Last year, we were hired by a lovely couple to advise them on the investment of assets and updating of their estate plan. Thirty days prior to hiring us, they had closed on the sale of $7.5 million worth of real estate and a business. Ugh!
While we were delighted to have them as new clients, our goal is always to build a “fence at the top of the tax cliff” for clients BEFORE they have a liquidity event. Most often we can either completely eliminate taxes on the sale of an appreciated asset – or at a bare minimum – defer the recognition of tax for 30 years.
But . . . what do you do when someone has already gone over the tax cliff – already having sold the asset? What can they do then? Fortunately, we know how to build nets and bring an ambulance to the valley floor quickly . . . as we did for them.
Because we were still operating in the same tax year, we were able to introduce several techniques/strategies that reduced their tax bill from an estimated $2.2 million to “just” $937,000. That is STILL a lot of “involuntary philanthropy” to pay when it could have been $0 had we begun helping them before the sale. Nonetheless, they were thrilled with saving $1.2 million in taxes. Gotta say . . . I would be, too! Not only that, we created an additional income stream to them for the rest of their lives.
So . . . just how did we reduce taxes – increase income – and bless others all at the same time . . . even AFTER the sale was completed? “Imagine That™!”
Tax Savings Idea #1 (With Income)
There is a philanthropic planning idea first created in the 1969 Tax Reform Act – and that received a “fresh coat of paint” in 2017. The donors will receive an income for the rest of their lives from a diversified pool of assets inside a tax-exempt – creditor protected – trust. This trust is ideally created prior to the liquidity event but can be created post-sale as long as it is the same tax year. As an independent Registered Investment Advisory firm, we then allocate the proceeds into various investments depending upon the client’s need for current income versus future income. In our clients’ case, they are receiving an income of approximately 5% per year. Since the trust principal will likely grow over time, they will receive an increasing income stream as well.
In addition to receiving income for the rest of their lives, our clients received a tax deduction of over $1.6 million by placing $2 million into this special trust in the same tax year – 2019. Why? Because when the second spouse dies, the remaining assets are given to charities selected by the donors. Great news! This has been their plan all along – they just didn’t receive any tax benefits for making the commitment to give post-death what we obtained for them. Further, they are not locked in but can potentially change charitable beneficiaries if they choose to. This can also include their own “Family Giving Fund” should they wish to continue their legacy of giving to future generations. (Note: if a charitable organization is named irrevocably, charities can recognize the gift in the year it was made for donor recognition purposes should that be important to the donors.)
What’s So Attractive About Tax Savings Idea #1?
There are six main benefits of using this planning strategy:
- Income for Life—the tax-exempt trust pays an income to the donors for their lifetimes. Moreover, this specialized trust can name income beneficiaries up to three generations and thus provide income to children or grandchildren as long as they are living when the trust is first created
- Large Income Tax Deductions—assets placed into the tax-exempt trust generate an income tax deduction in the year transferred. The deduction is based upon donor age(s) as of the time of transfer – using the IRS table of estimate life expectancy – which gives an estimate of how many years they will likely receive income. For example, as said above, our clients received a tax deduction of over $1.6 million from contributing $2 million into the special trust! This huge deduction was possible because they were in their late 70s/early 80s and desired income over their lifetimes only. Had they wished to have income continue to future generations, the tax deduction would have been less – although still quite significant. Tax deductions can be so large that it exceeds the amount which can be taken in a single year. Not to worry! Deductions can be taken over six tax years if needed – the current gift year and up to a five year “carry-forward”
- Eliminates Capital Gains Taxes on Appreciated Assets—a contribution to the tax-exempt trust avoids capital gains taxes on appreciated assets if transferred sufficiently in advance of a sale. For example, if you own appreciated stock or real estate, in most cases, you can transfer the asset into the tax-exempt trust and eliminate capital gains taxes completely. This gives more principal to be invested and thereby generates more income to be paid out! (Note: States vary on how long the assets have to “reside” in the trust before it can be sold without tax. Generally, this will be 2-3 months but ideally, longer is better. If a sale is expected prior to your contribution of real estate to the tax-exempt trust, the terms of the sale should still be under negotiation. The documentation must not have proceeded to the point at which the IRS would consider it a prearranged sale)
- Eliminates Federal Estate Taxes on Assets in the Tax-Exempt Trust—because the remaining value of assets will go to your own Family Giving Fund or other philanthropic outlet, the value of the remaining assets in the tax-exempt trust is not subject to the present 40% Federal estate tax. (If the income stream, however, is multi-generational, the present value of the future income stream will be included when tallying the value potentially subject to Federal estate tax)
- Income Received Retains its Taxable Category—income received from the tax-exempt trust retains its taxable category. That is, ordinary income from dividends and interest is taxed as ordinary income, but long-term capital gains income is taxed in a (presently) lower tax rate. This is not true of income from retirement plans where all income is taxed as ordinary income! For people trying to minimize taxes on ordinary income, shifting asset composition to long-term capital gains income will help reduce taxes. Also, because the tax-exempt trust generates a high tax deduction (69% for a male age 65, and 62% for a married couple age 65 in 2019), the taxable income can be further offset by the significant tax deductions generated to be taken for as long as six tax years
- Supporting Charities—after both donors (or income beneficiaries) die, the remaining assets are distributed to charities the donors wish to support – and remember – this could be your own Family Giving Fund or private foundation
Are There Drawbacks To Using Tax Savings Idea #1?
