The Overlooked Triple Tax-Saving Estate Planning Tactic

Estate Planning advisors agree that one of the most underused estate planning strategies is the charitable remainder trust (CRT). That might change. New trends are making CRTs more attractive for estate planning. Taxpayers with appreciated property should take a fresh look at CRTs as part of their retirement and estate planning strategies.

In a CRT, an individual transfers appreciated property to the trust. The first advantage is that the individual owes no taxes on the property’s appreciation, since the property was contributed to a charitable trust and not sold. The second advantage is that the individual gets a charitable contribution deduction based on the current fair market value of the property. We’ll soon get into some specifics about the amount of the deduction.

Most types of appreciated property can be donated profitably to a CRT, but real estate is an especially good choice to donate. Real estate has been in a bull market for a few years, and many analysts believe at least some properties are fairly valued or over-valued. This might be a good time to diversify by shifting the real estate into financial assets. A CRT is a way to do that without paying taxes on the appreciation.

Business or investment real estate has an extra benefit. If the property is sold, prior depreciation deductions must be “recaptured” as ordinary income. The 15% tax rate for long-term gains applies only to the amount of gain that exceeds the depreciation recapture. When the depreciated real estate is donated to a CRT, depreciation does not have to be recaptured.

Once the property is in the CRT, the trustee manages it. Usually the trustee sells the property and invests the proceeds in a diversified portfolio. Again, since this is a charitable trust, there are no gains due on the sale of the property, so the full value can be invested.

The trustee makes annual or more frequent payments to the donor. The amount and duration of the payments are determined by the trust agreement, and the donor wrote the trust agreement. A typical CRT pays a percentage of the trust’s value each year for the rest of the donor’s life (or for the joint life of the donor and his or her spouse). If the trust’s value rises, the payments rise. If the trust’s value declines, the payments will be reduced. This is known as a unitrust. Another option is an annuity trust, which pays the same amount to the donor each year, regardless of the trust’s value.

The tax law gives the donor a fair amount of flexibility in setting the payment schedule. Payments can be for a term of years instead of for life. In that case, if the donor dies before the term is up, a beneficiary named by the donor gets the remaining payments. The donor also can name someone else to receive all the payments, such as children or grandchildren.

The IRS limits the distributions to ensure that the charity is projected to receive some minimum remainder amount. Most long-term CRT unitrusts pay out 3% to 5% of the value each year. The distributions are taxed to the donor, usually as ordinary income.

After the payments end, the charity or charities named by the donor get the remaining value of the trust.

The amount of the tax deduction for the contribution is the present value of the property’s current value the charity is estimated to receive. IRS tables determine the exact amount of the deduction. Key factors are current interest rates and the expected length of the payments. The lower interest rates are, the lower the tax deduction. Also, the longer the expected payout period is, the lower the tax deduction will be. If you expect interest rates to rise, you might want to delay setting up the CRT until rates are higher.

You might not be able to take the entire charitable contribution deduction in one year. That’s because the amount you can deduct in one year is limited to no more than 50% of adjusted gross income. The limit might be lower, depending on the type of property donated and the type of charity that will receive the property. Unused deductions can be carried forward for up to five years.

The IRS will not allow the tax benefits of a CRT when mortgaged property is donated. That’s because the donor would effectively get to use tax-free income to pay off the mortgage. If the mortgage isn’t too big, some larger charities are willing to pay the mortgage to get named as beneficiary of the trust.

Another option with mortgaged property is to first transfer the property to a partnership. The partnership becomes liable for the debt (if the lender agrees). Then, donate the partnership interests to the trust.

You can serve as trustee or select another trustee. Another trend that is making the CRT more desirable is that some charities will offer their own investment professionals to manage the investments. In a well-run charity, this could generate higher, steadier income for you and a higher eventual gift for the charity. Your trust could have access to investments that otherwise would be unavailable, such as hedge funds and private equity. University endowments are in the forefront of this estate planning strategy.

One potential disadvantage of the CRT is that in most cases it leaves nothing for the children and grandchildren. If the donor has other assets available, that is no problem. If no other assets are available, a “wealth replacement trust” could be used. This is simply an irrevocable insurance trust. The donor uses some of the tax savings or annual CRT payments to fund the insurance trust. The trustee buys a life insurance policy that is payable to the trust. The eventual proceeds are distributed to the heirs. Another option is to make gifts directly to the children, who buy and own the insurance policy themselves.

Before deciding on a CRT, consider other options for your appreciated property.

The 2003 tax law reduced the capital gains tax rate to 15%. If there is no depreciation recapture, the potential donor might prefer to sell the property, pay the 15% tax, and invest the after-tax proceeds. The tax deduction is lost, but control over the proceeds is kept. In addition, in the November 2003 issue I pointed out that sometimes a charitable gift annuity will generate higher benefits than a CRT. Generally, the older the donor is the more sense a charitable gift annuity makes instead of a CRT. That article is available in the Estate Watch section of the web site Archive. An estate planning advisor should compare projections of the different options for you.

Another trend that makes CRTs (and charitable annuities) more attractive is that charities are becoming more sophisticated and more willing to help potential donors. Most sizeable charities have a legal staff or contract with lawyers who can do most of the document preparation and implementation, and ensure that the IRS’s requirements are met. This help reduces the cost to the donor. Charities also are more willing to act as a trustee or contract with trust companies to serve and handle the administrative work.

Charities are getting more flexible about the types of properties they will accept. It used to be a struggle to get a charity to accept many types of real estate and anything not publicly traded. Now a charity is more likely to have staff or firms on contract that can evaluate, manage, and sell real estate and other types of property.

Keep in mind that for the CRT to work, the trust has to be irrevocable. You cannot get the property back. You can, however, retain the power to change the charity.