Tax strategy: Donate appreciated stock

In March of every year, I have a ritual of digging through my center console looking for donation slips from Goodwill. There’s a donation center about a mile away from our house so every few months I stop by to drop off kids’ clothes as we make room for the next size up, grab a donation slip, and stuff it in the console. Those little pieces of paper are valuable during tax time as the IRS lets taxpayers deduct charitable contributions.

While some charitable organizations, like Goodwill, take donations in-kind, most prefer cash donations. They’re also happy to accept marketable securities which can offer a bigger tax break to donors when appreciated securities are donated in lieu of cash. Taxpayers can avoid paying the capital gains tax on the security donated and also deduct its current market value instead of what they paid for it.

The Devil’s in the donation details

The most important thing to know about this rule, and this may be news to some, is that this only applies to securities held for over a year. If you bought a stock last week, it doubles, and you wanted to donate it, you’ll only get to deduct your cost basis (although the charity will get the full market value). Since the short-term capital gain rate is higher than the long-term rate, being able to donate short-term winners would be a better deal for the taxpayer, but the IRS isn’t that generous.

The example in Table 1 shows what a $10,000 donation would look like under three different scenarios. Starting from the left is the simple cash donation. Assuming the taxpayer is in the top 37% tax bracket, they’ll get to itemize a $3,700 charitable contribution deduction on Schedule A. If instead, they sold $10,000 in stock and donated the proceeds, they’d still get the $3,700 deduction but would have a tax bill of $1,190, paying 23.8% in long-term capital gains tax on the $5,000 appreciated value (assuming stock doubled).

The ideal tax-efficient scenario is illustrated in the righthand column. Donate $10,000 worth of shares, avoid paying $1,190 in long-term capital gains tax and get the $3,700 deduction. When the charity receives the shares, they’ll liquidate immediately and use the cash for operations or invest according to their own endowment asset allocation, avoiding gains tax as a tax-exempt entity.

Table 1 – $10,000 donation: Three scenarios

Source: Natixis Investment Managers Solutions. For illustrative purpose only. Assumes the stock has a cost basis of $5,000 and would otherwise receive long-term gains treatment. Assumes 37% income tax rate and that the $10,000 charitable contribution reduces income by the same amount. Assumes 23.8% (20% capital gains tax + 3.8% net investment income tax) paid on $5,000 capital gain.

Choosing the best shares to donate

If an investor wants to donate securities, which shares should they donate? If the funding source is an S&P 500^® Direct Indexing account, the taxpayer will have about 150 stocks to select from and multiple tax lots in each.

The most tax-efficient way is to sort the tax lots (i.e. not just the aggregate stock) by unrealized long-term capital gains. And then determine how many shares are required to meet the charitable funding goal. In Table 2, we assume a $15,000 donation is desired. If we just looked for the stock with the largest unrealized gain by percentage, we’d select O’Reilly Automotive with an 89% unrealized gain as the most beneficial stock to donate.

Table 2 – Portfolio stocks with highest unrealized gains

Source: Natixis Investment Managers Solutions

But we need to focus on the tax lots instead. When you peel back the onion one more layer, you see in Table 3 that there are actually 56 shares of Adobe that have a larger embedded gain, even though Adobe, in aggregate, wasn’t in the top 5 based on percentage unrealized gains.

Table 3 – Portfolio tax lots with highest unrealized gains

Source: Natixis Investment Managers Solutions

For a $15,000 donation, about half the Adobe shares from the June 10, 2013 lot will do the trick. Specifically identifying these shares with the custodian and directing that they be transferred to the charity will provide the maximum tax benefit by avoiding the realization of nearly $13,000 in taxable income.

Evaluating other choices

If the investor isn’t too concerned about optimal tax efficiency, however, they might just look at the tax lots with a market value near $15,000 as shown in Table 4. In that case, they’d exclude Apple because it doesn’t have a gain. The Microsoft shares from April 20, 2023 also aren’t a good option, because those gains are still shorter-term in nature. Donating all of those shares would only provide the taxpayer with a deduction equal to the cost basis of $11,729 instead of the full $17,288 market value. Of the remaining options, the 245 Mondelez shares purchased October 30, 2008 would be the best choice, with a 74% unrealized gain. Again, not optimal, but maybe a little easier administratively.

Table 4 – Portfolio tax lots with market value in the $15,000 range