There are many strategies that investors can employ to offset, delay, or even eliminate capital gains taxes. One possible approach is creating a charitable remainder trust (CRT), which helps both reduce capital gains taxes and achieve philanthropic goals.
If you’re looking for a way to convert appreciated assets into income while also leaving behind a lasting legacy, understanding how a CRT works could be a valuable part of your planning process. Below, Realized 1031 has shared a guide to answer the question, “How might a charitable remainder trust reduce capital gains exposure?” Keep reading to learn more.
Capital gains are the income you earn after selling an asset at a price higher than the original purchase value. Since capital gains are a type of income, they are taxable, and this tax liability applies to most types of investments, particularly real estate. Furthermore, capital gains taxes have differing treatments and rates based on how long you hold the asset.
These rates can translate to substantial deductions from your cash flow. For example, if you sold a rental property that originally had a value of $500,000 for $700,000, then you’ll owe $40,000 if you belong to the highest tax bracket. This does not account for any applicable state taxes or the 3.8% Net Investment Income Tax (NIIT). As such, investors have tried various strategies to lower or defer their tax liability — and one of these is the charitable trust.
A charitable trust is a type of irrevocable trust designed to benefit one or more charitable organizations. This legal entity is often used in estate planning to reduce taxable income, defer the recognition of capital gains taxes, and provide ongoing support to charity. Charitable trusts are typically established by donors who want to contribute assets such as stocks, real estate, or other investments while still retaining some financial benefit, usually in the form of income over a certain period.
The person who creates the trust is known as the grantor or donor, and they appoint a trustee — an individual, financial institution, or organization responsible for managing the trust’s assets and disbursing income according to the terms set forth in the trust document.
Charitable trusts fall into two primary categories: Charitable Remainder Trusts (CRTs) and Charitable Lead Trusts (CLTs). In both types, the trust eventually benefits a charitable organization, but the order of who gets paid first (the charity or the non-charitable beneficiaries) differs.
One of the key features of a charitable trust, especially a CRT, is its tax treatment. When you transfer an appreciated asset into a CRT, the trust can sell that asset without incurring immediate capital gains tax. This is because charitable entities are tax-exempt. Instead of paying a large tax bill upfront, the proceeds from the sale stay within the trust and are reinvested, creating a potentially larger income stream for the donor or other beneficiaries over time. The deferred capital gains tax is gradually recognized as income distributions are made.
In the context of charitable trusts, there are two main categories as mentioned above: CRT and CLT. The key distinction between these two types is who receives the income stream and who ultimately receives the remaining assets upon the death of the donor. We can think of CRT and CLT as mirror images of each other.
In this setup, the donor transfers assets to the CRT. The trust is structured to make income distributions to one or more non-charitable beneficiaries (such as the donor or their family) for a fixed term or the life of the beneficiary. At the end of the trust term, the remaining assets are distributed to one or more qualified charitable organizations.
CRTs must meet specific IRS requirements, including a minimum remainder interest of at least 10% of the initial fair market value of the trust assets. Additionally, while CRTs can defer recognition of capital gains tax when appreciated assets are contributed, they do not eliminate tax entirely. Beneficiaries will recognize income over time as distributions are made.
Meanwhile, a charitable lead trust restricts who receives income from the transferred assets to only the chosen charities. This nonprofit organization or charity is the lead beneficiary, hence the name. However, after the trust term ends, the remaining assets can be distributed to one or more non-charitable beneficiaries. In most cases, these entities will be the donor’s heirs.
Both structures offer tax benefits, but CRTs may offer tax-deferral benefits under certain conditions.
Generally, charitable remainder trusts (CRTs) are exempt from capital gains tax when they sell appreciated assets, provided the trust complies with the requirements of Internal Revenue Code Section 664. As such, the CRT can sell properties, stocks, and other types of investments without triggering immediate tax liability for the donors.
Taxes are not avoided entirely, however. Instead, taxes are deferred and passed on gradually to the income beneficiary through periodic distributions. This allows the full, untaxed proceeds from the sale to be reinvested, with the potential to generate income for the beneficiary. In short, a CRT offers a way to unlock the value of appreciated assets without the upfront tax hit you’d face with a traditional sale.
Charitable Remainder Trusts (CRTs) offer a potential strategy for tax-efficient wealth transfer and philanthropic planning. When structured properly, CRTs may provide multiple financial and estate planning benefits.
While the capital gains tax deferral and income tax deductions are attractive, there are also structural and regulatory considerations that should be carefully evaluated:
Transferring assets to a trust also means relinquishing most of your control over them. Given how CRTs are irrevocable, the asset is also stuck in the trust until the term is over. So, even if new opportunities arise that may result in higher revenue, you cannot do anything directly yourself. Selection of a trustee with appropriate experience and fiduciary capabilities may help ensure the trust is administered in accordance with applicable tax laws and the donor’s intent.
Creating a CRT requires legal and financial expertise, including drafting custom trust documents and complying with IRS regulations. Initial setup fees can cost several thousand dollars, and ongoing administrative and trustee fees may impact the net benefit.
Income distributed to beneficiaries is subject to the performance of the trust’s investments and the terms of the payout structure. Depending on market performance and the length of the trust term, the income may be less than originally projected.
There’s also the possibility of scrutiny from the IRS. There are strict regulations surrounding CRTs to prevent abuse. Failing to follow these regulations, such as borrowing from the trust or using the funds to pay personal expenses, may result in unwanted tax consequences.
A CRT is an advanced strategy for managing appreciated assets, deferring capital gains tax, and giving back to causes you care about. By transferring assets into a CRT before selling, you can avoid immediate capital gains tax, receive income distributions during the trust term, subject to market performance and trust provisions, and eventually benefit a charity.
While CRTs are not a one-size-fits-all solution and have their own administrative complexities and challenges, their tax deferral potential can make them a valuable component of an estate or philanthropic planning strategy. Always consult with legal and tax professionals before setting one up.
The tax and estate planning information offered by the advisor is general in nature. It is provided for informational purposes only and should not be construed as legal or tax advice. Always consult an attorney or tax professional regarding your specific legal or tax situation.
Article written by: Story Amplify. Story Amplify is a marketing agency that offers services such as copywriting across industries, including financial services, real estate investment services, and miscellaneous small businesses.
Sources:
https://www.investopedia.com/terms/c/charitableremaindertrust.asp
https://www.investopedia.com/terms/c/charitableleadtrust.asp