How to Set Up a Charitable Trust – Rules & Strategy to Save Taxes
By James Cunningham Jr., Esq.
When is a great investment not such a great investment? When you go to sell it and find yourself owing taxes that wipe out far too much of your gains.
You bought a four-plex in 1990 as a real estate investment for a half-million dollars. You’ve been renting it out, but you’ve long since tired of fixing leaky faucets and clogged toilets and dealing with tenants who don’t pay their rent on time.
You property is now worth two million dollars. That’s a 300 percent profit. You should be dancing with joy. But if you sell, you’ll be taxed like a millionaire and have to pay extensive taxes of several kinds, including capital gains tax, that can reduce your profit dramatically. How can you preserve more of the proceeds?
There are any number of strategies to save you money on taxes. I’m going to focus here on charitable trusts and related strategies that can both save you money and assist in Estate Planning. These are strategies that will not just save you taxes, but also defer payment of taxes, which is basically an interest-free loan, and in many cases provide you with an annual income stream while supporting your charity of choice. A proverbial win-win.
Expert Advice Needed on Charitable Trust Strategies
As a taxpayer, you want to pay the legal minimum you are required to and not a penny more.
Most charitable giving is not what I call “mindful.” You contribute to your church, synagogue, or favorite charity annually without a tax-saving and estate-planning strategy in place. Good for you—but it would be better still if you, as well as your charity, could fully benefit from your generosity.
Many if not most people are unaware of the tax advantages of mindful or planned charitable giving. My purpose here is to make you aware of these options for reducing your tax bill, which will lead to more wealth for your loved ones and the causes you care about.
Before I go any further, let me make a disclaimer: what you are about to read in this article is for informational purposes only. It is not meant to constitute legal advice.
This is all the more important as the charitable tax strategies I’m going to be telling you about demand expert advice. These are not DIY strategies you can execute yourself. Charitable trust rules are complex enough to require trained input. Only a professional really knows how to set up and baby-sit—also known as administer—a charitable trust.
Charitable Giving Strategies
Savvy charitable strategies can pay you a lifetime income and benefit both your favorite charity and your heirs. We’ll be looking at seven of these strategies, but of course, there are more:
- Charitable Remainder Unitrust (CRUT)
- Charitable Lead Annuity Trust (CLAT)
- Charitable Remainder Annuity Trust (CRAT)
- Gift of IRA Required Minimum Distribution (RMD)
- Gift annuity
- Gift of stock
- Donor-Advised Fund
Each strategy has its own pros and cons, and only an expert can tell you which will be the right fit for your situation.
Your Tax Liability on an Appreciated Real Estate Asset
Let’s return to our charitable trust example: the four-plex you bought thirty-plus years ago as a rental property. You paid $500,000 and it’s now worth $2,000,000. If you sold it outright, you might be responsible for the following amounts in taxes:
- Federal Capital Gains Tax of up to 20% on your $1.5M gain: $300,000
- Federal Recapture of Depreciation Tax of up to 25%: $100,000
- Federal Net Investment Income Tax (NIIT) of 3.8 %: $57,000
- California State Income Tax of up to 13.8%: $252,700
Aside from your federal income tax burden, this adds up to an effective or total tax liability of $709,700, leaving a net of just $1,290,300. Take out the original $500K investment, and you’re down to a profit of only $790,000. Please note that, for illustrative purposes, we’re looking at the maximum rates that would be applied to a high-net-worth individual or couple.
Many clients mistakenly believe that only a capital gains tax will be levied when an income property is sold. But this misapprehension doesn’t take into account all the other taxes involved. These tax rates are all “bracketed,” which means the greater the profit, the higher the tax rate becomes.
Some of these tax categories may require explanation.
Federal Capital Gains Tax: This is the tax on your capital gain or profit from the sale of investment assets such as stock, bonds, cryptocurrency, and real property. The cost basis—the amount you originally paid for the property or other asset—is deducted from the amount of the sale. The remainder is your profit, which is subject to federal capital gains tax of up to 20 percent.
Federal Recapture of Depreciation Tax: If you buy an income-producing property, the tax code provides a depreciation allowance for 27 ½ years for residential rental property and 39 years for commercial and industrial property. This gives you a tax break every year you own the property, based on the assumption that the property declines in value from usage and wear-and-tear each year. In our example, you’ve owned the four-plex, with a 27 ½-year depreciation schedule, for over thirty years, so it’s fully depreciated.
When you sell an income-producing property at a profit, that depreciation is recaptured. Recapture of depreciation is based on the portion of your gain attributable to the accumulated depreciation you took on the property during your years of ownership. Depreciation recapture is generally taxed as ordinary income, up to a maximum rate of 25%.
Federal Net Investment Income Tax (NIIT): Under Internal Revenue Code Section 1411, this is a tax on income from investments, including rental income and the sale of rental property, payable at the rate of 3.8% if your income exceeds $200,000 if filing single or $250,000 if filing jointly as married.
California State Income Tax: This assumes that you live in California—or that you don’t live in California but are selling a property located in the state. Your profit on the sale is not subject to a special and lower state capital gains tax but is taxable as ordinary income. The maximum income tax rate is 13.3%!
