S.E.C. Real Estate Observer

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Many property owners face the problem of disposing of property that has appreciated so much in value that a sale would result in a huge tax liability. Even if the real estate is returning only a small return on their equity, they are still unwilling to sell because of the large tax bill. The most common answer for that situation is a tax deferred exchange under Code Section 1031.

However, for those owners who would like to totally divest themselves of all of their investment real estate, even if the replacement property might be better suited to their current needs, a Section 1031 exchange does not provide a solution. For those owners who would like to convert the real estate into a lifetime of management-free, steady income, often at a higher level of income than provided by the real property, without paying a tax on the capital gain, there is only one solution – the Charitable Remainder Trust (CRT).

Here’s how the CRT works. The CRT is a separate, income-tax-exempt, legal entity and is controlled by a trustee. In most cases, if desired, the donor can name himself as trustee and control and manage the assets of the trust. During the lifetime of the donor, the trust distributes earnings from trust assets to the donor according to the terms individually designed for that particular trust. Eventually, a qualified charity receives the balance of the trust upon the death of the last remaining donor. Unless you grant it authority, the charity has absolutely no control over the trust during the lifetime of the donor. In fact, in many trust arrangements, it is possible for the donor to re-designate the charity at any time, and/or name multiple charities. These features provide a great deal of flexibility in the trust.

The donor can gift an appreciated asset into a CRT and, because of the charitable donation, instead of paying taxes on the gain in the asset the donor receives a tax deduction to be used against his other income. The amount of tax deduction is based on an IRS-defined calculation that takes into account the fact that the gift will not actually benefit the charity until the death of the donors. Therefore, the age of donor is an important factor in determining the amount of the charitable tax deduction. The older the donor, the higher the tax deduction. Keep in mind; once the gift is made to create the trust, it is irrevocable.

Since the trust is exempt from income taxes, once the asset is in the trust, the asset can be sold – tax-free. Therefore, the entire net proceeds from the sale, without reductions from state and federal taxes, can be put to work to earn an annual income for the donor. While it’s true that the earnings inside the trust are not taxed, the donor’s annual income derived from the trust is taxable income to the donor. The trustee (keep in mind that the donor can be the trustee) manages the assets of the trust to produce the income for the donor. Any type of prudent investment, including debt-free real estate, is permitted in the trust.

Most retired people would rather have a professional investment counselor act as trustee and manage the assets, under the supervision of the donor. In those cases, the trustee will most likely invest in stocks, bonds, and other securities. Therefore, most of the time the real estate contributed to the trust will be sold. In a weak real estate market, the tax-free aspect of the trust means that the trust can be very competitive with respect to pricing the real estate. In a tax-exempt trust, a sale of the real estate priced slightly below market will still net more cash than a similar sale by an individual who did not have the tax-exempt status.

For married couples with estates in excess of the lifetime exclusion (the amount varies from year to year), the estate tax takes a large share of the excess over that threshold level. Since the gift to the CRT is irrevocable, once the gift is made, the asset is no longer a part of the donor’s estate. Therefore, for those who have larger estates, the CRT eliminates the heavy estate tax that would otherwise be imposed on the asset at death. Thus, the CRT not only eliminates the capital gains tax on any sale, but it also eliminates the estate tax at death.

To answer the concerns of those who wish to pass their estate on to their heirs, a Wealth Replacement Trust can be created to hold life insurance policies on the donors to provide cash to the heirs. Often the tax savings derived from the charitable donation and increased earnings from the trust are sufficient to pay for the life insurance policy. Properly structured, the insurance proceeds will not be a part of the donor’s estate and will flow, tax-free, to the heirs.

The use of this valuable tool needs careful and thoughtful planning and the assistance of experienced professionals from several disciplines.