Goodbye Capital Gains Tax:
It has become commonplace in America's quadrennial
presidential election platforms for Republicans to call
for reductions or repeal of the capital gains tax
("CGT") to stimulate investment and economic growth -
while Democrats demand the tax be increased as a means
of redistributing unjust gains from those who have
much, to those who do not.
Lost in all the political rhetoric is the long-
established availability of the charitable remainder
trust, an effective bypass of the capital gains tax for
a grantor who donates his or her appreciated property
to the trust. The law is well-established that a
transfer of appreciated property to a CRT is not a sale
or exchange on which a capital gains tax is imposed.
Hopefully, investments in real estate or other
forms of property eventually mature, appreciating in
value but too often declining in earnings or yield.
Before this process proceeds too far, the prudent
investor looks for new areas of investment with greater
yields. But one very real roadblock gives pause before
selling low-yield property and reinvesting elsewhere;
the federal capital gains tax, which at this writing is
set at the confiscatory maximum level of 28 percent.
Various states get into the act with their own
CGT, for example, California, where it is now set at 11
percent. This produces a combined federal-state CGT of
a whopping 36 percent - plus it pushes the taxpayer
into a higher income tax bracket and raises his income
taxes courtesy of that old devil "bracket creep."
To illustrate more vividly, suppose you are lucky
enough to own a building worth $1 million currently,
with a fully-depreciated acquisition basis of $40,000 -
a prescient value judgment you made years ago - but now
with a horrific taxable capital gain of $960,000. This
means a combined federal and state CGT liability (if
you live in California) of $344,832! That leaves
$655,168 to reinvest, and if the first year pays a 10
percent return (again, lucky you), you get $65,517 in
income - fully taxable at current federal and state
income tax levels.
And don't forget estate taxes. If you are in the
50 percent estate tax bracket, and are unfortunate
enough to die soon after your sale, your heirs will
only get $327,584 after paying an estate tax of
$327,584. Not much left of that $1 million building.
How discouraging for those who remain alive.
But if you create a charitable remainder trust,
then donate the building to the tax-exempt CRT, you pay
no capital gains tax at all - zero, nor does the CRT
trustee who sells the building later. The entire
proceeds from the sale go into the trust for
reinvestment - $1 million, tax free. (The CRT
assumes the donor's cost basis and the subsequent sale
of the property by the trust results in a capital gain,
but no tax is imposed - but see the related discussion
of taxation of a beneficiary's CRT payout, below).
Remember that you will need a qualified appraisal
of the value of real estate or any other property at
the time of transfer to a CRT, and the trustee is
required to report the transaction to the IRS. The
transfer itself can be accomplished by a simple or
quitclaim deed from the donor.
Of course low cost basis appreciated real property
(either developed or undeveloped) is not the only
candidate for donation to your CRT; it may be your
closely-held family business that has skyrocketed in
value over the years; it might be your personal
residence that has done the same; or growth stocks or
aggressive mutual funds that now would better be
replaced with conservative, safe, high income
investments.
A word about mortgaged property you might consider
for donation to a CRT. Under IRS rules, if the
property has been encumbered within five years prior to
the proposed date of transfer to the trust, acceptance
by the CRT, or any trust payment on the mortgage, would
cause it to lose its tax-exempt status - and defeat the
purpose of its creation. Or the transfer could receive
tax treatment as a "bargain sale," making at least part
of the appreciation immediately taxable to the donor as
a capital gain. If the donor cannot pay off the
mortgage before the transfer, there are possible ways
to get around these obstacles, including a trust
declaration provision forbidding the payment of
mortgages, or the donor formally agreeing to assume all
mortgage obligations personally.
There are some other qualifying factors you should
consider concerning transfers of property to a CRT.
In the case of a successful closely held business
of long duration, the original stock usually has a very
low cost basis and selling it through the medium of the
CRT will produce huge tax savings. The fact that the
business is sold through a tax-free CRT allows you as
seller (technically the CRT is the seller) to structure
a more attractive purchase agreement for the buyer,
perhaps conceding some business tax benefits that would
essentially be wasted if retained by the CRT. These
tax concessions can boost the business sales price
and/or clinch the deal.
A CRT donation works with personal property also.
Suppose you own a significant art collection. Naming
the art museum as the remainderman of the CRT provides
you with leverage on keeping the collection together
and its display.
You can also sell your home through a CRT. The
law says people over 55 years of age are entitled to a
one-time $125,000 capital gains exclusion on the sale
of their home, if they re-invest the proceeds in a new
home. If your home exceeds this exclusion in value,
you can sell it through a CRT and shelter all the
income from the sale. This maneuver is known as a
"charitable buy-down" in sophisticated real estate
circles.
The possibilities of legal tax avoidance and
significant guaranteed income are as limitless as the
assets available for transfer to a CRT.