Look Before Leaping – and Watch Out for “Step Transactions”
Before looking at each of our seven charitable strategies, I want to reiterate a vital point: Consult an expert before you sell. Many planning options are available only if you seek such advice before making any move to sell your property, including listing it for sale or signing a legal document such as a letter of intent or real estate purchase agreement.
The reason is the IRS’s “step transaction doctrine.” This simply means that a court can mash-up separate, individual transactions into a single transaction if the sole purpose is tax avoidance. Rarely is this a good outcome for the taxpayer and often leads to sub-optimal results. Translation: more taxes. If you put your property on the market, its sale is implied. If you haven’t properly established a charitable trust before putting your property on the market, it’s likely too late to effectively utilize the strategies we are covering here.
The time to get in touch with qualified legal and accounting professionals is when you first think you might want to sell your property. Contact your lawyer for tax-planning strategies and also your CPA to quantify your probable tax liabilities.
Let’s say you and your spouse are now seventy years old. You create a charitable trust and transfer your property into the trust. You sell the property for two million dollars. But there’s no $700,000 tax bill due the year of sale. Now, you really can jump for joy!
Let’s look at our six options. The first two are charitable or charity trusts.
Charitable Remainder Unitrust (CRUT)
CRUT is hardly the most inviting acronym around, but a charitable remainder unitrust is a very attractive option for many in your position.
How does a charitable trust work? As we begin digging into the various types of charitable trusts, you should know that these are not revocable living trusts but irrevocable trusts. There’s no turning back once they’re established. Fair warning.
Also, there are two critical terms to come to grips with when talking about charitable trust funds: “lead” and “remainder.” These refer to when the charity gets its money. In a remainder trust, you get money first and the charity gets the remainder of the money after you die. In a lead trust, the charity gets its money first. A CRUT, as the name indicates, is a Charitable Remainder Uni-Trust. This means you get income for life or for a period of years, and what’s left over goes to charity.
You and your spouse have decided to sell your four-plex. After consulting your attorney and accountant, you decide to establish a Charitable Remainder Unitrust (CRUT) and transfer the deed in the property into the trust. Only then do you put the property on the market.
Betty, a woman in her thirties, buys the property for the listed $2 million. Another win-win: Betty’s excited about the prospect of becoming a real estate investor and creating multigenerational wealth for herself and her children.
That $2 million is paid into the CRUT which is a tax-exempt trust (for now), which gives you and your spouse an annual payout of a minimum of 5 percent, meaning that in the first year you’ll receive $100,000. Not bad.
The assets in the trust are revalued every year. Say that the year after you sell, the trust assets value goes up to $2.2 million. You’ll now receive $110,000 that year. If its value has gone down to $1.8 million, you’ll get $90,000.
Another big advantage of a CRUT is that you’ll receive a federal tax deduction of 30, 60, or even 100 percent of the amounts contributed. You’ll need help from your accountant and attorney to determine the exact amount of the deduction. In this case, you receive a $548,000 tax deduction.
If all of this seems too good to be true, realize that all of this has been in the IRS tax code since 1969! It’s as legal as can be. The basic structure is solid and backed by Federal Law.
When you and your spouse die, the remainder of the funds in the trust go into your designated charity. The downside is that none of this can be inherited by your children or other beneficiaries.
There are several remedies for this. You might, for instance, want to use some or all of the income to buy a substantial life insurance policy on behalf of your kids. In this case, the CRUT is also known as a “Wealth-Replacement Trust.”
Charitable Lead Annuity Trust (CLAT)
You don’t like that the money will be gone, inaccessible to your children, when you pass away? You might want to consider a Charitable Lead Annuity Trust (CLAT).
As the name indicates, this is a “lead” rather than “remainder” trust, where your charity gets payment of funds up front.
You decide to sell your four-plex and consult your lawyer and accountant. They help you set up a CLAT, into which title of your property is transferred.
Again, Betty, eager to start investing in real estate, buys the property for $2 million. That money goes into the CLAT, and the trust pays your charity, say, $100,000 a year for twenty years. At the end of that period, you and your spouse—or your kids or other beneficiaries—receive all the funds that remain in the trust.
Unlike in a CRUT, the property will not be revalued every year. The payments are fixed and remain the same.
However, as in a CRUT, you’ll receive a federal tax deduction of 30, 60, or even 100 percent. In this case, you’d receive a huge $1.9 million deduction, which means you’ll be able to apply a deduction of up to 30 percent of your taxable income, carried forward for a few years if not used in the first year.
Half-and-Half Charitable Trusts
What if you want both an annual payout and money left in the trust for your kids? That doesn’t seem like an unreasonable request and is one that can be accommodated.
How? Set up both a CRUT and a CLAT.
Then transfer half interest in the property into each trust. Your charity will get $50,000 a year and you’ll get $50,000 a year, not to mention a $1.23 million tax deduction. And you kids will receive an inheritance from the CLAT without your having to buy insurance.
