San Francisco Apartment Association

Debits & Credits

Charitable Remainder Trusts Can Save Money

by Douglas Schultz & Alexander Yarmolinsky

Q. I think it's time to sell my residential rental building and diversify proceeds into liquid investments. I plan to live off the income that will be generated by my new investments, and I want to make a gift of the principal to my favorite charity when I die. The biggest problem with this plan is paying income taxes. My tax cost basis is very low, and I know that I have to pay around 25% in federal and California income taxes on my gain. My accountant suggested that I set up a Charitable Remainder Trust (CRT). What is this kind of trust?

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 can continue for a term not to exceed 20 years or 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 one or more designated charities.

Let's look at an example of a typical situation in which a CRT is used. Mr. and Mrs. Smith own a four-unit residential rental building. Their adjusted cost basis (net of depreciation taken in prior years) is $100,000. The value of this building is $1,100,000. Every year, they collect rents (net of expenses) totaling $50,000. There is no mortgage on this property. Their total estate is large enough for this building to be taxable at a 40% marginal tax rate for estate-tax purposes. If sold, it will be taxable at a combined federal and California income-tax rate of 25%. Accordingly, if they sell the building they will have a capital gain of $1,000,000 ($1,100,000 sales price/$100,000 basis). They will pay income tax of $250,000 ($1,000,000 gain subject to 25% tax). It will leave them with $850,000 in after-tax money that they can invest at a 6% return, which will give them $51,000 of annual income.

Instead of selling the property, the Smiths 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-gains tax. Accordingly, the trust now has $1,100,000 to invest. At a 6% return, the trust will receive $66,000 of annual income. The Smiths can write into the trust that they want a 6% annual income for the trust, and then they will receive $66,000 per year in income. This income will be paid to the Smiths for the duration of their lives. Upon the deaths of both Mr. and Mrs. Smith, the balance of the funds in the CRT will be paid to one or more designated charities.

When the trust is created and the real estate is contributed to it, the Smiths are making a charitable donation of a portion of the value of the real estate. The value of the charitable deduction that the Smiths receive is calculated as the original value of the gift, less the present value of the future stream of income going to the Smiths. 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 $237,770, which will save income tax of $95,108. Since the money is now in an irrevocable trust, the $1,100,000 is no longer included in the Smiths' estate for estate-tax purposes, thus saving $440,000 ($1,100,000 times the 40% marginal estate-tax rate).

In summary, instead of paying $250,000 in capital-gains taxes for the sale of the property (first example), the Smiths will receive $95,000 in income-tax benefits for contributing this property to their CRT. Every year the Smiths will collect $66,000 of income instead of the $51,000 they would receive in the first example. The principal will also not be subject to estate tax, thus saving $440,000 for their heirs and providing one or more of their favorite charities with $1,100,000 in cash, to be donated when the Smiths die.

Three Primary Types of CRTs:

  • Charitable remainder annuity trust (CRAT): The CRAT pays a fixed amount, at least annually, to the income beneficiaries on the basis of the initial value of the trust principal contributed to it.
  • Charitable remainder unitrust (CRUT): The CRUT pays a fixed percentage, at least annually, to the income beneficiaries, but is valued every year to determine the amount to be distributed.
  • Charitable remainder unitrust with net income makeup provisions (NIMCRUT): The NIMCRUT pays 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.

In conclusion, please don't forget that your CRT strategy should be included in your overall estate and financial planning strategy to ensure the most beneficial results for both 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 the San Francisco Apartment Magazine. Doug Schultz is a CPA and partner in the tax practice at Burr, Pilger and Mayer. Alex Yarmolinksy is a CPA and manager in the tax practice at Burr, Pilger and Mayer. Both can be contacted at 415-421-5757. Copyright © 2005 by the San Francisco Apartment Magazine. All rights reserved.