losses incurred on the capital gains. Additionally, you'd need to have another far better investment prospect waiting in the wings. With the top long-term capital gains tax rate at 28%, securities prices need to be pretty far out of whack before selling stocks held in taxable accounts becomes attractive.
This isn't a concern if you give the stock away. The IRS cares only about the market value of the stock--not your view of its intrinsic value. Thus, if investors give away the shares, they can immediately capture a portion of this market overvaluation for themselves. After all, the full $50 market value can be deducted as a charitable donation; the IRS doesn't care that you think it's worth only $40. So while the market might need to offer an extremely enticing premium to fair value before you'd be willing to sell (and incur the capital gains tax hit), the market needs to offer only a modest premium to make it worth your while to give the shares away. According to Morningstar's own data, now might be an opportune time to take advantage of this rule. Of the more than 1,500 stocks we cover, 458 are currently in either 1- or 2-star territory and would make prime candidates for charitable donations.
Still, despite all the tax reasons to give to charity, the biggest reward of all will be in knowing that you helped out a worthy cause.