Charitable Remainder Trusts (“CRT”) is one of the best-kept strategies in estate planning. When structured correctly, they allow you to sell an appreciated asset and avoid any capital gains. The best part is that you can use them to structure a steady stream of retirement income for yourself. The benefits go on and on.
Even though these trusts are typically established for estate planning, they do allow you to benefit from trust income over your life.
A CRT is a particular type of irrevocable trust that is structured to lower your taxable income.
But CRTs have a few other benefits. They can lower your estate taxes, provide support for charities and provide a stream of retirement income.
How Do Charitable Remainder Trusts Work?
A charitable remainder trust is a specific type of “split-interest” charitable vehicle. This means that the assets in the trust are divided between two beneficiaries: the initial beneficiary (you or someone else you name) and a charitable organization.
So here is how the process works. When the trust is established, the grantor contributes assets into the trust. These assets are usually cash, stock, or mutual funds. But it can also be real estate or certain collectibles.
As a general rule, the grantor would contribute assets that are likely to appreciate. To take it a step further, you would generally want to contribute an asset that has already significantly appreciated. At this point, the terms and provisions of the trust are established.
The next step is to determine how much annual income you want yourself or your beneficiaries to receive as a distribution from the trust. This disbursement must be between 5% and 50% of the fair value of trust assets. You must also determine how long you want to have the trust in place. This could be up to 20 years or the remainder of your life. You also must decide how much you anticipate donating to charities at the trust expiration. This should be at least 10% of the fair market value. However, since the remaining amount residing in the trust at the expiration date is donated to charity, this remaining amount may be more or less than initially anticipated.
Once the trust has been funded, the trustee determines its fair market value and essentially controls them. The trustee will sell assets as needed to cover the required annual income stream paid to you. Assuming the trust allows it, the trustee can also distribute the asset itself instead of the cash.
Upon trust expiration, the remaining assets are distributed to the charities named as beneficiaries.
What is a Charitable Remainder Unitrust (CRUT)
There are two types of CRTs. A charitable remainder unitrust (CRUT) has a few unique characteristics.
The income stream from a CRUT that you or your beneficiaries receive is based on a set percentage of the fair value of the remaining trust funds. This gets revalued each year. This is a significant benefit if you are looking to place appreciating assets into the trust. Assuming the appreciation continues, your income from the trust might continue to grow.
Let’s look at an example. Below are the key provisions and circumstances of a CRUT:
1) you contribute $100,000 of stock and mutual funds;
2) you have named yourself as the beneficiary;
3) you want to receive 10% annually of the assets in the trust;
4) In year one, you receive $10,000 of trust income;
5) At the end of year one, the fair value of the assets is revalued to $150,000. Based on the revaluation, you will receive $15,000 in income during the second year.
Another critical element to a CRUT is that you can make additional asset contributions even after it has been established. Again, this is great if you have other highly appreciated assets. You can make continuous contributions to the CRUT to generate a more retirement income and leave a larger amount to your selected charity.
What is a Charitable Remainder Annuity Trust (CRAT)
Unlike CRUTs, charitable remainder annuity trusts will pay out a fixed dollar amount every year. This amount is locked in and is not based on a percentage of assets.
Looking at the last example, you’re contributing stock valued at $100,000 into a CRAT. Rather than receiving 10% annually, you decide to receive $7,000 annually regardless of the value of the stock.
CRATs make the most sense when you are looking for consistent income. If you need steady income during retirement, then a CRAT might be your best option. The consistent income will give you more control over your tax bracket. This is the opposite of a CRUT because increased asset values will typically mean higher taxable income being distributed to you.
Advantages and Disadvantages of Charitable Remainder Trusts
Let’s take a look at some of the pros and cons of CRTs.
Charitable remainder trusts can be an excellent way to spread the capital gain on certain assets over several years. In addition, you will still have access to the funds from the asset sale.
CRTs also will provide a steady source of income. If you are not named the initial beneficiary, the income stream can benefit a spouse or other family member.
Of course, a CRT gives you a great structure to allocate a portion of your estate to charitable organizations. You are allowed to take a partial charitable tax deduction when you initially fund the trust. This deduction is based on the remaining amount planned to distribute to the charitable organization when the trust expires.
Let’s look at an example of the charitable tax deduction. Let’s assume that when the trust was established, it was assumed that you would leave 30% of the trust assets to charity. As such, you can immediately take a charitable tax deduction on the 30% of the fair value of trust assets you are expected to donate. In addition, since those assets are removed from your estate, you will lower your estate tax liability.
There are a few downsides to a CRT that need to be considered. When assets are placed into the trust, control is relinquished. Because the trust is irrevocable, you cannot alter the terms of the trust once established.
Remember that these trusts are technically tax-exempt. However, they can still generate taxable income. You still have to pay taxes on the annual income that you receive from the trust.
In addition, when the trust sells assets, you don’t have to realize the capital gain upfront. But when the distribution is paid to you, the unrealized gain gets allocated to you.
As an example, let’s assume the trust realizes a $50,000 capital gain from the sale of real estate. Let’s also assume the trust distributes $5,000 to you annually.
The first ten payments you receive are taxed as capital gains until the entire $50,000 gain has been distributed to you. One exception is if the trust generates income with a less preferred rate (like interest income taxed at ordinary rates). The ordinary income will be distributed to you first, with the remaining distribution being capital gain.
Lastly, because the trust is funded with assets, the value in the trust can fluctuate over time. This can impact the income distributed, and there could, in fact, be no assets available for charity upon the expiration of the trust.
A CRT will work great in the right situation. You must closely examine whether you have highly appreciated assets and if you are looking to delay paying capital gains tax on the sale. It also helps if you have a charitable purpose in mind. In any case, CRT might be a great benefit to your estate plan.