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Steer around the car-donation roadblock

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in Small Business Tax

The IRS just pulled the strings tighter on a tax loophole that it virtually closed last year. The agency issued a ruling that explains the tough new rules limiting deductions for charitable car donations. (IRS Notice 2005-44, Internal Revenue Bulletin 2005-25)

Strategy: Slip through a narrow exception carved out by the new ruling. If you qualify, you can claim a top-of-the-line deduction for a used car, just as you could in the good ol' days. All you need to do is investigate how the charity plans to use your vehicle.

Here's the story: In the past, you could typically deduct the fair market value (FMV) of a vehicle that you donated to charity. But as more taxpayers took overly aggressive valuations for donations of beat-up jalopies, Congress nipped this practice in the bud. In 2004, Congress limited the deduction for donated vehicles to the amount the charity actually receives from reselling the vehicle.

The loophole: If the charity "materially improves" the vehicle or it "significantly uses" the car for its own purposes, you can still deduct the full FMV.

Those new rules affect charitable vehicle donations made after 2004. The crackdown also applies to boats and aircraft donations. The new rules clarify these three key points:

1. Significant use. If the charity uses your donated vehicle to further its regular activities, it's met the "significant use" test. Example: using the car to deliver meals to homeless shelters. The vehicle must be used by the charity for a significant time, say one year.

2. Material improvements. If the charity "materially improves" the vehicle, you can also deduct the FMV. The IRS now says "material" improvements are those that increase its value. Simple cleaning, painting, maintenance or minor repairs aren't enough.

3. Fair market value. If you can still deduct the car's FMV, you can determine the value through an established used-vehicle-pricing guide, such as a Blue Book. But it must list the sales price of a car that is: 1) the same make, model and year; 2) sold in the same area; 3) in the same condition; and 4) with the same or substantially similar warranties and guarantees.

Under the new IRS notice, the regular limit on the donation value doesn't apply if the charity sells the vehicle at a price significantly below FMV, or simply gives it away. To qualify, the charity must be dedicated to relieving the poor or underprivileged that need transportation.

Bottom line: Before you donate a car to charity, investigate how the organization intends to use it. If it meets the special tax exemption described above, secure a commitment from the charity to fulfill the exception. Then go ahead and deduct the FMV based on a used-car-buyer's guide.

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