Case:

Abigail was a wonderful and spirited 80-year-old woman. She worked in her garden, handled all her finances and played golf each weekend. In addition to her busy schedule, she also made time to help at a local 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 the shelter $5,000 each year. However, she wanted to make a more significant gift to the shelter this year.

In January, she decided to establish a $100,000 charitable gift annuity. She liked the fixed payments, the approximate $46,000 tax deduction and the simplicity of the arrangement. Because Abigail funded the CGA with cash, a large portion of each payment was tax-free. What she loved most though was the eventual gift to the shelter.

Sadly, Abigail suffered a heart attack a few weeks later 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. At the time she passed away, Abigail had $100,000 of income (mainly from an IRA distribution in January). Her CPA knew he could deduct the $46,000 charitable tax deduction on Abigail's final tax return. However, he wondered if she was entitled to any other deductions since she passed away prematurely.

In looking for this answer, the CPA contacted the shelter to inquire about the gift annuity. The shelter informed the CPA that Abigail never received a payment since she passed away prior to the first payment.

Question:

Since Abigail died prematurely, is there an additional 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 that lasts until the end of her life expectancy. Because Abigail passed away before the end of her life expectancy (and before the first payment), she did not receive any of her tax-free income that she was entitled. "Unrecovered investment" is the term for this shortfall of tax-free payments. Fortunately, the unrecovered investment may be claimed as a deduction on Abigail's final income tax return. Section 72(b)(3)(A).

With a $100,000 charitable gift annuity and a charitable tax deduction of approximately $46,000, Abigail's total investment in the annuity contract was a little over $54,000. Because Abigail died prior to the first payment, she did not receive any tax-free income. Thus, the portion of the $54,000 total investment that would have been returned to her tax-free remains entirely unrecovered. See Section 72(b)(4).

The CPA was pleased with the additional deduction amount. The tax-free portion of the $54,000 amount is not deducted as a charitable tax deduction, but rather as a “Other Itemized Deduction” deduction. This deduction can be claimed on line 16 of Schedule A of Form 1040. Moreover, it is not subject to the 60% AGI limitation on charitable deductions. So, the CPA can claim an approximately $46,000 charitable tax deduction for funding the CGA and deduct the unpaid tax-free portion of the $54,000 as an Other Itemized Deduction all in the same year. Accordingly, these two deductions can significantly reduce the taxable income on Abigail's final income tax return!