Let's assume you have one highly appreciated asset you would like to sell but are reluctant to do so because of the significant capital gains taxes you would owe. At the same time, you are looking for ways to reduce your current year's taxable income and would like to receive an ongoing income stream. Moreover, you would like to diversify your overall investment portfolio.

Usually, this would mean selling that highly appreciated asset, paying the high taxes and reinvesting with a substantially reduced amount. In this situation, the charitable remainder trust (CRT) may be an ideal option for you.

Used properly, a CRT can potentially:

  • Reduce current income taxes with a sizable income tax deduction.
  • Eliminate immediate capital gains taxes on the sale of appreciated assets, such as stocks, bonds, real estate and just about any other asset.
  • Increase your disposable income throughout the remainder of your life.
  • Create a significant charitable gift.
  • Reduce estate taxes that your estate might have to pay upon your death, thus leaving more for your heirs after your lifetime.
  • Avoid probate and maximize the assets your family will receive after your death.
  • Protect your highly appreciated property from future creditors.

Think of a CRT as a tax-exempt trust that provides benefits to two different parties. The two different parties are the individuals receiving income and the chosen charity or charities.

The "income beneficiaries" (usually you or your family members), typically receive income from the trust for either their lifetimes or a specified number of years (20 years or fewer). At the end of the trust term, the chosen charity will receive the remaining principal to use for its charitable purposes.

How a CRT works

A CRT is an irrevocable trust that makes annual or more frequent payments to you — typically until you die. What remains in the trust then passes to a qualified charity of your choice.

A number of tax-saving advantages may flow from the CRT. First, you will obtain a current income tax deduction for the value of the charity's interest in the trust. The deduction is permitted when the trust is created even though the charity may have to wait until your death to receive anything.

Second, the CRT is a vehicle that can enhance your investment return. Because the CRT pays no income taxes, the CRT can generally sell an appreciated asset without recognizing any gain and paying any tax on the sale.

This enables the trustee to reinvest the full amount of the proceeds from a sale and thus generate larger payments to you for the rest of your life. A portion of the distributions that you, the donor, receive may be taxable income and gains, but they will be spread out over time.

Using life insurance for wealth replacement

Many people would be more motivated to make gifts to charities, but they are afraid that they won't leave an adequate inheritance to their heirs. Savvy clients understand that they can make donations during their lifetimes, save income taxes and find a way to leverage the tax deduction to achieve a similar, or sometimes larger, inheritance for their heirs than if they hadn't utilized charitable planning.

This concept of using life insurance for "wealth replacement" will be discussed below.

A trust is eligible for the estate tax deduction if it passes assets to one or more qualified charities at the time of one's death. If you wish to replace the value of the contributed property for heirs who might otherwise have received it, you can use some of your cash savings from the charitable income tax deduction to purchase a life insurance policy on your life held in an irrevocable life insurance trust for the benefit of your heirs. This is called a "wealth replacement trust."

Often, through the leveraging effect of life insurance, it is possible to pass on assets of greater value than those contributed to the trust. In this way, your heirs are not deprived of property they had expected to inherit. In fact, your heirs may find it advantageous to receive cash, in the form of proceeds from a death benefit, as opposed to an asset that they did not wish or know how to manage.

Let's see how this works:

1. You gift a highly appreciated asset to the charitable remainder trust. You receive a current income tax deduction that you can use to reduce your income tax liability for up to five years.

2. The CRT sells the asset. Neither you, nor the CRT, pay any taxes on the sale. One hundred percent of the value of the asset is preserved and invested in a tax-free environment.

3. You receive a larger annual distribution from the CRT than you would have received if you had paid taxes on the sale of the asset and invested the proceeds in a taxable environment.

4. Although the annual distribution is taxable, it is taxed in accordance with how it was earned in the trust. This form of taxation is beneficial given the lower dividend and capital gains tax rates. The income beneficiary will save a significant amount in taxes each year.

5. After the death of all income beneficiaries, the remaining assets from the CRT go to your selected charity.

6. A wealth replacement trust can be funded with insurance to replace those assets given to charity and give the family even more than they would have received had no charitable planning been done.

The CRT's cousin — The charitable lead trust

When it comes to charitable trusts, CRTs seem to get all the attention. But the cousin of the CRT the charitable lead trust (CLT) also can provide significant charitable and tax benefits, particularly in an environment of lower interest rates, as we have had for the past five-plus years.

With a CLT, sometimes called a charitable income trust, you transfer cash or income-producing assets to the trust. The trust then pays out income earned by the assets to a designated charity or charities.

The payout may be an annual fixed dollar amount set at the time of the transfer — called an annuity trust — or an amount based on a percentage of the assets in the trust at the time of each annual payout — called a unitrust.

At the end of a specified number of years, the remaining assets in the trust are distributed to the noncharitable beneficiary, usually someone other than you or your spouse. It could be your children, grandchildren, other family members, or a trust for the benefit and protection of any of these heirs.

This timing is, in effect, the opposite of the CRT, in which the donor receives current income from the trust assets and the assets go to the charity at the end of the designated time.

Gift tax may be due at the time the assets are transferred to the trust, because noncharitable beneficiaries (your family) will ultimately receive the assets. However, this can often be planned so that no gift tax will be due.

This is because (1) the gift is discounted, as the beneficiaries won't receive the gift for some time; and (2) you receive a gift-tax deduction because a charity is receiving the income from the assets (the deduction is based on the amount transferred into the trust and the amount of time the assets are to remain in the trust).

Furthermore, the gift won't be taxed at all if its discounted value is less than your remaining applicable gift tax exclusion.

Conclusion

If you have a charitable intent and want to reduce current income taxes, capital gains taxes or even estate taxes, then you should seriously consider charitable planning techniques. Often, you and your family will stand to benefit as much as the charity itself.