Article of the Month

The past decade has been challenging for charities and particularly for foundation endowments. The equity return on the S&P 500 or the Russell 2000 for the past decade has been essentially flat.

Housing has experienced a very substantial bubble. In January of 2000, the Case-Shiller housing price index was 100.59. It soared to 203.95 by March of 2007. However, when the bubble deflated, the housing index returned to 141.20 in March of 2011. Even with the housing bubble, the typical home appreciated approximately 3% on average between January of 2000 and March of 2011.

What will the stock and bond returns be during the next decade? While bonds currently produce a low yield, the concern of many investment advisors is that there may be a return of modest inflation levels during the decade. If so, total bond returns over the next decade could be below the 5% to 5.5% average of the past 75 years.

Similarly, stocks are in a period of uncertainty. With the potential sovereign debt default of Greece and other Southern European nations, markets are concerned that banks will experience a second major financial shock. At the same time, there is a substantial debt-deleveraging process underway. Consumer debt peaked in 2007 and has been steadily declining. The financial problems of banks, housing weakness and lower consumer spending could lead to a period of equity returns less than the 75-year average.

Potential Real Estate Returns This Decade

Given the challenges to stock and bond returns for the next decade, it is logical to consider real estate. Housing is not likely to appreciate at rapid rates and could continue to be flat for several years. However, over a period of seven to 12 years housing is likely to move forward from its current base.

A measure of housing affordability is the ratio of home prices to annual household income. In 2000 the Case-Shiller housing index for the home price to median income was set to 100. It rose to 177 in 2006 and declined to 118.4 in March of 2011.

With home interest rates at low levels, this opens up the housing market to millions of potential new buyers. While it may be 2013 before the full impact of the foreclosure crisis has been resolved, the affordability rate will eventually lead young and middle-age buyers back into the housing markets. As a result, there is a reasonable prospect for returning this decade to the historic 3% to 4% appreciation rates for homes in good locations.

Location-Location-Location. The key in acquisition of real estate is always selection of homes in good locations. However, over the next decade there are many cities, particularly within the Sunbelt, that will experience moderate growth. Acquiring homes in these locations is likely to be beneficial for endowments - especially if the purchase price is far below the current market value.

Gift Annuity for Remainder Interest

The least expensive way for charities to acquire property is through an agreement that combines a charitable gift annuity and a life estate. There are two general investment strategies that apply. First, if the property is desired by the charity for long-term ownership, the gift annuity for remainder interest is by far the preferred acquisition method. The property value is first reduced by subtracting the life estate or income interest. The remainder is further divided into the gift portion and the annuity contract. The actual purchase price of a property through a gift annuity for remainder interest is one-third to one-half of the present value. Because the purchase price is quite reasonable, an acquisition of a property that is intended to be retained has an obvious financial benefit.

Example A – New Home for University Executive

A university in the southern state was offered a home by an individual age 83. She wanted to remain in the home for her lifetime and desired additional income. The home was a beautiful southern residence with white pillars in the front and a spacious lot. The university was able to purchase the home through a gift annuity for remainder interest. The cost was estimated to be one-third of the price they would have paid if they later bought it from her estate. She passed away after five years. The home was renovated and now serves as the residence of an officer of that university.

Life Estate

The first component of the gift is a calculation of the life estate. A remainder interest in a home or ranch may be transferred to charity. The owner who creates the life estate is permitted a charitable deduction for the remainder value. Sec. 170(f)(3)(B). The remainder interest may be for a life or term of years. Reg.1.170A-7(b)(3). However, the gift annuity must be written for one or two lives and so the combination agreement is normally a life estate combined with a one-life charitable gift annuity.

The life estate is created through a deed. The owner deeds the property to the charitable organization, reserving use of the property as the life tenant. It is a best practice for the owner to also sign a Maintenance, Insurance and Taxes Agreement.

Example B – Maintenance, Insurance and Taxes Agreement

THIS AGREEMENT is entered into at ____________County, State of _______________, on ________________, by and between _____________________, a qualified exempt Section 501(c)(3) charity (the "Charity"), and _________________ and ___________________, husband and wife, of ____________, _______________ (the "Donors"). WHEREAS, the Donors have this day executed a deed giving to the above charity a remainder interest in their personal residence in the City of ____________, and County of ____________, known as ________________________ _______________ (the "Property").

NOW THEREFORE, the parties hereto agree as follows:

1. The Donors, jointly and severally, shall have the sole responsibility for maintaining the property, insuring the property against loss and liability and paying real estate taxes, and shall not, without the consent of the Charity, permit any lien or mortgage to be placed on the property other than liens or mortgages which may now exist, and shall not, without the consent of the Charity, permit the amount of any lien or mortgage now existing to increase.

