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.