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Now Is the Time to Use a Charitable Remainder Trust

What to do when client investments have large unrealized capital gains but they need liquidity now?

As the stock market falls and inflation rises, some people need more cash now to meet rising costs. They often have a quandary, however, since their investments, even with a decline in value over a year ago, still have large unrealized capital gains. If they sold now, they would have to pay federal capital gains taxes of at least 23.8% for stocks (or 31.8% for artwork and collectibles), plus state income taxes. The result is that either they sell now at a lower value, and pay the tax,  or hold the investment with hopes that it will recover before their costs outpace their income. In times like these, consider using a Charitable Remainder Trust.

A Charitable Remainder Trust (or CRT) is a “split interest” trust, that is both the client and one or more charities have an interest in the trust assets. The client has a right to an annuity from the trust for either their lifetime or a term of years, and the charities have a right to the remainder of the trust assets when the trust ends.  There are two basic types of Charitable Remainder Trusts, one with a fixed annuity (a Charitable Remainder Annuity Trust or CRAT) and one with a variable annuity (a Charitable Remainder Unitrust, or CRUT). 

The advantages of a CRT are numerous.  First off, if assets are placed into the CRT before they are sold, then no capital gains tax is due at the time of the sale. Second, the client gets an immediate charitable income tax deduction of at least 10% of the value of the assets transferred to the trust.  Third, the annuity can be set for either a term of years or for a single or joint life expectancy (with a maximum of 20 years).  Fourth, like a Qualified Retirement Account, the investments that remain in the CRT accumulate income tax-free, which encourages a higher rate of appreciation than in taxable accounts.  Fifth, the client can, during the term of the trust, change which charities the remainder goes to in the end.

A further advantage of the CRUT is that, as a variable annuity, if the value of the assets in the trust rises, the amount of the annuity paid out also rises; providing some protection against inflation.  Though, if the value of the assets falls, then the amount of the annuity also falls. This variability allows the actual payout rate to be set much higher than a similar CRAT can be set.

There are relatively few disadvantages to the CRT.  One is that gifting the annuity to someone else (other than to a spouse) is a currently taxable gift, but against which applies both the annual exclusion (now $16,000) and the Unified Credit (now $13 million). Second, the CRT must be drafted precisely to comply with all statutory and regulatory requirements. Third, the CRT is subject to the same investment restrictions that Charities and Private Foundations are subject to, so investing in anything other than publicly traded stocks and bonds may result in a large excise tax. 

The basic requirements for a CRT are that the trust be in writing; the trust functions only as a Charitable Remainder Trust; that the assets transferred to the CRT qualified as a charitable deduction; that at least one income beneficiary is not a charity; that  the remainder beneficiaries are,  and remain, qualified as a charity; and, the annuity interest is calculated according to  the regulations.

When the annuity is paid out each year to the client,  the payment is taxable.   Unlike a regular annuity, however,  the income is not just ordinary income, it can be, depending on what the nature of the trust assets are, dividend, interest,  capital gains and even tax-free return of principal.

Here is an example of how the CRAT and the CRUT work:

John, age 65, and Jane, age 64, inherited a work of art 20 years ago that, at the time, was valued at $20,000.  Today the art will net $1,500,000 at sale.  John and Jane plan on retiring but, with the rise in inflation and the rise in the cost to insure the artwork, they feel that they will need to sell the artwork to raise the needed cash to supplement their retirement income.

If John and Jane sold the artwork, they would have $1,480,000 worth of long-term capital gains taxed at a rate of 28%, plus the Investment Income Tax of 3.8%, for a total tax rate of 31.8%, or $470,640 in taxes due that year. The net available for investment is $1,029,360 which, we will assume, earns 5% or $51,468, a year. 

Now, if John and Jane placed the artwork into a CRAT before it is sold, with an art museum as the remainder charity to make the donation deductible, then they would have the full $1,500,000 after the sale, and take a $77,195 annual annuity for their joint lifetimes. They would pay taxes on only the $77,195 distributed each year, and they would have an immediate income tax deduction of  $223,000.

Finally, if John and Jane place the artwork into a CRUT before it is sold, again with the art museum as the remainder charity, they would have the full $1,500,000 after the sale.  They would receive a variable annuity at a rate of 11.07% of the fair market value of the trust assets each year, beginning in the first year with a payout of $166,065 and would receive an  immediate income tax deduction of $150,000.

So, if your clients are looking at how to raise the needed cash to retire, or if they have met their goal for appreciation of the stock and, like General Electric a few years ago, it has gone from a great to a terrible investment, or their artwork has suddenly skyrocketed in price, then now is the time to use a charitable remainder trust.

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