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Writer's pictureJay Judas

Tier One: Charitable Remainder Trusts & Irrevocable Life Insurance Trusts

Real estate values often follow a cyclical pattern.  As markets begin to rebound from downturns, many investors may start seeing gains in their real estate holdings.

However, realizing those gains typically comes with a cost—capital gains taxes.  Many investors know they can defer taxes with a 1031 like-kind exchange, but that only postpones the tax burden by swapping one property for another. If you're worried about a potential drop in property value, simply trading properties doesn't resolve your concerns.


For nearly half of a century, there has been a solution available for real estate and stock investors, which allows them to create a trust that:


  • Appoints themselves as the Trustee;

  • Provides them with income for life;

  • Sells real estate or stocks without paying capital gains tax;

  • Offers an immediate income tax deduction;

  • Makes a charitable gift upon their death; and

  • Potentially doubles or triples the wealth transferred to their heirs.


Consider the following example:

Discussing charitable remainder trusts

Enrique and Susan own a property valued at $400,000, which they purchased for $100,000 (giving them a cost basis of $100,000). If they sell it, they face $300,000 in capital gains. With federal capital gains taxes at 15% and state capital gains taxes at 9%, they would owe $72,000 in taxes. This would leave $328,000 to reinvest. If they reinvest that amount at a 6% return, they will generate $19,680 of income annually.


Instead, they transfer the property to a Charitable Remainder Trust, naming themselves as Co-Trustees and beneficiaries.  The trust then sells the property. Since it's a charitable trust, no capital gains taxes are owed. The trust reinvests the entire $400,000 at 6%, resulting in $24,000 per year in income—a $4,320 or 22% increase.


Unlike a 1031 exchange, which merely defers the tax, the sale of assets within a Charitable Remainder Trust is tax-exempt.


Because the property is irrevocably designated for Enrique and Susan's chosen charity upon their deaths, they receive a current-year income tax deduction for the present value of the future charitable gift.  This value is determined by their ages and the trust’s rate of return. Assuming Enrique is 60 and Susan is 58, the deduction in this scenario would be $88,232.

 

Enrique and Susan can then use these tax savings to purchase life insurance through an Irrevocable Life Insurance Trust (ILIT).  Upon their deaths, the proceeds from the ILIT will go to their heirs, while the remaining Charitable Remainder Trust assets are distributed to the charity.  Since life insurance proceeds from an ILIT are exempt from federal estate taxes, their heirs receive the full amount tax-free.


By using a Charitable Remainder Trust, Enrique and Susan retain the full $400,000 for reinvestment rather than paying any portion in capital gains taxes. Assuming a 6% return, this would provide them $24,000 annually, compared to just $19,680 if they had sold the property, paid the tax, and reinvested. The charitable deduction for the future gift to the charity allows for an $88,230 reduction in taxable income, potentially saving over $41,000 in taxes. Upon their deaths, the life insurance policy replaces the wealth donated to the charity, ensuring their heirs receive a tax-free inheritance.


If you own low-basis real estate or stock and want to lock in gains without paying capital gains taxes, a Charitable Remainder Trust may be worth exploring.  Not only can it help you avoid capital gains taxes, but it also provides a significant income tax deduction that can offset other income.

 

At Life Insurance Strategies Group, we do not sell life insurance products.  We help our affluent individual and institutional clients make decisions about complex situations involving life insurance.  If we can help you, visit us at lifeinsurancestrategiesgroup.com.

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