With rising real estate prices many people find themselves
facing the prospect of high capital gains
taxes when selling property. Most people are familiar
with like-kind exchanges (1031 transactions), a method of selling
real property and then reinvesting the sales proceeds into a new
property of "like-kind," such as selling a rental
property and then reinvesting in other real estate investment
property. However, not everyone wishes to reinvest.
Moreover, there might be other motivations for selling, such
as receiving a stream of income or giving to
charity. As such, charitable remainder trusts are a
useful alternative to like-kind exchanges, can achieve a stream of
income and eventually satisfy charitable goals, and be another way
to defer capital gains taxation. Like 1031 transactions,
charitable remainder trusts have specific rules that must be
followed in order to receive the tax benefits, and we will briefly
outline those in this article.
A charitable remainder trust is a type of split interest trust.
What is meant by that is that there are current benefits
(that in this case would go to a noncharitable beneficiary) and a
remainder that would go to a charitable beneficiary. The
noncharitable beneficiary can be anyone that the person setting up
the trust and donating the property (the "settlor")
selects, and can even be the settlor himself or herself. For
example, a husband and wife can both be income beneficiaries.
There are two types of charitable remainder trusts, an annuity and
a unitrust. An annuity trust must be a sum certain between 5%
and 50% of initial asset value, and a unitrust pays out a fixed
percentage between 5% and 50% of current asset value. Thus,
an annuity trust is a fixed percentage payout based on the value of
the property transferred into the trust, and a unitrust payout will
vary in amount based upon the performance of the trust's
investments. The timing of the payout can be monthly or less
frequent such as quarterly or even annually. Unitrusts allow
for additional contributions. Note that there are some
variations on these, so it's important to discuss with your
attorney and accountant regarding the possible choices.
There are income, gift and estate tax deductions for the remainder
interests that are transferred to charity, and that is one of the
attractions of using this tax planning device.
The income earned within a charitable remainder trust is exempt
from current income taxes. Thus allowing for tax-free growth,
which is particularly important for unitrusts, since the amount
given to noncharitable beneficiaries could be larger as the
investments within the trust are allowed to grow.
The charitable remainder trust can give the noncharitable
beneficiary payments for life or for a term of years, and can be on
joint lives of a husband and wife (in some instances children may
qualify as income beneficiaries). Upon the death of the
noncharitable beneficiary (i.e., the beneficiary receiving the
trust income) or upon the expiration of the term of years, the
remainder goes to the specified charity. Moreover, the person
establishing the trust may reserve the right to change the
charitable beneficiary from time to time.
Each distribution from the trust will be subject to taxation (which
can vary based upon the nature of the income, which is another
issue to be sure to discuss with advisors), which will generally be
capital gains. So it will eventually be taxed, but again the
charitable remainder trust will not be subject to income tax,
allowing for tax-free growth. In addition, capital gains tax
rates are at graduated rates, so by spreading out the gain, as
opposed to paying all at once, it may be possible for a taxpayer to
reduce their capital gains rate.
So how does this work for appreciated property? First, a
person ( the "settlor" of the trust) donates appreciated
property that has been held for more than one year (for long term
capital gains treatment) to the charitable remainder trust.
There is no immediate taxable gain on the property.
Generally, the trustee of the charitable remainder trust will
sell the property, with no immediate tax consequences to the
settlor (since there is only tax on each separate monthly
distribution to the noncharitable beneficiary). However, and
importantly, there cannot be a preexisting agreement to sell the
property, so the property must first be transferred and then the
trustee of the charitable remainder trust must be the person to
enter into any contracts to sell the property and must be the one
to sell the property.
The charitable tax deduction amount is valued using tables and a
rate issued by the IRS, and typically practitioners use specialized
software to calculate. There are limitations on the amounts
that can be deducted each year, and there is a five year
carryforward. As such, the exact deduction amount and how
much can be deducted each year is a good conversation to have with
your professionals.
Again, the benefits of a charitable remainder trust are as
follows:
- No immediate capital gains tax.
- Benefit to a charity or charities.
- Charitable tax deduction.
- The settlor can be the trustee.
- Since the charitable remainder trust is tax free, allows for investment of full amount of the gain on the property.
- May allow for lower capital gains if the beneficiaries' taxable income is under $400,000.
- Asset protection (except for the distributed income amounts).
- Reduce estate taxes, if applicable.
- Can replace remainder with life insurance (and if estate taxes are a concern can use an irrevocable life insurance trust to avoid such taxes). Life insurance premiums can be paid from the annuity/unitrust amounts.
There are other technical requirements for charitable remainder trusts outside the scope of this article. Our estate planning team at Stites & Harbison is happy to help answer any questions that you might have in determining both the appropriateness and the use of this often underutilized tax planning technique.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.