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BYPASSING THE CAPITAL GAINS TAX WITH CHARITABLE REMAINDER TRUSTS

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.

Now, let's assume you need to fund your retirement for twenty years to age 85. Assuming the same 7% constant earnings rate, you would receive approximately 20% of the CRT's annual value as retirement income (total over 20 years: $2,812,485) and still leave $100,000 (10% of your original contribution) to charity. See Table 3.

Remember, if you planned your investment strategy carefully, invested for long-term capital growth and each year withdrew the appreciation plus some trust principal, the average tax rate on CRT distributions may be less than 10%. See Table 4.

On the other hand, without the CRT, assuming the same 7% annual earnings rate and assuming you also draw your available funds down to near zero by age 85, you would receive a total over 20 years of $1,487,380 — $1,325,105 less than from the CRT. Compare Table 4 with Table 5.

It gets even better: Not only do you receive $1,325,105 more via the CRT, you pay $37,156 less in taxes ($236,497 total tax on annual CRT distributions versus $48,653 total tax on annual non-CRT earnings plus $225,000 tax on original sale of the asset).

Your benefits eclipse the $100,000 left to charity thirteen times over. Clearly the CRT wins.

Here's how the numbers work out:

This is not the result of smoke and mirrors; it is merely the magic of tax-free compounding. Since more money is left in the tax-exempt CRT than is left in the taxable non-CRT fund, the CRT grows faster, continuously compounding tax-free.

Furthermore, the assets contributed to the CRT are no longer part of your taxable estate when you pass away. The removal of a $1,000,000 asset from your estate could result in an estate tax savings of $500,000, depending on the total value of your taxable estate at death.

In addition to the immediate capital gains tax savings, the continuous income tax savings and the future estate tax savings, the CRT's charitable contribution requirement provides for an immediate income tax charitable deduction of $12,321, which equals the present value of the future $100,000 gift to charity, even though the charity will not receive the gift for many years.

This additional tax savings could be used for additional investment or for any other purpose.

Finally, you may get anything from a thank you note to a testimonial dinner from the charity, depending on the size of your final gift.

If used properly, a CRT can serve as a private pension plan without the restrictions usually associated with pensions. Pension plans are subject to penalties for early withdrawal, as well as limitations on initial funding.

Pension distributions are taxed at your personal income tax rate no matter how the money was earned by the pension (you lose the benefit of long-term capital gains).

By comparison, a CRT has no age restriction; distributions can be made by a CRT immediately, regardless of age; and taxation on CRT distributions is based on how the money was earned by the CRT, not on your income tax bracket.

A CRT has no limitations or restrictions on the amount of initial funding. Finally, the investor who creates the CRT also gets a tax deduction for the present value of his future charitable gift and a reduction in estate taxes.

Remember, some of the money must ultimately go to a recognized charity — at least 10% of the original amount that funded the CRT. In addition, you must make sure that your annual withdrawals are not so large as to completely deplete the CRT before it expires, leaving nothing to charity.

Charitable Remainder Trusts are complicated plans requiring computer-generated spreadsheets and voluminous legal documents, mostly written in "revenue-eze." They are governed by complicated tax regulations, so they must be planned and prepared by an attorney who practices in this specialized area. It all comes back to the old adage — you have to spend money to make money.

But if you are prepared to spend some, you can make a lot, and more importantly, you can keep almost all of it.