There are two types of charitable remainder trusts (CRTs): charitable remainder unitrust (CRUT) and charitable remainder annuity trust (CRAT). This article focuses on the CRUT, which provides a larger income-tax charitable deduction when interest rates are below 5% (as they are now) and, unlike a CRAT, avoids application of a so-called exhaustion test imposed by the IRS.
I’ll provide a brief overview of some of the benefits and rules of CRUTs and explain how they can be used for purposes of obtaining income-tax deferral of a taxable gain on a cash sale of an asset. The article is not intended to provide a detailed overview of the technical rules regarding CRUTs or an analysis of the various types of CRUTs.
Benefits of a CRUT
A properly implemented CRUT offers:
- Income-tax deferral for appreciated assets such as stock or investment real estate.
- Charitable income-tax deduction (equal to the value of the contributed asset minus the present value of the retained income stream).
- Estate-tax deduction (equal to the value of the charitable remainder interest).
The Basics of How a CRUT Works
A CRUT allows an individual to transfer an asset to a trust, and to retain the right to receive a distribution of a predetermined percentage of the trust assets for a period that is measured either by an individual’s lifespan or by a fixed term not greater than 20 years. For purposes of this article, we will assume that the individual who contributes the asset to the CRUT will be the same person who retains the right to distributions from the CRUT.
The percentage that the individual retains is determined upon the CRUT’s creation, but the value of the trust principal is calculated annually. This means that the amount that is actually distributed to the settlor will change on an annual basis.
In the year the CRUT is created, the settlor is allowed an income-tax deduction that is equal to the present value of the trust assets that will ultimately pass to charity. When the CRUT ends, the remaining trust principal will pass to charity.
When determining the unitrust interest that can be retained by the settlor, there are two factors. First is the age of settlor (because the Internal Revenue Code uses mortality tables issued by the Treasury to determine the settlor’s life expectancy). Second is the interest rate based on IRS code Section 7520 (which is issued by the IRS on a monthly basis). Importantly, the specific value of the unitrust interest that the client wishes to retain within the allowable parameters may vary depending on the client’s specific objectives.
A CRUT’s income is tax exempt under the Internal Revenue Code, which means that if an individual contributes an appreciated asset to a CRUT, which then sells the asset to a third party, the CRUT will not pay income taxes on the gain from the sale of the asset. Instead, when the CRUT distributes principal to the settlor, the settlor will recognize the income tax in a tiered ordering system set forth in the Code.
Therefore, the actual payment of the income tax from the sale of the appreciated asset by the CRUT can be deferred over the course of the term of the CRUT. One important rule that must be followed in order to obtain the income-tax deferral benefits is that the settlor must contribute an asset to the CRUT prior to a deal for its sale being finalized. In other words, as long as there is no legally binding obligation for the settlor or the CRUT to sell the property at the time it is contributed to the CRUT, then the income-tax benefits that are associated with the CRUT can be achieved.
Example with Appreciated Stock
Meet Jane, age 65, who owns $2 million of stock in a public corporation. Her basis in the stock is $100,000. If Jane sells the stock, she will pay federal and state income taxes of approximately $570,000, based on a combined effective state and federal income tax rate of 30% ($1,900,000 x 30%). This will net Jane an amount of $1,430,000 to invest.
Instead, Jane could contribute the $2 million of stock to a CRUT, which could then sell the stock without paying any income tax, and begin investing the full $2 million in a diversified portfolio. Based on Jane’s age of 65, her life expectancy is 82.4 (another 17.4 years). If we assume a Section 7520 rate of 2.2%, Jane could retain a unitrust interest of 19%. This 19% is based on Jane’s life expectancy and the Section 7520 rate that would satisfy the requirement that the present value of the remainder interest passing to charity must be at least 10% of the value of the initial trust principal.
This means that each year for the rest of her life the CRUT will distribute an amount equal to 19% of the value of the trust assets, which are determined annually. In the first year, Jane would receive a distribution equal to $380,000 (19% of $2 million).
Therefore, if the CRUT earns 5% income on the initial $2 million at the end of the first year (equal to $100,000), the CRUT will distribute to Jane the $100,000 of income (taxed at ordinary income rates) plus $280,000 of trust principal (a portion of which is taxed at long term capital gain rates and a portion of which is tax-free return of basis).
The point is that the CRUT can invest the full $2 million proceeds from the sale of the appreciated stock, whereas without the CRUT Jane would only have the ability to invest the $1.43 million after paying the long-term capital gain tax. The CRUT technique allows Jane to defer the income-tax liability on the sale of appreciated assets over her lifetime rather than paying the tax up front. This provides Jane with a larger amount of assets to invest from which she can generate a stream of payments for the rest of her life.
Example with Investment Real Estate
Another scenario where a CRUT can provide extensive tax and financial benefits is where a client owns rental real estate that has appreciated in value and has been fully (or significantly) depreciated. Upon the sale of such rental property, the client could pay (depending on the tax bracket) federal long-term capital gain tax at a 20% rate on the amount of the appreciation, plus an additional depreciation recapture tax at a 25% rate on the amount of the depreciation that was taken over the years. The client would also incur additional state income taxes if the client lives in a state with an income tax.
If, on the other hand, the client contributed the rental property to a properly implemented CRUT and retained a lifetime unitrust interest, then the income taxes could be deferred over the course of the client’s lifetime and the CRUT would have a larger amount of initial cash to invest in order provide a larger stream of income to the client.
Assume Jane from the prior example owns a $2 million rental property, which she bought for $1 million and which has been fully depreciated. For simplicity, let’s assume the entire value of the property is allocated to the building and none of it to the land. If Jane sells the property for $2 million, she could incur a federal income tax liability of $450,000. This results from a long-term capital gain tax of $200,000 ($1 million gain x 20%) plus a tax on the depreciation recapture of $250,000 ($1 million depreciation recapture x 25%). If Jane lives in a state with a state income tax, she could owe even more in taxes.
However, if Jane contributed the property to a CRUT (which contained the same provisions that were used in the previous example), which then sold the property to a buyer, she could defer all of those income taxes over her lifetime. The CRUT would not pay any income tax on the sale of the property, and could therefore invest the $2 million proceeds. At the end of the first year, Jane would receive a $380,000 distribution, assuming her unitrust interest is 19%. Jane would pay income taxes on that distribution, which would be a combination of ordinary income, long-term capital gain and depreciation recapture.
Since the CRUT will not pay any income taxes on the sale of the property in this example, it has a larger amount of assets ($2 million) to distribute to Jane over her lifetime. It is an income tax deferral technique.
A CRUT is an attractive option for clients looking to defer income taxes when selling appreciated stock or investment real estate. Determining whether a CRUT is the appropriate transaction for a client depends on a variety of factors (financial and otherwise), so it’s important to consider each client’s objectives on a case-by-case basis.
Matthew Guanci, who holds an LL.M in taxation and estate planning, established Boston-area Guanci Law in 2018 after working for several boutique law firms as an estate planning and tax law specialist. He can be reached at email@example.com.