Charitable Remainder Trusts (CRT’s) – The Exit Strategy for Charity of Your Choice!

A CRT is a trust established for the benefit of a charitable organization under which the trustor receives income from an asset for a set number of years or for the trustor’s lifetime. It is a tool that enables you to reduce or virtually eliminate capital gains tax on the sale of an asset funding the CRT, claim an income tax deduction, or receive income and make a gift to the charity or charities of your choice. Upon the termination of the trust, the asset reverts to the charitable organization. The trustor receives a charitable contribution deduction in the year in which the trust is established, and the assets placed in the trust are exempt from capital gain tax.

Tina Colson: Hi, I’m Tina Colson with Equity Advantage. I’m thrilled to be here today with the Lon Dufek, senior manager of the Office of Gift Planning with Providence Foundations of Oregon. When our clients are ready to sell their properties and retire, they’re always hit with this heavy capital gains tax. The good news is we have a variety of options and end games to offer those clients to help mitigate the tax consequences.

We brought Lon in today because he is a well-known expert in the planned giving arena of charitable remainder trusts, CRTs as we’ll call them today. It’s an excellent strategy for our investors for, again, that end game piece.

Tina Colson: Lon, CRTs are so technical. Can you briefly tell us about yourself and what led you to working with the CRT in your field?

Lon Dufek: Well, I graduated from a college way back in 1976, over 40 years ago now, and before my graduation I began to work as an intern at a charitable foundation in Arizona, in Phoenix. I was hired full time immediately out of school, and I became acquainted with CRTs as far as I was responsible for the accounting of the CRTs, the administration, and also the filing of the tax returns. Then during the time I was there, for about 13 plus years, I began sharing CRTs with some of our supporters who held real estate and they were very impressed by the benefits. We’ll talk about the benefits of a CRT here in a second, but there are very nice benefits of CRTs as far as charitable planning is concerned.

Tina Colson: Great. That just leads me into the next question, is what is the benefit to our investors when using a CRT as an exit strategy?

Lon Dufek: Well, if you look at real estate investors, typically they have held their property for a number of years and so that property has appreciated over a long period of time. Due to the depreciated cost basis, there’s a large capital gain involved in those assets and so they’re typically involved in a situation where they come to me and say, “I really don’t want to pay this capital gain tax when I sell the property. Is there some methodology that I can sell it and avoid that tax?” I say, “Well, let me talk to you about a CRT, which basically has three major benefits.

The first is that you’re able to bypass the capital gain tax, the second is that you’re able to receive income for typically lifetimes and that income is typically more than the net rental income than you were receiving before, and then the last major benefit is the charitable deduction.” I like to emphasize that there are three major benefits of a charitable trust. I like to say they’re BIC. The B stands for bypass capital gains, the I stands increased income, and the C stands for charitable deduction.

Tina Colson: Excellent. Let’s talk about that. Can you give an example of how the BIC would come into play on the sale of property?

Lon Dufek: Yeah, sure, I’d be glad to. Let’s take an example where you have a couple, aged 70, they’re looking at exiting out of some of their properties. Say that they have a rental home that’s worth $500,000, and their cost basis, let’s say it’s $100,000. If they were to go to sell that property, they would incur a capital gain of $400,000. If you look at the capital gain rate, state and federal combined, you’re typically looking at about 30 to 33%, so they would actually pay a capital gain of $120,000.

I like to say to people, “Well, do you want to benefit the IRS or do you want to benefit your favorite charity with that tax?” I had one gentleman say, “Well, that’s a no-brainer. I would be glad to send that tax to my favorite charity.”

Looking at this example, what a person does, or in this case, a couple, what they would do is they choose a payout rate. A payout rate on a CRT has to be at least 5% or above. Let’s assume that they choose a payout rate of 5%. They would receive about $25,000 per year, that $500,000 times 5%, for the rest of their lives. Then they also receive a very nice income stream. That $25,000, as I explained before, is typically more than a net rental income than they were receiving previously. Then they also receive a nice charitable deduction as well, and the charitable deduction in this case is about $203,000.