Charitable Remainder Annuity Trust (CRAT)
In all Charitable Trusts, the charity must receive at least 10% of the funds put into the trust. That leaves 90% for the rest of us.
A Charitable Remainder Annuity Trust (CRAT), like a CLAT, provides an annuity, but unlike a CLAT, provides that up-front annuity to you. Your charity takes the remainder.
Suppose you transfer that four-plex to a Charitable Remainder Annuity Trust (CRAT) and take out a little under 10% for 10 years. That leaves 10% to charity at the end of ten years and also provides you with an extremely powerful tax deferral strategy.
This is a long-used but little-known alternative to a 1031 exchange, which is a swap of one investment property for another that allows capital gains taxes to be deferred. If the 1031 exchange is ever repealed, you will likely see a lot more CRATs!
Gift of Required Minimum Distribution (RMD)
Let’s look at four other charitable tax strategies that don’t involve the transfer of property or other assets into a trust.
When you reach 72 years old, you are required to take a minimum annual distribution from your IRA(s). (This used to be 70 ½ years old but has recently changed.) However, you can choose to donate that distribution to a charity.
Why would you do that? To reduce your income.
If you are “married, filing jointly,” and your income is greater than $174,000, or, if you are filing singly and your income is greater than $87.000, you are required to pay higher premiums for your Medicare Part B and prescription-drug coverage.
One way to lower your taxable income is to have your IRA custodian donate your RMD to a charity. Be careful: this has to be a direct transfer. It doesn’t work if the money is first transferred to one of your personal accounts and then donated.
If you have a high IRA RMD, this strategy could save you thousands of dollars a year.
You attorney will assist you in properly setting up these direct donations. Large charitable organizations frequently already have a system that facilitates the receipt of these funds. Smaller charities often don’t, and a bit more work is required in these cases.
Charitable Gift Annuity
A Gift Annuity is similar in some ways to a CRUT. It is easier to set up but gives you somewhat less control. Once you make a gift, for example, you’re unable to change the recipient.
When you as a donor make a gift annuity to a charity, you get an income stream annually for life totaling half of the amount. When you die, what remains in the annuity goes to the charity.
The income you get annually is based on actuarial tables. The younger you are, the smaller the percentage of the principal you receive each year. The opposite is also the case: If you set up a gift annuity when you’re eighty years old, for example, you’ll get a distribution of 7.2 percent annually, under current rates. That’s far better than you’ll be able to get with a CD.
As with a CRUT, your children or other beneficiaries get no distribution from the gift annuity when you or you and your spouse pass away.
Gift of Stock to a Charity for Reset of Cost Basis
As an alternative to a charitable gift annuity, you can give a gift of stock to a charity, which has certain advantages. Say you bought $1000 of Amazon stock a while back, which is now worth $11,000. You can donate that $11,000 in stock to your charity and, if you wish, immediately turn around and buy another $11,000 in Amazon stock. The “wash-sale” rules, which mandate a 31-day waiting period before repurchasing a stock, don’t apply in this situation.
The advantage here is that your cost basis in the stock is now $11,000 rather than $1000. By raising your cost basis, you’ll lower your capital gains taxes when you sell the stock.
An efficient, simple way to donate stock, other appreciated assets, or cash to charity is through a donor-advised fund. This is a dedicated fund created for the sole purpose of supporting charity. You establish or, more commonly, employ an already established fund into which assets are transferred. This is irrevocable: the funds or other assets cannot be returned to you.
The assets are donated to the qualified charities you designate on your timetable. These assets can remain in the fund, appreciating or accruing interest, or you can reinvest and grow them further, until you decide to distribute them to the charities of your choice.
As soon as assets are placed in the fund, you’ll receive a tax deduction, as well as avoidance of any capital-gains tax, making this an excellent tax-planning option in high-income years. Cash donations can, in most cases, make you immediately eligible for an income tax deduction of up to 60 percent of your adjusted gross income. A donation of a long-term appreciated asset can make you eligible for a tax deduction equal to its full value, up to 30 percent of your income.
Contact Us Today About Charitable Trusts and Advanced Tax Planning
I’ve discussed seven charitable giving strategies that will not only save you money on taxes but in some cases also provide an income stream, while allowing you to make substantial donations to your favorite charities. Many other options exist, and of course, it’s impossible to go into all the important details in an article of this length: you need to speak with a professional about the best strategies to set up a charitable trust for you and your family. No two cases are the same.
In any case, it’s vital to speak with a professional well before making any move to sell or transfer an asset. Seek out expert advice, first from an attorney, and then from your CPA, financial advisor, and/or realtor.
The team at CunninghamLegal has years of experience assisting clients and charitable foundations in long-term partnerships and trusts that benefit both donors and the charities they care about. We also provide advanced tax planning for high net-worth families.
Request an appointment with one our expert attorneys or call us at +1 866.988.3956.
We look forward to working with you!
James Cunningham Jr., Esq.
At CunninghamLegal, we guide savvy, caring families in the protection and transfer of multi-generational wealth.
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Savvy charitable strategies can pay you a lifetime income and benefit both your favorite charity and your heirs.