Case:

Abigail was a wonderful and spirited 80-year-old woman. Even as an octogenarian, she still worked in her garden, handled all of her finances and played golf each weekend. In addition to her busy schedule, she also made time to help at a local homeless shelter. She believed that whenever you can lend assistance to your fellow neighbor it is your responsibility to do so. Because of this belief, she gave her time, love and money to the shelter. Abigail's normal practice was to give $5,000 each year to the homeless shelter. However, she wanted to make a more significant gift to the shelter this year.

So, in January of this year, she decided to establish a $100,000 charitable gift annuity. She liked the high fixed payments, $49,000 tax deduction and simplicity of the arrangement. Because Abigail funded the CGA with cash, a large portion of each payment was tax-free. But of course, what she loved most was the eventual gift to the shelter.

Sadly, Abigail suffered a heart attack in March and died soon after. It was a terrible loss to the community. Now several months have passed and Abigail's family and CPA are winding up Abigail's financial affairs. Despite living only several months this year, Abigail had $100,000 of income (mainly from an IRA distribution in January). The CPA knows he can deduct the $49,000 charitable tax deduction on Abigail's final tax return. However, he wonders if she is entitled to any other deduction since she passed away prematurely.

In looking for this answer, the CPA contacts the shelter to inquire about the gift annuity. The shelter informs the CPA that Abigail never received a payment. The payments were quarterly; however, she passed away prior to the first payment.

Question:

Since Abigail died prematurely, does she get another tax deduction? If so, what type of deduction is available and how is it reported?

Solution:

Abigail's income from her gift annuity, as mentioned above, was partially tax-free. This tax-free component is essentially a return of principal, and it would last until the end of her life expectancy. Because Abigail passed away before the end of her life expectancy (and before even one payment), she did not receive any of her tax-free income. "Unrecovered investment" is the term for this shortfall of tax-free payments. Fortunately, the amount of unrecovered investment may be claimed as a deduction on Abigail's final income tax return.

With a $100,000 cash CGA and charitable tax deduction of $49,000, Abigail's total investment in the annuity contract was $51,000. Because Abigail died prior to even one payment, she did not receive any tax-free income. Thus, Abigail had $51,000 of unrecovered investment in the annuity contract. See Section 72(b)(4).

The CPA wondered how to deduct the $51,000. If the $51,000 is an additional charitable tax deduction, it will be lost due to the 50% AGI limitation rules. For instance, Abigail's AGI for this year is $100,000. As a result, $50,000 is the limit for cash gifts. But she already has a $49,000 charitable deduction which resulted from creating the CGA. So, any additional charitable tax deductions in excess of $1,000 would be unusable on her final income tax return.

To the CPA's great delight, the $51,000 amount is not deducted as a charitable tax deduction, but rather as an "other miscellaneous deduction" (not subject to the 2% floor). This deduction can be claimed on Schedule A of Form 1040. Moreover, it is not subject to the 50% AGI limitation on charitable deductions. So, the CPA can claim a $49,000 charitable tax deduction and a $51,000 miscellaneous deduction all in the same year. Abigail's death, for tax purposes, transformed a potentially nondeductible item into a deductible item. Accordingly, these two deductions can effectively wipe out any taxable income on Abigail's final income tax return! This is a very nice benefit – especially since the shelter will receive a major part of Abigail's estate.