Bypassing the Capital Gains Tax with Charitable Remainder Trusts02/23/2013 | By: Kenneth Rubinstein, Esq.
If you own assets that have significantly appreciated in value, you may find that your options are limited. Keeping the appreciated asset is not always advisable as it may now be a mature investment earning a low return.
Other investments may be more attractive. Worse yet, the asset's value may have peaked and you fear that continued retention of the asset will wipe away your profits.
On the other hand, selling the asset will subject your profits to the federal capital gains tax (18%) and any applicable state capital gains tax. In addition, any depreciation previously taken on real estate or other tangible assets will have to be recaptured at regular income tax rates. With such a tax bite, you are left between a rock and a hard place.
Is there any way to sell out but avoid the capital gains tax (and the depreciation recapture income tax, if applicable)?
Yes, there is. For many years wealthy individuals have been legally avoiding the tax on sale of appreciated assets and at the same time earning reputations as generous philanthropists. How? By creating Charitable Remainder Trusts.
Charitable Remainder Trusts (CRTs) are recognized and accepted by the I.R.S. By using a CRT, the sale of the appreciated asset will be exempt from all taxes, allowing you to benefit from one hundred percent of the profit.
There is, however, a catch: you do not get to use all of the proceeds from the sale of the asset at once.
Here is how it works: In order to eliminate the tax burden, the appreciated asset is transferred to a CRT. This transfer is not taxable. The CRT is created for a specific term (your life, or yours and your spouse's lives, or 20 years, etc.).
The trustee of the CRT (you can be the trustee) then sells the asset. The CRT is tax-exempt. Therefore, the sale of the asset by the CRT is not taxable and all of the sale proceeds compound and grow within the trust tax free.
You receive a distribution from the CRT, at least annually. That distribution may be as large as you like as long as there is a “reasonable likelihood” that at least ten percent of the original amount that you contributed to the CRT (10% of the fair market value of the appreciated asset) will go to charity at the end of the trust term.
This amount, known as the "charitable remainder," is eclipsed by the tremendous tax savings you may receive from the CRT.
Table 1 illustrates the difference between selling an appreciated asset via a CRT and selling it by yourself subject to capital gains tax. Let's assume you bought real estate for $100,000 and sold it for $1,000,000.
Utilizing the CRT yields $225,000 more for re-investment. Keep in mind, the higher the capital gain the greater the advantage to using a CRT.
There's more. The CRT itself does not pay tax on its income. Funds in the CRT compound tax-free, in the same manner as a qualified pension fund or an IRA. Like an IRA, you pay taxes when you take your money out. But unlike an IRA, you do not necessarily pay regular income taxes when you take your money out of the CRT.
Instead, your taxes are calculated based on how the CRT earned the income; regular income and capital gains are taxed at their respective rates and distributions of trust principal are tax-free.
As trustee of your CRT, you can plan an investment strategy that minimizes the taxes on your yearly withdrawal by investing for growth rather than income and taking out the appreciated amount (at 18% federal capital gains tax plus any applicable state capital gains tax) plus some trust principal (at 0% tax) each year (for a possible average tax of less than 10 %).
Let's assume you established the CRT at age 55 with $1,000,000, as described in Table 1. Let's also assume you kept the money in the CRT for ten years and invested it to earn 7% per year.
In the CRT, that $1,000,000 would compound tax-free. At age 65, you would have $1,967,151 available in the CRT to fund your retirement. On the other hand, without a CRT you would have $775,000 to start, which would not compound tax-free.
You would pay tax on the 7% earned each year. At age 65 you would have $1,292,774 without the CRT — about $675,000 less to fund your retirement. See Table 2.