By Magnus Advisors
Location, location, location. Ask real estate professionals, and many of them will likely confirm that location is the most important factor when buying a luxury investment property. Close your eyes and pick a spot in the Hamptons, London’s West End or one overlooking Switzerland’s Limmat River, and it is hard to imagine the home’s value will not do well over time.
But long before you plan to get into luxury real estate, you should have a plan for getting out, and that means there are three bigger considerations — taxes, taxes, taxes. Making a killing in real estate — but getting killed in taxes — is hardly a worthwhile plan. Can advanced financial planning allow you to make a sale, keep the proceeds, distribute income to yourself and give money to charity? The answer is yes it potentially can, and, in this article, we will look through a window and explore the planning utility of a charitable remainder trust (CRT).
What is a Charitable Remainder Trust?
Financial planners have many tools at their disposal, but the CRT is one of the most versatile, provided you know how to use it. A basic strategy is to transfer an appreciated asset (or assets) into an irrevocable trust and name a charity (or charities) as beneficiary. You can transfer cash, but benefits can also come from transferring highly appreciated assets, such as stocks, bonds, cryptocurrencies — even private business interests. By transferring the assets, you are removing all rights of ownership, which means you cannot modify or terminate the CRT without the permission of the beneficiary. However, there is an exception: You can use a donor-advised fund, which means the charity does not need to be named when you set up the trust, and you can even change the beneficiaries without additional paperwork. Regardless of the choice, how can a CRT benefit you?
CRTs are created under the authority of Internal Revenue Code (IRC) Section 664. You can receive an immediate charitable income tax deduction which can be used to help offset taxable income up to 60 percent (cash donations) of adjusted gross income (AGI) in the year of the donation. A deduction of real estate to a CRT is generally limited to 30 percent of the donor’s AGI. Since you have gifted the asset irrevocably, the asset has been removed from your estate and thereafter will not be subject to estate tax when you die. The trust is managed by a trustee, who can sell the donated assets at full market value without capital gains tax and then reinvest the net sales proceeds into income producing assets, such as a diversified portfolio of marketable securities. In addition, any investment gains on CRT assets grow tax-free and assets can compound in a tax protected environment.
A CRT can be structured to provide income benefits for the life of the donor (single life) or for a duration up to 20 years, where a donor’s spouse (joint life) and/or children can be designated as beneficiaries. Since the income payout may last longer than the life of the donor (but not longer than 20 years), the benefits can potentially continue to your spouse and/or your children when you die. The longer the payouts continue to others, the lower the charitable income tax deduction. At the end of the 20 years, or when the last beneficiary dies, whichever comes first, the remaining trust assets go to the charity or charities that you have chosen. That is what makes it a charitable remainder trust.
Depending on how you set up the trust, you and your beneficiaries may receive income on a payment frequency of your choosing. It could be a fixed amount, say $10,000 per month, or a percentage of the remaining assets for that year. The IRC outlines several statutory requirements for CRTs. For example, the annual annuity payment to the beneficiary must be at least 5 percent of the trust’s assets but no more than 50 percent each year.
To see the benefits, let us look back to a sale of real property completed in 2018 by Heritage Auctions and incorporate a CRT. Heritage successfully sold a beautiful home in East Hampton, N.Y., through their real estate auction platform for $4.6 million. The seller in our hypothetical example was a 65-year-old with one child 29 years of age. They had a cost basis of $1 million and gifted the property to a CRT prior to the sale. In doing so, the donor would receive a charitable deduction up to $460,000 for the donated property and all capital gains tax associated with the subsequent sale would be eliminated. Following the sale, the net sales proceeds were reinvested in investment portfolio of income-producing securities. Assuming a 6.5 percent net rate of return (2.5 percent growth and 4 percent income), the plan could provide profound benefits for the donor for 20 years (Age 85):
• Income to Donor – approximately $4 million
• Distributions to Charity – approximately $5.2 million
• Remainder Interest to Charity – approximately $6 million
The results could have been amplified by incorporating the donation of cash coupled with appreciated home which would result in a higher income tax deduction. Alternatively, using some trust assets to fund a properly structured life insurance policy on the life of the donor could replace the wealth lost from the donated assets at the death of the donor.
“Heritage Auctions’ Luxury Real Estate team is always open to working with clients in creative financial fashions,” says Nate Schar, Heritage’s director of Luxury Real Estate. “CRTs are another great example of how to sell your dream home with Heritage, from the Hamptons to the West Coast.”
Inherit the IRA – Without the Taxes
With the passing of the SECURE Act (Setting Every Community Up for Retirement Enhancement) in 2019, CRT planning has garnered additional attention. The “stretch” IRA was eliminated for anyone other than a surviving spouse. Previously, a stretch IRA could be passed on to non-spouse beneficiaries, thus allowing assets to transition to the second-generation tax-deferred growth. The Act now forces nonspouse beneficiaries of inherited IRAs to withdraw all the money within 10 years of receiving it, leaving parents with concerning questions: Will my children have enough money to support their prolonged lives? Will they be forced into a higher tax bracket? These are good questions and CRTs can potentially provide answers.
With proper planning, a testamentary transfer to a CRT can be a great solution. You can set up a CRT with your children named as IRA beneficiaries. In doing so, rather than the IRA going to your children upon your death, it gets transferred to the CRT, which means it does not trigger the recognition of income. Instead, the CRT can take up to 20 years to distribute the money.
CRTs are a powerful charitable planning tool but are often misunderstood and underutilized. You can convert a highly appreciated asset into a stream of income, avoid capital gains on the sale, eliminate future estate taxes, and gain protection from creditors. Best of all, you are helping charities that are meaningful to you.
As the Hamptons are for real estate investors, a Charitable Remainder Trust may be one of the best destinations for your hard-earned assets. After all, tax-mitigation is a function of asset location, location, location.
ABOUT MAGNUS FINANCIAL GROUP, LLC
Michael Schwartz, CFP®, AEP®; Michael Brown, Ron Deutsch, CFA®, MBA; Brian Flynn; Paul Hoerrner Jr., CFP®; Michael Tanney; and Travis Nelson, CFP®
at Magnus Financial Group LLC.
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