S.E.C. Real Estate Observer

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Unfortunately, I have seen a great many people instantaneously close their minds and stop listening to anything said when the word “charity” is mentioned. The problem is that a Charitable Remainder Trust (CRT) would be the most ideal strategy for preserving their wealth for a large percentage of these people. When using a CRT strategy, nothing goes to charity until all the asset owners have died and the heirs have received the whole value of the assets tax-free. The fact is, until all owners die, all the benefits of ownership remain with the owner of the assets. A companion Wealth Replacement Trust is used to pass the entire value of the assets on to the heirs in cash tax and probate free. So, lets explore how this all works in the real world.

I have found that it is possible to overcome the emotional barrier to considering this great investment strategy is to ELIMINATE THE USE OF THE WORD “CHARITABLE.” Think of a CRT as a “SELF-DIRECTED TAX-EXEMPT TRUST.” There are some limitations on ownership benefits with this trust as there are with many other forms of asset ownership. This will help to reopen the thought process and clear the vision. Assets are owned to produce benefits such as regular cash flow income, capital wealth accumulation, personal use, pride-of- ownership, emotional security, and financial security for family members after death. The various forms of trusts, partnerships, and corporations are just tools and strategies when one thinks of their assets in terms of BENEFITS. Millions of people own assets in regular “C” corporations. This form of ownership has many benefits but also subjects the owner to double taxation, limitations on tax deductions, and many other negative ownership aspects. Under some circumstances, the “C” corporation is absolutely perfect to achieve certain benefits. The “C” corporation does not fit all circumstances nor do any of the other legal forms under which title can be held. A CRT is no different. It all depends upon the benefits the owner is seeking under their specific circumstances.

Twenty-five years ago, George and Helen took some classes and read some books and became very adept at buying rental houses and two-family rental properties with NOTHING DOWN. Over the years, they have accumulated ownership of 20 such properties. They have renovated, managed, leased, maintained and improved their properties. The lovely, wonderful tenants have paid off virtually all of the mortgages for them and they now have a substantial monthly income from these properties.

George and Helen’s circumstances have changed greatly in 25 years. Their children are all grown, through college and on their own. The grandchildren are spread over several different states. They have depreciated all of their rental properties down to the land value and they have no interest deductions. Virtually all of their rental income is being taxed at ordinary income rates for both Federal and state taxes. They are good managers and do not have a lot of after-hours emergencies. However, they still must be there to MANAGE. They also have to replace roofs, refrigerators, air conditioners, etc. at regular intervals. They must see to cleaning and maintenance between tenants and handle leasing. All the accounting and record keeping has become much more of a chore in the last few years. They are now in their 60’s and have become more interested in getting in the motor home to go see the grandchildren and taking a cruise a couple of time a year with their family and friends. They have not had good experiences with professional property managers when they have tried them. The good news is that they now own approximately $4,500,000 in nearly free and clear income-producing rental property. The bad news is that their basis for tax purposes is only about $300,000. In addition, their income from the property is so great that they are now in the very highest income tax bracket. To add insult to injury, they do not need anything close to the amount of income on which they are paying taxes to live in the style they want. After doing some financial planning, they have discovered that if they were to die, the estate taxes in 2004 would be at 50% of all their assets in excess of $1,500,000. There are strategies using living trusts that can be used to double the amount of the estate tax exemption but they would eventually have to deal with estate taxes when both spouses have passed away. There are a number of estate planning strategies that can be used to eliminate tax problem upon death and a IRS Section 1031 exchange could be used to convert the ownership of 20 small residential rental properties to a larger low or no management income-producing property without the current CAPITAL GAIN taxes. Unfortunately, the 1031 exchange will NOT eliminate the estate tax problem.

