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Charitable Remainder Trusts

April 24, 2013 Douglas Davis

Charitable-Trust1[dropcap4 variation=”red”]I[/dropcap4]t is not often that we have the ability to eliminate capital gains tax on the transfer of an appreciated asset, obtain income for life and the life of our spouse, and receive a charitable deduction against current income tax.  A Charitable Remainder Trust (CRT) is one of those solutions that accomplishes all of those objectives.  As icing on the cake, it also reduces the size of an estate for estate tax purposes and saves the donor and his estate from writing a very large check to the Internal Revenue Service at death.

CRT’s are irrevocable trusts that provide for two sets of beneficiaries. The first set are the income beneficiaries (you and, if married, a spouse).  Income beneficiaries receive a set percentage of income for their lifetime from the trust. The second set of beneficiaries are the charities you name. The charities receive the principal of the trust after the income beneficiaries pass away.  While a CRT is an irrevocable trust, you may change the charitable beneficiaries at any time during your lifetime.

1.  Capital Gains:  Because their assets are destined for a charity, Charitable Remainder Trusts do not pay any capital gains taxes. These taxes can range from 10% to 20% of an asset’s growth in value. For this reason, CRTs are ideal for assets like stocks or property with a low cost basis but high appreciated value.

For instance, suppose you sell one of your rental properties for $1 million. Let’s assume you originally paid $100,000 for the property. Upon completion of the sale, you would owe capital gains taxes on the $900,000 difference. That tax could easily top $150,000 (or more with the new 3.8% investment tax), depending on how long you owned the property and your overall tax situation.

Funding a CRT with highly-appreciated assets (like real estate) allows you to sell those assets without paying any capital gains taxes. Since CRTs have a charitable intent and do not have to pay capital gains, the full value of any assets transfers to the trust (and thus, to your family and favorite charity).

2.  Draw Income:  The amount of income to come out of the CRT during your lifetime depends upon the payout percentage that you choose, and the amount of income your assets generate while inside the CRT. The IRS states that, at a very minimum, the CRT must distribute at least 5% of the net fair market value of its assets. If you don’t need the income one year, you may elect to defer income through a “makeup provision.” However, the CRT’s net distributions must eventually equal 5% to be considered valid by the IRS.

When setting the payout percentage, be forewarned: the higher it is, the lower your charitable income tax deduction. Considering market conditions and the possibility that taking out too much may reduce the principal inside the trust, you really should not receive income of more than 10% each year.  Generally, we recommend 5% or 7%. 

3.  Retirement Planning:  Many clients use Charitable Remainder Trusts to supplement their current retirement plan. By setting a CRT up in your peak earning years, you can make contributions to the CRT in the form of zero coupon bonds, non-dividend paying growth stocks, or professionally-managed variable annuities.

By letting the CRT grow without taking income from it during the early years, the CRT can begin making payouts to you when you retire. These payouts can include makeups for any shortfalls in income you did not receive earlier. Unlike IRAs or 401(k) plans, there are no limits on how much you can contribute. 

4.  Income and Estate Taxes:  For death tax purposes, a CRT is not considered to be an asset of your estate by the IRS.  Because of this, you may end up saving as much as 40 cents of every dollar you move to the CRT. Plus, you are usually not limited in how much you can contribute by the annual gifting limit or the Estate and Gift Tax Credits.

Because the ultimate beneficiary is a charity, by establishing and funding a CRT you also qualify for an income tax deduction. The amount of your deduction is the present value of the remainder interest to the charity. Your current deduction also depends on the type of property you contribute, as well as the type of charity you name as a beneficiary.

Average deductions normally fall in the range of 20-50% against your adjusted gross income. Any deductions not used in the year of contribution may be carried forward for the next five years.  This is a tremendous benefit for individuals who are trying to offset large amounts of annual income with available tax deductions. 

5.  Combining With Other Strategies:  CRTs are designed to give the principal to charities when you and your spouse pass away. This bypasses any children, which could lead your heirs feeling slighted. These feelings of ill-will can be overcome by combining the CRT with another strategy to “make up the difference” that goes to the charity.

For instance, some large estates combine the CRT with Life Insurance Trusts (ILIT’s) to provide a cash distribution upon the death of the insured. The ILIT then either pays out or can subdivide into individual trusts for each your named beneficiaries.  In this scenario, everyone wins. The estate owner receives income streams and tax deductions, the charity gets the principal of the CRT, and the children receive a cash distribution as their inheritance.

If you would like to discuss how a CRT can enhance your estate plan specifically, please call us at 757.420.7722