A popular strategy for individuals who want to sell a rental property that has appreciated in value while deferring income tax on the gain is a 1031 exchange. Named after the IRS code section that authorizes this tactic, you can defer tax on the gain by purchasing a replacement property whose purchase price and loan amount are the same or greater than the property being sold provided various timing and other rules are met.
Suppose, however, that you no longer want to manage or own rental properties, you don’t want to pay income tax on the gain if you sell your property, and you need ongoing income. You can accomplish this using a long-standing strategy recognized by IRS provided that there’s either no mortgage on the property or one that can be paid off.
Enter the Charitable Remainder Trust
A charitable remainder trust, or CRT, can be a great solution for someone in this situation. It has been used by numerous families since 1969 to increase income, save taxes, and benefit charities. Its appeal as a retirement income planning strategy is compelling given the scarcity of traditional pension plans and ongoing concern about the financial stability of Social Security.
A CRT is an irrevocable trust created under the authority of Internal Revenue Code Section 664. When you transfer title of property to a CRT, your CRT becomes the legal owner. You, and potentially your children, receive lifetime income from your CRT. When you pass away, the remaining assets are distributed to one or more charities of your choice.
A CRT offers the following five benefits when used for highly appreciated assets such as rental properties:
- Sizable charitable contribution deduction
- Avoidance of capital gain tax on the sale of property
- Conversion of highly appreciated asset into tax-favored lifetime income
- Removal of current asset value and future appreciation from estate
- Helps charities that are important to you
Sizable Charitable Contribution Deduction
When you transfer title of property to a CRT, you transfer ownership to a separate legal entity, the ultimate beneficiary of which will be one or more charitable organizations of your choice. This entitles you to a charitable contribution deduction, the amount of which is equal to the “present value of the remainder interest” that will go to charity.
The calculation of the present value of the remainder interest takes into consideration several factors. These include the value of the property transferred to the CRT, the age and sex of the individuals receiving income from the CRT, and the CRT income distribution percentage.
Generally speaking, the older the income beneficiaries, the greater will be the charitable contribution deduction since income will be paid by the CRT to the income beneficiaries for a shorter period of time. As an example, a 76-year old woman who transfers rental property to a CRT valued at $900,000 who will be the sole income beneficiary of the trust is entitled to a charitable contribution deduction of approximately $335,000.
The amount of federal and state income tax savings associated with the charitable contribution deduction is dependent upon your federal and state marginal tax brackets and your ability to use the deduction. The deduction is limited to 30% of adjusted gross income, with the unused portion carried forward for five additional years. Income tax planning, including analysis of the timing of the transfer of a rental property to a CRT, is critical.
Avoidance of Capital Gain Tax on the Sale of Property
When you sell highly appreciated rental property, the capital gain and associated income tax liability can be significant. The gain can be sheltered to the extent that you have “suspended passive losses.” Suspended passive losses arise when a property has expenses that exceed its income, income from all sources exceeds a specified threshold, and the property owner isn’t a real estate professional. They are nondeductible in the year in which they occur.
Suspended passive losses for a specific property can be used in their entirety when the property is sold. A CRT should be considered whenever there are no suspended passive losses or the losses won’t substantially reduce projected income tax liability on the sale of the property. One important caveat, as mentioned earlier, is that there can be no mortgage on the property or it can be paid off prior to transferring title to the CRT.
Continuing the earlier example, assume that the 76-year old woman sold her highly-appreciated rental property for $900,000. The property has no mortgage, no suspended passive losses, and a low cost basis. Her projected federal and state income tax liability attributable to the sale would be $330,000. This would leave her with net sales proceeds of $534,000 after assumed closing costs of $36,000.
Let’s assume instead that title of the property is transferred from this individual to a CRT and is subsequently sold by the CRT for $900,000. Since the property is sold by a CRT, there would be no capital gain tax. The CRT would net $900,000 less closing costs of $36,000, or $864,000 from the sale.
Conversion of Highly Appreciated Asset into Tax-Favored Lifetime Income
Assuming that replacement of rental property income is a goal, the CRT in our example could be designed to distribute 5% or more of its net income each year for the remainder of the income beneficiary’s life. The net proceeds from the sale of the rental property would generally be invested in a professionally managed investment portfolio and other types of appropriate investments. A portion of the portfolio would be liquidated each quarter to pay income distributions, investment management fees, and trust administration fees.
Using a distribution rate of 5%, the distribution to the CRT income beneficiary in the first year in our example would be $864,000 x 5%, or $43,200. Since the origin of the CRT investment portfolio is a long-term capital gain, the income would be reported by the CRT as a long-term capital gain on the income beneficiary’s K-1. This would continue until such time as 100% of the long-term capital gain from the sale of the property has been reported as income.
Unlike rental property net income that’s often less than CRT distributions and is taxable as ordinary income at an individual’s highest tax rate, CRT income in this situation would receive favorable long-term capital gain tax treatment. This could result in minimal income tax liability attributable to the CRT income depending upon the individual’s other income sources and amounts.
Removal of Current Asset Value and Future Appreciation from Estate
Since a CRT is a separate legal entity with one or more charitable organizations as the remainder beneficiary, the transfer of property to a CRT removes the current value and future appreciation of the property from one’s estate. As such, a CRT can be used to reduce estate tax liability for individuals with a high net worth who will be subject to estate tax. This currently applies to an estate value in excess of $5.6 million for single individuals and $11.2 million for married couples.
Even if estate tax liability isn’t a concern, estate preservation often is. Going back to our example, the sale of the rental property by a CRT would result in net proceeds of $864,000, or $330,000 greater than the net proceeds of $534,000 if sold individually.
There are various strategies that can be used by a CRT to preserve one’s estate in this situation. They include the following three, a discussion of which is beyond the scope of this blog post:
- Reinvest income tax savings and annual CRT distributions in excess of former rental property income to offset the loss of one’s estate resulting from transferring property to a CRT.
- Provide for continuation of lifetime income payments to children upon the death of the initial income beneficiary.
- Use income tax savings to fund a “wealth replacement trust” that purchases life insurance to replace the value of the rental property that’s transferred to a CRT.
Helps Charities That are Important to You
As previously stated, the ultimate beneficiary of a CRT is one or more charities of your choice. After you, and potentially your children, receive lifetime income from a CRT, the remaining value at death is distributed to one or more charitable organizations. The knowledge that this will occur can be very rewarding depending upon one’s charitable inclinations and legacy goals.
A Powerful Retirement Income Planning Strategy
Anyone considering the sale of highly-appreciated unencumbered rental property, the gain from which won’t be significantly sheltered by suspended passive losses, is a potential candidate for a charitable remainder trust, or CRT. The various benefits of a CRT, including substantial income tax savings and tax-favored lifetime income for one or more generations, can provide creative planning opportunities. It’s especially powerful when used as a retirement income planning strategy.
Robert Klein, CPA, PFS, CFP®, RICP®, CLTC® is the founder and president of Retirement Income Center in Newport Beach, California. Bob is also the sole proprietor of Robert Klein, CPA. Bob applies his unique background, experience, expertise, and specialization in tax-sensitive retirement income planning strategies to optimize the longevity of his clients’ after-tax retirement income and assets. He does this as an independent financial advisor using customized holistic planning solutions based on each client’s needs and personality.