In our last article we spoke about charitable trusts. (Click here to find our article on Charitable Trust Basics.) These trusts can be invaluable for those with philanthropic intent. In that article we also mentioned a specific type of charitable trust that splits the property put into the trust into two interests: an income interest that is paid to a beneficiary for a set time period, and a remainder interest that goes to a beneficiary after the income interest time period is complete. In this article we will look at one category of split interest charitable trust, the Charitable Remainder Trust (CRT). A CRT is an irrevocable trust that provides an income stream to you (and/or other beneficiaries of your choice) for a term of years, normally for your life, and then gives the remaining assets in the trust to your chosen charity. For the right client, a Charitable Remainder Trust can maximize how much you can give to the charity of your choice while lowering your tax burden.
Who is a Charitable Remainder Trust Most Effective For?
A CRT is most effective for a person who owns a highly appreciated asset and who has charitable intent. The reason why a CRT is most valuable for this type of person is because of the tax advantages of this type of trust. A CRT is exempt from capital gains and income tax. Typically, the person will take the highly appreciated asset, use it to fund the trust, and then the trustee will sell the asset. By selling the highly appreciated asset inside the trust, you are able to diversify your holdings without incurring any of the capital gains tax that you would have paid selling it outside of the CRT. Because the IRS does not take out capital gains taxes, the total value of the trust remains high. The higher value of the assets in the trust allows for a higher income stream. For example: you have an asset worth $1,000,000 with a basis of $0, if you sold outside of the trust, with a capital gains rate of 23.8% (20% top capital gains rate +3.8% tax on investment income) then you would pay $238,000 in tax, meaning you would have $762,000 remaining to reinvest. If you could reinvest this money and get a 10% return, then you would receive an income stream of $76,200 a year. On the other hand, if you sold inside the trust, and didn’t pay the capital gains, assuming you could reinvest the $1,000,000 at a 10% return, your income stream would be $100,000 per year. If you are a person who plans on living off of the income made by your assets, without touching the principle, this technique can greatly improves your yearly income. The IRS still requires you to pay income tax on the percentage of the amount the trust distributes to you; if the IRS would assess tax the income would be taxable if you made the income outside of the trust. For example, if the trust makes $500 from taxable dividends and $500 from tax free municipal bonds, and then distributes $1,000 to you, you would then have to pay tax on the $500 in taxable dividends.
Tax Benefits of a Charitable Remainder Trust
Apart from the ability to diversify your holdings without paying capital gains, there are other tax advantages that a CRT provides to those settlors with charitable intent. The primary tax advantage is that the donor receives an income tax deduction in the year they contribute the asset to the trust. The amount of the deduction is the calculated value of the remainder interest. Charitable income tax deductions are limited to 20-50% of adjusted gross income, depending on the type of gift, so it is a good idea to set up a CRT in a year where you have unusually high income. An example of a good year to set up a CRT is a year when you convert a Traditional IRA to a Roth IRA. The advantage of the CRT is that you can get the income tax deduction now (be it a discounted value) while still enjoying the income stream from the asset for life. As an added bonus, the CRT allows you to sell a high basis asset that may be underperforming in order to reinvest those funds in a more diversified portfolio that will hopefully increase your yearly income going forward.
In the year the donor transfers the property to the trust, the donor also receives a federal gift tax charitable deduction in the amount of the remainder interest in the property.
While technically there is an inclusion and offsetting deduction, in practice, by putting assets into a CRT, you are able to enjoy the income from the assets for your life, and then have the IRS not include those assets in your estate at your death, reducing your eventual estate tax bill.
Charitable remainder trusts are a valuable tool for those in the situation to use them. They can increase yearly income, decrease your income tax, gift tax and estate tax all while helping your favorite charity. There are a variety of different types of CRT and as many strategies to use them. In future articles we will go through some of the more popular types and strategies for Charitable Remainder Trusts.
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