Debits & Credits
by Doug Schultz & John Campbel
Q. My parents are 70 years old and own three apartment buildings. They would like to sell one of the buildings and diversify the proceeds into liquid investments. They are also charitably inclined and would like to make a gift of the principal amount to their favorite charities when they die.
Their main concern with this plan is paying income taxes on the sale. Their second concern is the fact that a large portion of their estate will be going to charity, rather than their children.
To achieve their goals and satisfy their concerns, their accountant suggested that they set up a Charitable Remainder Trust and fund a life insurance policy naming their children as the beneficiaries. What is a CRT? How would a life insurance policy make up for the building donated?
A. A CRT is an irrevocable trust created for the purpose of holding assets given to the trust by a donor during the donor’s lifetime or upon the donor’s death. A CRT is designed to pay income to one or more noncharitable trust beneficiaries (usually the donor and the donor’s spouse) for a specified length of time, after which the remainder of the trust’s assets are paid to or held for designated charitable beneficiaries. The percentage of income that must be paid annually to the noncharitable income beneficiary cannot be less than 5% of the value of the trust assets. A CRT may continue for the lifetimes of the persons selected as income beneficiaries. When the last income beneficiary dies or the term of years expires, all assets remaining in the trust must be distributed to the designated charities.
There are three primary types of CRTs. Charitable remainder annuity trusts pay a fixed amount, at least annually, to the income beneficiaries on the basis of the initial value of trust principal contributed to it. Charitable remainder unitrusts pay a fixed percentage, at least annually, to the income beneficiaries, but is valued every year to determine the amount to be distributed. Finally, charitable remainder unitrusts with net income makeup provisions pay income just like a CRUT, but it allows the income beneficiary to defer current payments to be paid later out of the trust’s income.
Let’s look at a typical situation in which a CRT is used. Mr. and Mrs. Landlord own a six-unit residential rental building. Their adjusted cost basis (net of depreciation taken in prior years) is $100,000. The current value of this building is $1,600,000. Every year, they collect $90,000 in rent (net of expenses). There is no mortgage on this property. Their total estate is large enough for this building to be taxable at a 45% marginal tax rate for estate tax purposes. If sold, it will be taxable at a combined federal and California income tax rate of approximately 25%. Accordingly, if they sell the building they will have a capital gain of $1,500,000 ($1,600,000 sales price minus the $100,000 basis). They will pay tax of $375,000 ($1,500,000 long-term capital gain subject to 25% combined tax rate). It will leave them with $1,225,000 in after-tax money that they can invest at a 7% return, which will give them $85,750 of annual income.
Instead of selling the property, the Landlords can create a CRT and donate their real estate to it. The CRT then sells the building. Since a CRT is charitable in nature, it pays no capital gain tax upon the sale. Accordingly, the trust now has $1,600,000 to invest. At a 7% return, the trust will be earning $112,000 of annual income. The Landlords can write into the trust that they want a 7% annual income from the trust. Thus, they will then be receiving taxable distributions of $112,000 per year. This income will continue to be paid to the Landlords for the duration of their lives. The taxes on these distributions can be as low as the capital gain rates (combined 25%) that were deferred inside of the CRT, thus spreading any gains they realize over their lifetime. Upon the death of both Mr. and Mrs. Landlord, the balance of the funds in the CRT will be paid to the designated charity.
When the trust is created and the real estate is contributed to it, the Landlords are also making a charitable donation of a portion of the value of the real estate. The value of the charitable deduction that the Landlords receive is calculated as the fair market value of the building, less the present value of the future stream of income going to them. The present value of their future income is based on their life expectancies as determined by actuarial tables. In this case, they receive a charitable deduction of $404,356, which will save income tax of approximately $161,742. There are limits on how much can be deducted in a single year as a charitable contribution. The Landlords have up to five years to enjoy the benefit of their charitable deduction. Since the money is now in an irrevocable trust, the $1,600,000 is no longer included in the Landlords’ estate for estate tax purposes, thus saving $720,000 ($1,600,000 times the 45% marginal estate tax rate).
In summary, instead of paying $375,000 in capital gain taxes for the sale of the property, the Landlords will receive a $161,742 income tax benefit for contributing this property to their CRT. Every year, the Landlords will collect $112,000 of income instead of the $85,750 they would have received if they had sold the property (as described above). The principal will also not be subject to estate tax, thus saving $720,000 for their heirs, and providing their favorite charity with $1,600,000 of cash, to be donated when the Landlords die.
Since donating the appreciated asset would reduce the size of the Landlords estate, a life insurance policy can be utilized to make up for the assets that would have been left to their children had they not donated the building. If they opt to use the tax savings they received by donating the building and/or use the increase in annual income they are now receiving, they could purchase a sizable life insurance policy, naming their children as the beneficiaries. With proper estate tax planning, this life insurance policy would not be included as part of their estate, thus protecting the considerable estate-tax savings achieved from the original contribution to the CRT.
In conclusion, please don’t forget that use of a CRT and/or life insurance policy should be included in overall estate and financial planning strategies to ensure the most beneficial results for you and your family. You should contact your CPA and estate planning attorney in order to figure out the best solution for your estate and income tax planning.
The opinions expressed in this article are those of the authors and do not necessarily reflect the viewpoint of SFAA or SF Apartment Magazine. Doug Schultz is a certified public accountant and partner in the tax practice at Burr, Pilger & Mayer. John Campbell is a tax manager in the tax practice at Burr, Pilger & Mayer, LLP. Copyright © 2007 by SF Apartment Magazine. All rights reserved.