[As with anything tax-related, see my disclaimers.]
If you are currently making charitable contributions using cash, you’re doing it wrong. You can save save big tax bucks by instead gifting securities with appreciated long-term capital gains.
Money is Fungible
If I have $100 cash and $100 stock, I could choose to either gift the cash and sell the stock, or I could gift the stock and keep the cash. Either way the charity has received $100 worth of value and I have $100 remaining. The cash and stock are fungible.
However, Uncle Sam treats the two situations very differently. Pretend that I had originally paid $45 for the stock a couple years ago, giving me $55 worth of appreciation. In the first scenario where I sell the stock and gift the cash, I’ll be paying Uncle Sam capital gains tax on the appreciation, which at the 15% long-term capital gains is $8.25 of tax. My remaining $100 is now actually only $91.75.
In the second scenario where I gift the shares and keep the cash, neither I nor the charity owes any capital gains tax on the gift. Uncle Sam treats me as if I gave the full amount of $100 (useful if you’re itemizing deductions) and the charity gets the full amount of the gift as well.
By gifting shares instead of cash I came out ahead tax-wise.
Turbocharge Giving With Tax Loss Harvesting
You can turbocharge the benefits of gifting appreciated securities through tax loss harvesting. Tax loss harvesting is one of the features touted by robo-advisors like Wealthfront and Betterment. The idea is that market dips are typically temporary, and that by selling shares that have lost value and buying highly-correlated-but-different shares of another security, one reaps a tax loss but is still able to benefit when the market inevitably recovers. These losses can offset capital gains made elsewhere (generally unlimited) or even regular income (limited).
So how does this help? The tax loss saves me on my taxes today, and by gifting the shares later, I avoid the capital gains tax.
Over the past couple years, VTI has dipped a couple times. Each time it’s dipped, I’ve sold the shares of VTI at a loss and bought SCHB, a similar total-market index ETF that tracks a different index. SCHB’s performance is highly correlated to VTI but tracks a different index, thus avoiding the IRS’s wash sale rules. VTI and SCHB happen to be the same pairing used by Wealthfront in its tax loss harvesting strategy.
A quick example. I’m in the 22% tax bracket (2019) and my capital gains are taxed at 15%. I purchase $1000 of VTI. Shortly after the market takes a dip and my shares of VTI are only worth $900. I sell the shares, locking in a $100 loss that I can use to offset a $100 of my regular income, saving me $22 of tax. I immediately use the $900 proceeds from the sale to buy SCHB. The market recovers back and some and my shares of SCHB are worth $1100 by the time I gift them a year later. By gifting the shares, I save an additional $30 of tax on the $200 of appreciation.
It doesn’t make sense to gift shares that are worth less than when I originally purchased them. It would make more sense to sell the shares to capture the loss and then gift the cash from the sale.
Gifted shares should be held for more than a year before gifting them. If held shorter than a year, the IRS only allows me to deduct the amount originally paid and not the appreciated amount. Maximizing the strategy requires only gifting shares that I’ve held over a year so I can deduct the full, appreciated value.
A couple years ago, I opened a taxable brokerage account at Vanguard and started making regular purchases of securities of an index ETF, VTI. Over time, the shares appreciated about 20%.
Before making my first gift of securities, I first contacted the target charity to find out the best way to transfer the shares to them. They already had a Vanguard account that accepted these in-kind transfers.
Whenever I’m ready to gift shares to the charity of my choice, I hop onto Vanguard’s website and fill out the Letter of Instruction for Gifts of Securities. Gifting the shares was as simple as putting in the charity’s Vanguard account number into the form and specifying which securities should be transferred. Vanguard requires me to physically mail the form to them, and I’ve found that from the date I drop the letter in the mail to when the transaction goes through is usually a couple weeks.
I keep a Google Sheet that tracks the stock purchases I’ve made and I’ve set up the sheet to highlight lots that are (a) older than a year old and (b) how much gain they’ve experienced. When I’m ready to make a contribution, I pick the stocks that have the most appreciation and that I’ve held for at least a year. After I make the gift, I take the cash I would have given and use it to buy more shares of the securities I just gifted. Lather, rinse, repeat.