2. The Donors shall, during their respective lifetimes, have the sole right to occupy and utilize the premises as their residence and to lease the premises to any other person for use as a personal residence. The Charity shall join in any lease of the premises to another in order to permit the lease term to continue beyond the death of the surviving Donor, provided that such term shall not continue for more than one year beyond the date of death of the surviving Donor and provided further that the Charity shall be entitled to the rent from the property from the date of death of the surviving Donor.

3. In the event of any damage to the property, the Donors, at their sole expense, shall cause such damage to be repaired unless the Donors and the Charity shall agree that it is impractical to do so, in which case, any insurance proceeds resulting from such damage shall be divided between the Charity and the Donors in accordance with the value of their respective interests as of the date such damage occurred. For purposes of determining the value of the Charity's interest in the event of such loss, the value shall be determined in the same manner as is used to value a remainder interest in a personal residence as is provided in U.S. Treasury Regulations Section 1.170.

4. The Donors, jointly and severally, agree to hold the Charity harmless against any and all liability arising from the property during their lifetimes. The Donors may at any time or times at their sole expense make improvements to the property, provided that such improvements shall not result in a reduction of the value of the property.

IN WITNESS WHEREOF, the parties hereto have set their hands and seals the day and year first above written.

THE CHARITY	DONORS
By: ____________________________	____________________________
And by: ________________________	____________________________

Charitable Gift Annuity

A current, or immediate, gift annuity is a contract between the charity and the donor. The donor transfers property to the charity and the charity promises to pay the annuity for one life or two lives. Sec. 514(c)(5).

As a contractual obligation, the annuity payments are secured by the assets of the charity. Most charities maintain an annuity reserve fund, which is required by some state insurance commissioners. However, the endowment and even all of the real property and other assets of the charity stand behind the promise to pay a gift annuity.

From the perspective of the donor, a gift annuity is a relatively simple agreement. He or she transfers cash, securities or other assets to the charity and receives a payment for one or two lives. The payment may be made monthly, quarterly, semiannually or annually. In addition, there is an income tax deduction and partially tax-free payout from the annuity contract.

When the gift annuity is created, part of the value represents a charitable gift and part is the amount exchanged for the annuity contract. There are several specific Treasury requirements for qualification as a gift annuity. A qualified gift annuity must be for one or two lives, there must be a minimum 10% charitable deduction, there can be no guaranteed minimum or maximum payments and the annuity may not be adjusted based on the income earned on the transferred property. Sec. 514(c)(5).

Only a portion of the amount transferred for a gift annuity qualifies as a charitable deduction. If a donor makes a gift to a charity and value is returned to the donor, the gift is described by Treasury as a "bargain sale." With the transfer of cash or other property to a gift annuity, the donor receives a deduction for only part of the transfer, since the charity has promised to transfer a value annuity payout back to the donor. In effect, the donor has made a gift of part of the property and purchased an annuity contract with the balance. Reg. 1.1011-2(c).

While charitable organizations are less likely to fund a gift annuity for real estate, it is permitted and gift annuities in exchange for real estate are issued every year. Quite often, the gift annuity for real estate is a current annuity for a fee interest in the real estate. The gift annuity must be issued based on the appraised value of the real estate. After the charity receives the real estate, most organizations will then choose to sell the real estate and transfer funds to the reserve account.

Gift Annuity for Remainder Interest

A gift annuity for remainder interest is a combination of two qualified charitable gifts. First, the remainder value for the individual is calculated. To retain the life estate, the attorney for the donor drafts a deed from the donor to the charity, reserving the use of the property for his or her lifetime.

However, with a gift annuity for remainder value, a deed is then exchanged for a gift annuity. The property fair market value is divided first between the value of the life tenant and the remainder interest. That remainder interest is then exchanged for a gift annuity. That value is divided a second time between the charitable deduction and the contract value.

Example C – Life Estate

Ellen Kelly is age 80 and owns a home valued at $600,000. She agrees to exchange the remainder interest in her home for a charitable gift annuity from her favorite charity.

The remainder value based upon her age and the home fair market value is $420,728. The balance of the $600,000 value is the fair market value of her life use. In addition to being able to live in the home for life, she receives a gift annuity. Based on the $420,728 remainder exchanged for a 7.5% annuity for a person age 80, she receives $31,554.60 each year. She allocates her $250,000 sale-of-a-personal-residence exclusion to the annuity contract and most of this payment is tax-free.

