How would you like to be able to sell appreciated real estate without paying a dime in capital gains tax? In fact, you do not have to purchase replacement real estate with the sale proceeds and all of the future gains from your new investment will be tax FREE. (If you think this is an IRA or a qualified retirement plan you are wrong.) Even better, rather than paying any tax you will actually receive an income tax deduction. Does it sound to good to be true? It is too good and it is true. The strategy I am alluding to is a Charitable Remainder Trust, “CRT”. If you have never heard of this tool count yourself among the vast majority of real estate investors whose local professionals only know of 1031 tax deferral strategies for real estate investments. Tax deferral is great, but TAX FREE is sooooo much better.
A CRT is a specific type of trust specifically authorized under federal tax law. Like all trusts, a CRT has four players; the grantor (the person who contributes assets to the trust, a trustee (the person who controls the assets held within the trust), an income beneficiary (the person or persons entitled to the income generated by the trust), and the remainder beneficiary(ies) (the person or in this instance, the charitable organizations entitled to receive the trust assets when the income beneficiary dies or after a set term of years). Alright, if I threw you a curve with the last party to the trust, i.e., the remainder beneficiary being a charity, then it should shed some light on how this type of trust received its name. Unlike a living trust that distributes it assets to family members when you pass away, a CRT must distribute any undistributed assets to one or more charities of your choosing (more on how your kids can benefit from this payout later).
If you are inclined to stop reading now because you are of the opinion that charity starts at home then you are missing out on one of the greatest tax benefits still available under the tax code. Believe me when I write you want the charitable beneficiary. It is the requirement you name a charitable beneficiary that will produce phenomenal tax planning opportunities. Consider the following benefits:
- When you transfer an asset into the trust you will receive an immediate income tax deduction for 10% of the assets value;
- Appreciated assets contributed to the trust can be disposed of tax free;
- All future gains generated inside of the trust are tax free to the trust; and
- All the income generated by these assets when paid out
Consider Robert who is looking to sell a commercial property he has owned for many years. After consulting with his tax preparer Robert was given the following numbers regarding the tax consequences of this sale:
Original Basis $550,000
Taxable LTCG $650,000
Depreciation Recapture $450,000
Tax Liability ($450,000 x 25%) + ($650,000 x 20%) = $242,500
Robert considered a 1031 exchange to avoid taxes but a recent investment opportunity in an oil and gas venture has Robert reconsidering his options. If Robert sells his property and invests in the oil and gas venture he will not be able to take advantage of the favorable 1031 exchange rules because oil and gas is not a like kind investment. However, not excited over the prospect of paying $242,500 in taxes, Robert seeks counsel from an experienced real estate asset protection attorney (hmm let me guess who he called J).
My recommendation to Robert was form a Charitable Remainder Trust. We will establish the trust with Robert as the trustee, he and his wife as the income beneficiaries (they will receive an income stream from the trust for life) and a private foundation as the remainder charitable beneficiary (more on this later). When Robert deeds the property into the trust Robert will immediately receive a $120,000 income tax deduction. Given Robert’s personal income tax bracket of 39.6%, his tax deduction will save him $47,520 in taxes. Further, when the property is later sold Robert will save an additional $242,500 in taxes and have the full $1,200,000 million to reinvest in his oil and gas venture.
Robert was ecstatic and thought his financial situation could not get any better until I informed him we could make his future income from the trust completely tax free. (I think this was when Robert dropped the phone.) If you recall, a CRT is designed to pay you an income stream for life or a period of years. What is so exciting about this trust is you are in control. By control I am not just referring to how the trust assets are invested, but control when the trust begins paying you out income and how that income is taxed upon receipt. Basically, you become Uncle Sam.
As I explained to Robert, when he was ready to begin receiving income we will make some adjustments to his investments so the income generated by the trust is non-taxable. This is the income we will distribute to Robert thus, turning what would have been a taxable event when he sold his real estate and all future gains therefrom into a completely tax free endeavor.
Robert’s final concern was the distribution to the charity when he and his wife pass away. Robert wondered if there was anyway his children might benefit. Funny he should ask because it just so happens Robert’s CRT could morph into a private foundation run by his children. His two children, in exchange for running the foundation, could draw a salary. The only requirement on the children would be they give away 5% of the foundation’s assets annually.
I have just scratched the surface of the various tax and wealth building opportunities easily achievable with this particular trust. If, you would like to learn more about the CRT and how it might produce results similar to Robert, do not hesitate to contact me for a free consultation.