Charitable Remainder Trusts
You can use the Charitable Remainder Trust to provide an income for you, contribute to a charitable cause and preserve an inheritance for your loved ones. Let’s start by listing the benefits of planning with a Charitable Remainder Trust (or CRT) by showing how it can solve problems you may encounter.
Problem: You have a piece of real estate that is producing no income for you. You would like to sell it and reinvest the proceeds to create a regular income, but the real estate has greatly appreciated since you purchased it and you don’t want to be hit with massive capital gains taxes.
Problem: You want to create a legacy by funding a scholarship fund for disadvantaged students in your community, but the piece of real estate is the only asset you can use to fund the scholarship fund. You also wanted to use a part of the real estate to fund your children’s inheritance.
How can you sell the real estate, use the proceeds to invest and provide yourself a stable income, use the proceeds to set up a scholarship fund after your death and provide for your children’s inheritance? The answer is the Charitable Remainder Trust. To show you how this works, let’s look at a fictional example:
In 1995, you and your spouse purchased a piece of vacant commercial real estate for $100,000. Lately, you have received offers of $1,100,000 for the property from a developer who wants to build a shopping center on it. You currently receive no income from the property. To the contrary, you have annualexpenses for property taxes and liability insurance.
If you sell the property to the developer, you will have a capital gain of $1,000,000 (sales price of $1,100,000 less you $100,000 tax basis in the property). At a 15% capital gains rate, you would pay $150,000 in capital gains tax, leaving only $950,000 to reinvest. If you invest it at a 7% annual rate, you will receive $66,500 each year in income which will be taxed at your ordinary income tax rate. When you and your spouse have both passed away, whatever is left of the $950,000 after estate taxes can be divided between your children and the scholarship fund.
Now, let’s insert the Charitable Remainder Trust into the equation. Instead of selling the real estate to the developer, you can create a CRT and donate the real estate to it. The CRT would then sell the real estate to the developer. Since it is a charitable entity, the CRT does not pay the capital gains tax. As a result, the entire $1,100,000 is available to invest.
With a Charitable Remainder Trust, you can specify what percentage return you want to receive (provided the return falls within limits determined by a number of factors, including your age). A higher return to you would reduce the amount ultimately donated to the scholarship fund and conversely a lower return would increase the donation.
Let’s say you choose the 7% rate we used above. You will receive $77,000 in income each year, an increase of $10,500 from the example without the CRT. This amount would be paid to you and your spouse for a long as one of you survives.
It gets even better. In addition to the increased annual income, you will receive a charitable deduction toward your income for a portion of the contribution you made to the CRT. Since part of the contribution you made will come back to you and your spouse as an annual income, you will not receive a deduction for the entire $1,100,000. Your tax advisor would determine the present value of the total income you and your spouse would receive from the CRT based on your life expectancy and subtract that amount from your total contribution to arrive at your charitable deduction. This deduction can be applied against your CRT income, further increasing your after-tax income.
Upon the death of the survivor of you and your spouse, all of the assets then in the CRT will be paid to your designated charity. But that’s not all. Using the tax savings created by the charitable deduction plus a portion of the increase in annual income, you can establish a wealth replacement trust for the purpose of acquiring a second-to-die life insurance policy that will provide a tax-free inheritance for your children. The increased income you receive as a result of the CRT can be used to fund the insurance premiums.
This is a win-win-win situation. You and your spouse win with these benefits:
1. No Capital Gains Tax on the Sale of the Real Estate
2. Charitable Income Tax Deduction
3. Increased Annual Income
4. Eliminate or Reduce Estate Tax
5. Create a Legacy in the Community
Your children or other heirs win with the following benefits:
1. No Reduction in their Inheritance
2. No Probate
3. They Receive their Inheritance in Tax-Free Cash
The community wins because you have made a significant contribution that will make a difference in other people’s lives.
The only non-winner is the IRS. And believe it or not, it endorses the Charitable Remainder Trust wholeheartedly. In fact, the Treasury Regulations instruct you in detail how to set up a CRT. Imagine that!