In addition, Miss Kelly receives a charitable deduction of $197,116. This is an appreciated property charitable deduction that she may deduct over the next six years. The deduction will be limited to 30% of her adjusted gross income each year. Miss Kelly has benefited from the ability to live in her home for life, has received a generous income and will save very substantial income taxes for the next six years.

Cost Benefit Analysis

A charitable organization normally invests its endowment in stocks and bonds. While some charitable organizations have experimented with hedge funds, timber and other more creative investments, the vast majority of investment portfolios are in public stocks and bonds.

During the typical decade holding period of a gift annuity for remainder interest, a charity could achieve a much higher rate of return. Endowment stock-bond portfolios historically have returned approximately 8% to 9%. Even if a CFO projects that historic returns will be attainable during the next decade, it is possible to achieve a substantially higher return through the CGA for life estate strategy.

Many foundations and other organizations with endowments are permitted under their investment policies to place 5% of the portfolio in real estate. It would be possible to invest this portion of the endowment in residential real estate. Because the gift annuity for home is the lowest possible purchase price and housing is now likely to be close to the bottom, it is an unusually favorable time for CFOs to consider this option.

Potential Internal Rate of Return

Internal rate of return is defined as the return earned on a series of cash flow payments that produce a selected total amount. It is a reasonable method to determine the rate of return to a charity with a gift annuity for remainder interest. The charity must pay the annuity amount from reserves for the life of the donor, but will receive the full value of the home upon his or her demise. The cost to the charity is the payment and the lost interest on those amounts. The benefit is the value of the home at maturity, less any sales cost.

Assume that a number of single donors age 75 to 90 are in your donor pool. If they transfer remainder interests for gift annuities, it is appropriate to consider the potential return. With housing affordability levels now at extremely favorable percentages for young and middle-age buyers, it is quite probable that housing in good neighborhoods will appreciate by 3% over a typical seven to 12 year term. If a CFO determines that this is a reasonable assumption, then it is possible to build an analysis that shows the potential internal rate of return on this investment. The lost interest is 7% and the home sales cost is also 7%.

Donor Age	Payment	Deduction	Term/Years	IRR
75	6.5%	$156K	13.4	12.2%
80	7.5%	$197K	10.2	15.1%
85	8.4%	$251K	7.6	21.7%
90	9.8%	$300K	5.5	31.0%

Investment Assumptions

The CFO should consider the possibility of changes in some of the investment assumptions. Will the donors live longer than normal life expectancy? It certainly is possible that they will live longer and the IRR analysis can be done with the assumption of a longer lifespan. If there are 10 or more homes, the probability of an average expectancy that is one year greater than the tables is fairly modest, but it is possible. Because individuals are receiving a gift annuity, there may also be self-selection by donors who are in good health.

The other consideration is the appreciation rate. The IRR analysis can be run with appreciation rates of 2%, 3% or 4%. Based upon the present affordability index, it seems quite possible that homes in selected neighborhoods will be likely to appreciate over the decade, but a CFO may certainly use more conservative assumptions.

Even with more conservative assumptions, the stated 12% to 31% returns could be adjusted to a lower level. With more conservative assumptions, the estimated return for single donors with the gift annuity for remainder interest remains in double digits. This is likely to be a very good endowment return during the next decade.

Insurance Regulations

A gift annuity for remainder interest is permitted in all states except New York. The gift annuity for remainder interest requires allocation of endowment funds to the annuity reserve fund in California. Arkansas and Florida also have specific prudent investor standards that may require adjustments in endowment and gift annuity fund reserve balances.

While it may be necessary to allocate endowment funds to the reserve fund, or use the excess funds presently in the gift annuity reserve account, this is not an expenditure. The funds still remain under the control of the charity in a different account. Upon the maturity of the plan, the allocated funds may be recommitted to endowment.

Increased Investment Return

One of the functions of a CFO is to project probable endowment investment returns over the next decade. Given the uncertainty on interest rates, bond returns are likely to be projected at a conservative level. Similarly, with the major sovereign debt challenges in Europe, many investment advisors think that equity returns should be estimated conservatively for the next decade. As a result, many CFOs are now projecting endowment investment returns of 7% to 8%, rather than the higher levels of the past decade.

In comparison, the gift annuity for remainder interest has the potential to provide substantially greater returns. While it is essential to understand the location and probable growth pattern of housing for the remainder interests that are acquired, this creative gift agreement has genuine potential to produce annualized investment returns of 12% to 18%.