How Can We Postpone The Capital Gain Tax?

Fred (65) and Ethel (62), are a married couple living in Florida.  Fred owns real estate (Golden Pond) he inherited from his grandmother, which has a current fair market value (FMV) of $3,100,000, but his inherited cost basis is only $100,000.  Recently, interest in this property has spiked, and because of the increasing number of inquiries, Fred is seriously considering selling the property.  Fred knows that if he does no planning his capital gain exposure is approximately $714,000 ($3,000,000 times 23.8%, 20% long term capital gain rate plus 3.8% Net Investment Income Tax (NIIT)).  So Fred has asked the question:  how can we postpone the capital gain tax?

One possible strategy is creating a Charitable Remainder Trust (“CRT”).  There are two types of CRTs, the unitrust and the annuity trust.  The annual income stream can vary based on the market valuation of the trust (a unitrust) or can be sum certain (an annuity trust).  This income stream will be taxable to the beneficiary for the trust term. This discussion will expand on the attributes of the Charitable Remainder UniTrust, (“CRUT”).

How does a CRUT work? And what are the advantages?

A transfer of Golden Pond to an irrevocable CRUT (the trust) will:

a) create a current year charitable deduction for Fred and Ethel’s joint individual return (deduction subject to the amount of their Adjusted Gross Income)[1],

b) create an income stream for a term of years, Fred’s life or both Fred and Ethel’s lives’ if that is their wish (“the beneficiaries”), and

c) pay the remaining corpus at the end of the trust term to a qualified charity that has been preselected by Fred and named in the trust agreement.

The contribution of Golden Pond to the trust does not trigger capital gain recognition.  The gift to the trust is measured at its fair market value.  The charitable gift is the actuarial present value of what the charity might receive at the end of the trust term (there is specialized software to do those calculations). 

The capital gain event will occur when the trust sells Golden Pond. The resulting capital gain is now trapped inside the trust and the capital gain is not reported by Fred. The trust, which does report the gain, pays no capital gains tax, takes the proceeds and invests in income-producing assets.

The transfer of Golden Pond also removes the asset (and all future appreciation) from Fred’s estate and possible estate tax.  Fred would be required to file a gift tax return for the transfer of this asset to the trust.

Every year the trust will distribute income to the beneficiaries

Some of the advantages of a CRUT:

• Allows for the conversion of a non-income producing asset into an income stream without triggering capital gain tax;
• The asset (and all future appreciation) is no longer an element of the estate;
• There is an immediate charitable deduction at the funding of the trust;
• The donor can make future additions to the trust for additional charitable deductions;
• The trust will pay the beneficiaries income for the term of the trust,
• The Settlor(s) will have the satisfaction of benefiting a charitable organization that they care about.

Here’s how one scenario would look:

A) Fred decides on a Unitrust, with an annual payout of 5% per year for both his and Ethel’s lifetime. The trust is created and funded in September 2022.  Fred and Ethel would be entitled to a charitable deduction in 2022 of $ 992,000, which Fred and Ethel can use over 5 years, and assuming a 35% marginal tax bracket, could result in a tax savings of $ 347,000.   Fred and Ethel would receive an income stream for their lifetimes valued at 5% (Assuming the FMV is $3,100,000 a distribution of $155,000) of the trust corpus for each year.

There are very many different scenarios the couple could use to optimize their personal desires.  But this methodology does generate a charitable deduction, avoid immediate capital gain recognition, provide an income stream for one or two lives and benefits a charity at the end.

In conclusion, in an environment of rising interest rates, CRTs should not be overlooked as a tool to defer capital gains, decrease the gross estate, provide income to the beneficiary and support a worthy charitable cause.

[1] Charitable deductions are limited to a fixed percentage of Adjusted Gross Income (AGI), as shown on the Form 1040.  If the CRUT was funded with cash, the Form 1040 charitable deduction would be limited to 60% of AGI.  Funding the trust with appreciated property, the charitable deduction is limited to 30% of AGI.   However, any charitable deduction not used in the year created is carried forward for up to 5 years.