There are a few possible drawbacks when choosing this planning idea:
- Income Can Vary—receiving lifetime income is a great perk but the amount of income received can vary depending upon the investment environment. The income will obviously depend upon what types of investments are chosen and whether the client is looking for more income now or in the future
- Items of Contribution May Be Limited—depending on the tax-exempt trust you are interested in, some trusts only allow donations of cash, publicly traded stocks and bonds, and shares of mutual funds. We, however, utilize charitable organizations that will also accept appreciated real estate or a privately held business or restricted stock. This gives you more options for donating assets prior to the sale, paying no tax on the sale, and then reinvesting the proceeds to generate income – potentially for generations
- After the Last Income Beneficiary Dies, Remaining Assets go to Charity (Not Family)—The primary question to explore up front is, how much of your estate do you wish to go to your heirs after you are gone? For many clients, this is not an issue with using the tax-exempt trust. When it is, however, we have been able to use a portion of the tax savings and increased income from the tax-exempt trust to purchase life insurance on the donors – or even the next generation. Placing the insurance in an “Asset Replacement Trust” allows the donors to replace the value of the assets going to charity, and do so in a vehicle that protects beneficiaries generationally against divorce, creditors, Federal estate taxes, IRS, etc.
Tax Saving Idea #2 (Without Income)
Our clients planned on giving their home to three different charities upon their deaths. Again, another lovely and thoughtful gesture, but one for which they had not received a current tax benefit . . . until we came along. We filed a document with the County Recorder’s Office in San Diego where the home is located. Our clients get to live the rest of their lives in the home and have the full use of the home just as before. Upon the death of the second spouse, however, the real estate automatically transfers to the three charities our clients wish to benefit . . . and without having the cost and delays of going through probate proceedings. Two of the charities selected by our clients are well known (The Salvation Army and Goodwill Industries). The third charity is a more regional animal rights organization, Best Friends Animal Society, which has its main office in Utah, and the closest location to us is in Los Angeles.
By simply naming a non-profit organization as the beneficiary (or three in our clients’ case), they received a $1.3 million tax deduction on their federal and state tax returns. The actual calculation of the tax deduction is complicated and beyond the scope of this article but takes into account many factors, including age(s) of the individual(s), value of the real estate, original purchase price of the real estate (called “basis”), value of the building(s), estimated life of the building(s), and salvage value of the building(s).
What Are The Pros Of Using Tax Saving Idea #2?
There are at least five pros of using this planning strategy:
- Can Live Elsewhere—the life tenant(s) as they are called, does not have to live at the property
- Entitled to All Income—the life tenant(s) is entitled to receive all income from the property if some or all the property is rented out
- Won’t Affect Medicaid if Properly Done—naming a charity as the “remainder beneficiary” of the real estate will not create issues with receiving Medicaid benefits. This is true as long as the transfer occurred more than your state’s “look-back period” before you applied for Medicaid. The “look-back period” is 5 years in all states, except California, where it is 30 months
- Income Tax Deduction—naming a non-profit as a remainder beneficiary in the document recorded at the County Recorder’s Office results in an income tax deduction in the year of the transaction for federal and state tax returns. If the deduction is greater than can be taken in one year, it can be carried forward for up to an additional five tax years
- Avoid Probate—avoids the cost and delays involved in probate court proceedings
What Are The Cons Of Using Tax Saving Idea #2?
There are potential cons one should be aware of when looking at whether this may be a good option:
- Must Pay All Expenses—the life tenant(s) must pay all expenses for the real estate, including real estate taxes, maintenance, repairs, insurance, and homeowners association fees for a condominium
- Reduction of $250,000 Capital Gains Tax Exclusion Per Spouse—the life tenant(s) does not receive the full income tax exemption normally available when a personal residence is sold
- Less Control—the life tenant(s) cannot unilaterally sell or mortgage the property. They will need to have the remainder beneficiary agree to the sale or mortgage and the remainder beneficiary will be entitled to part of the proceeds
- May Lose Medicaid Eligibility if Done Too Close to When Applying—if the document recorded at the County Recorder’s Office is recorded less than your state’s “look-back period,” which is 5 years for all states, except California, where it is 30 months, you may lose Medicaid eligibility
Conclusion: You CAN Reduce Taxes, Receive Income And Do Good for Others!
If you are interested in creating more tax deductions and receiving lifetime income, consider using Tax Savings Idea #1. This updated tax-exempt trust is one of the brightest tools/strategies for sophisticated clients looking for a better answer to the question, “How can I sell my appreciated asset(s) and not pay taxes on the gain?”
If you own real estate, consider using Tax Saving Idea #2, which permits you to enjoy the use and benefits of the property during your lifetime. This will create a sizeable tax deduction and will benefit a non-profit organization when you are gone – which can be your own Family Giving Fund or private foundation.
No two clients are the same, however. They all have different needs and goals. Please contact us to have a complimentary conversation about your situation. We can discuss the above strategies as well as many more that could apply to your circumstances and help reduce your tax bill. At the same time, we can assist in balancing your charitable goals with your financial plans – directing money for good that would otherwise have gone to “involuntary philanthropy” also known as taxes!
It is possible to do well by doing good . . . “Imagine That™!”
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Written by R. J. Kelly – October 2020
Image by 3DConcepts on shutterstock