This situation is ideal to employ a SELF-DIRECTED TAX-EXEMPT TRUST with a companion WEALTH REPLACEMENT TRUST to pass on the entire value of their assets tax-free and in cash to their children and grandchildren WITHOUT even the problems and costs of probate. The simple approach is to establish the George and Helen tax-exempt trust with George and Helen the directing beneficiaries. The wealth replacement trust is established with their children and grandchildren as the beneficiaries. The titles to the rental properties are transferred from George and Helen to the George and Helen Trust. The trust sells the property tax-exempt and all the proceeds after costs of sale are then reinvested at George and Helen’s direction into their choice of more passive investment. These investments could be no-management net leased properties, mortgages, partnership shares in larger high quality income properties, or any of the traditional types of securities such as stock, bonds, mutual funds, etc. They might choose to spread their reinvestment cash out over several of these investment alternatives to provide income security as long as they live. The income they take out of their trust will be taxable but they do not have to take out more income than they need to live in the lifestyle they choose. If they have income inside of their trust greater than their personal needs, they can simply direct the reinvested inside the trust TAX-EXEMPT.

BIG BENEFIT!!! If they were to sell their property for $4.5 million with a current adjusted basis of $300,000 they would owe Federal capital gains taxes of a minimum of $600,000 allowing for sales costs. If they are subject to depreciation recapture, their tax bill will be larger. If they live in a state that also taxes capital gains, their tax bill will be even greater. By using a self-directed tax-exempt trust, George and Helen will be able to keep and reinvest the $600,000. Even at 5% return, that would provide $30,000 per year ADDITIONAL income for as long as either George or Helen is alive. Since they are only in their 60’s, they will most probably live at least another 20 years. That means they would get all $600,000 to use during their life and then they can pass the $600,000 along with the rest of their assets on to their heirs tax-free in cash.

The Wealth Replacement Trust is the vehicle use to pass on the total value of the assets to the heirs. There are a variety of structures to accomplish this but the most used is method is an Irrevocable Life Insurance Trust. A small amount of the income paid out of the George and Helen Tax-Exempt Trust is used, in compliance with the IRS rules, to purchase a specialized insurance program to fund the life insurance trust. Unless the dollar amount of assets is extremely large (over $10 million) the cost of the life insurance can be structured to have very little impact on the growth of the assets in the tax-exempt trust. There are a variety of methods to deal with a high-dollar asset situation, which I will not go into here. There are two important benefits to using a life insurance trust as proposed. (1) The life insurance trust can be used and structured exactly as one would a will WITHOUT the problems of probating a will. (2) The assets are passed on to the heirs tax-free in cash. 100% of estate taxes are eliminated and one does not have to schedule dying in 2010 to accomplish this objective. The Wealth Replacement Trust can even be indexed for inflation.

Only after George and Helen have passed away is there a gift to charity of whatever assets that are left in the tax-exempt trust. George and Helen get to choose which charities are to receive this residual benefit. They can change their choice at any time while they are alive. They can choose more than one charity as long as it is a qualifying charity, which may include their church. In this case, George and Helen decided to have their tax-exempt trust convert to the George and Helen Family Foundation when they have both passed away. Their family foundation will distribute the income from the assets to the charities of their choice as long as the foundation has any assets. Their children will participate in future decisions concerning which charities are to receive the annual gifts, which can provide many social and prestige benefits to the children and grandchildren for generations.

BONUS BENEFIT!!!! Since there is eventually a gift to the charity or charities of the choice of George and Helen, they will receive a current tax deduction for the present value of that future gift. The amount of the current tax deduction will depend upon the ages of George and Helen, the amount of income they will take out of THEIR trust each year, a government funds rate, etc. There is a formula proscribed by IRS to calculate the deduction. To put it into simple terms, the current tax deduction will range somewhere between 10% and 40% of the value of the assets placed into their tax-exempt trust.

Obviously, any use of tax-exempt trust or any other tax reduction and estate planning strategy needs to be accomplished with the guidance of qualified and experienced tax, legal and financial planning professional. The example presented here is only one relatively simple application of the SELF-DIRECTED TAX-EXEMPT TRUST strategy. In the next issue, we will explore how to use a self-directed tax-exempt trust to accomplish the disposition of a property with multiple owners who have widely divergent financial and lifestyle objectives.