For many investors, a barrier to diversifying their portfolio is the impact of losing 25% of their profits if they sell a highly appreciated asset. If you are charitably inclined, that barrier can be eliminated by using a tax-exempt trust, as outlined by the following example:
Let’s assume you have a highly appreciated asset (perhaps stock or real estate) that you paid $200,000 for, and that has a market value of $1,200,000. Your capital gain would be $1,000,000. If you sold that asset, you’d only have about $950,000 to reinvest after paying 25% of your gain in taxes (approximately $250,000). By using a tax-exempt trust you would have the full $1,200,000 to reinvest.
Here’s how it works:
- You establish this trust prior to selling the asset. The terms and provisions of the trust are established at its inception. Prior to selling the asset, you transfer the asset to the trust. You and your spouse (if married) become income beneficiaries for your lifetimes to the trust. The IRS sets a range of “approved interest rates”; let’s say 5% per year. So, in year 1, the trust will distribute an income to you of $60,000 ( 5% of $1,200K). If the trust earns a return of greater than 5%, your income the next year will go up. But the big advantage is that you have $1,200,000 to invest, rather than the $950,000. Additionally, you can be your own trustee, so that the investment decisions and control of the assets are retained.
- Why does this trust qualify to be tax-exempt? Primarily there are 2 reasons:
- The trust is irrevocable, so once established, it cannot be modified.
- A t the death of the last income beneficiary, the remaining balance of the trust is paid to a 501c3 charitable organization (the legal name of this trust is a Charitable Remainder Trust). An additional benefit is that upon transferring the asset(s) to the trust, you receive an immediate charitable income tax deduction for the “present value of the future interest” of the “gift”. Depending on the age(s) of the income beneficiary and the established interest rate, the deduction can be in the range of 25% of the gift. So, in this example, instead of paying $250K in capital gain taxes immediately, you’ll SAVE $100K in income taxes as a result of the charitable deduction.
The main disadvantages of this arrangement are:
- Lack of liquidity. You do not have access to principal; only the income that the trust distributes. If you are dependent on the principal from the sale proceeds for your lifetime/retirement, this may not be the best strategy for your cash needs.
- At the death of the last income beneficiary, the money is not retained by your heirs. That “negative” can perhaps be eliminated through the use of a life insurance policy (the premium will be substantially less than the capital gains taxes you, otherwise would have paid). However, for those investors where this trust makes sense, this technique allows them to fulfill their charitable wishes, and normally, this is only a “piece of their estate” so the balance of their net worth will be distributed to their chosen heirs.
- While the earnings and gains in the trust are tax-exempt, the income that is distributed from the trust to the income beneficiaries is generally taxed.
The above is only meant to be a concise summary of this strategy. You should consult your financial advisor, tax professional or attorney to obtain more information. Tax rates used in this article are for illustrative purposes only and may not apply to your unique situation.
This information is presented for educational purposes only, is hypothetical in nature and does not represent actual clients. The information presented is not written or intended as financial, tax or legal advice, and may not be relied on for purposes of avoiding any federal tax penalties under the Internal Revenue Code. Use of this information is not a substitute for legal counsel, and Morton Capital makes no warranties with regard to information contained herein. You are encouraged to seek financial, tax and legal advice from your professional advisors before implementing any transactions and/or strategies concerning your taxes or estate plan.