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Portfolio construction

Tax strategy: Donate appreciated stock

May 06, 2024 - 7 min read

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

Source: Natixis Investment Managers Solutions


The Direct Indexing advantage

Investors using Direct Indexing strategies are accustomed to the tax efficiency of separately managed accounts (SMAs) where they own individual stocks and with different tax lots. These tax lots – a record of the security and number of shares purchased on a specific date – allow portfolio managers to opportunistically identify specific shares to tax loss harvest throughout the year and bank losses to be used against future gains.

The cash raised from selling the “losers” is used to create new basis in a different position. As equity markets typically go up, this has the effect of creating a portfolio of long-term winners with embedded unrealized gains. These long-term winners are ripe for being donated. And if the client can add cash back into the account to replenish the donated security, they can keep the direct indexing tax loss harvesting engine running longer.

Performing due diligence on charitable organizations is beyond the scope of this article. But suffice it to say: make sure the organization is a registered charity so that you can get the tax write-off. Organizations like Charity Navigator, GuideStar and Charity Watch provide resources to determine how effective the organization is in extracting value from each dollar donated, i.e., more goes to the intended purpose and less goes to overhead or fundraising costs. And if you want to get further into the weeds, the IRS makes Form 990 available for inspection – that’s the tax return that charities must file.


Caveat: For itemizers only

The Tax Cuts and Jobs Act of 2017 limited the number of taxpayers benefiting from the ability to donate appreciated shares by raising the standard deduction. The Tax Foundation estimates that raising the standard deduction removed 46 million itemizers. To be able to deduct a charitable contribution on Schedule A, you need to be itemizing deductions. In 2024, that means total itemized deductions must exceed the standard deduction of $29,200 for married couples filing jointly. However, if a taxpayer can’t meet that threshold in a particular year, they can cluster donations in one tax year to meet it. For example, instead of donating $5,000 per year and not exceeding the standard deduction threshold, they can donate $15,000 in year one and nothing in years two and three.

Another detail to consider is that long-term capital gain property deductions, like marketable securities, are limited to 30% of Adjusted Gross Income. So, if a taxpayer’s AGI is $400,000 they can only deduct $120,000 in charitable contributions of property. However, if charitable contributions exceed the 30% limit for the year, the excess contributions can be carried forward and deducted over the next five years.

Donating appreciated long-term stock can be very beneficial to both taxpayers and the charitable organization receiving the shares. We like to say that tax loss harvesting isn’t just an end-of-year activity – and the same holds true for charitable donations. Consider donating stock throughout the year when gains exist and keep good records for when tax time rolls around.

Natixis Investment Managers | Solutions

Natixis Investment Managers Solutions provides design, development and execution of portfolio strategies tailored to clients’ specific investment objectives and unique portfolio constraints.

CFA® and Chartered Financial Analyst® are registered trademarks owned by the CFA Institute.

This material is provided for informational purposes only and should not be construed as investment advice. Investors should not make choices solely on the content contained herein, nor should they rely on this information to apply to their specific situation or any specific investments under consideration. This is not a solicitation to buy or sell any specific security.

Although Natixis Investment Managers Solutions believes the information provided in this material to be reliable, it does not guarantee the accuracy, adequacy, or completeness of such information.