Lon Dufek: So not only do they get a bypass of the capital gain, but they get some substantial income tax savings as well. If they’re in about a 35% tax bracket, that actual income savings is about $70,000.

Let’s get back to the BIC. First of all, in this case, they bypass the capital gain tax of $120,000. The I is increased income, to $25,000 per year, and that will vary on a year-by-year basis. Then the C is your charitable deduction, which is about $203,000. So very, very nice in benefits, as you can see.

Tina Colson: Absolutely, that’s great. There are different types of CRTs that I’m aware of. Can you give us a brief overview of the different CRTs?

Lon Dufek: Sure.

Tina Colson: Which is the most widely used and why?

Lon Dufek: Okay. There are actually two major types, and there’s some subtypes as well. I won’t get into the subtypes, but the two main types are the charitable remainder annuity trust, we sometimes call that a CRAT. That provides for a fixed income over the term of the trust and annuity, an annuity by definition is typically a fixed income stream. Then the other one is a charitable remainder unitrust, sometimes called a CRUT, and that provides for a variable income. On each January 1, the trust is valued and whatever the value is, is multiplied times the trust payout percentage. Those are the two major types, and as I said, there’s some subtypes of unitrust as well, but for our discussion, just looking at CRATs and CRUTs.

Tina Colson: Okay, that’s great. With this, are there any limitations to the type of property that can be used to fund the trust?

Lon Dufek: Yes. First of all, the most important aspect of a property that we look at is that it needs to be free and clear, or unencumbered. No mortgage on the property, because according to IRS regulations, you cannot put an encumbered asset into a charitable trust. But all types of property can be used. It can be commercial property, it could be warehouses, apartment buildings, office buildings, in which we’re sitting right now. I’ve done residential rental property, I’ve done vacant land. Even in the case of LLCs, you can put an LLC interest into a CRT as well.

What’s nice about a CRT too, is that suppose that a real estate investor has a property worth a million dollars and they’re thinking, “You know, I don’t really want to put the full million dollars into the CRT,” and so I say, “Well, you can do an undivided interest.” Say that you want to do an undivided interest of 50% into the CRT and retain 50%, so when the property sells, the investor receives $500,000 and then $500,000 is used to fund the CRT. That can work out extremely well because the capital gain tax that he owes on the portion that he kept, the 50%, is typically offset, the tax on that portion is offset by the charitable tax deduction.

Lon Dufek: Most of the time, because of the BIC benefits, charitable trusts, CRTs, are funded with appreciated property so they take advantage of that benefit. You can also put other types of property, like tangible personal property into a CRT, like antiques or I’ve seen vintage autos being put into a CRT. That works extremely well. The tax benefits are very complex in that case, but that can be done as well.

Tina Colson: You know, there was a beautiful time when we were able to use personal property, such as vintage autos, within the 1031 exchange world, but that is all changed to these days.

Lon Dufek: I see.

Tina Colson: It’s all real property. Okay, we’ve got an investor, he’s looking for that end game exit strategy. They decide to go with the CRT after talking with you and they’ve gotten their illustration. I guess my question would be, at what point within their decision process should they reach out to you, or is there a time limit where they can no longer do a CRT as an option?

Lon Dufek: Yes, there is. That’s a very good question. I’ve had people come to me and say, “I heard about the CRT idea, but my property is in escrow, will that work?” The answer is no. The property needs to be put into the trust before there’s a purchase contract signed. Basically, the rules state that you cannot have a designated buyer and a designated sales price prior to creating the charitable remainder trust.

It’s important to put the property into the trust, to establish the trust, put the property in prior to listing the property. That’s the best time period in order to set up a CRT. Put it in before, because if you put it in and you have a sale, you have a purchase contract, the IRS looks at that as a completed sale, which means that the investor would be subject to the capital gain tax, which would not be a good result in this case. Prearranged sales are not good, you need to do it before. I would always encourage people to set up a CRT, transfer the property into the CRT prior to listing the property.

Tina Colson: Great, and because these are such a technical vehicle as well, I’m sure that you have many conversations with clients prior to everybody just saying, “This is what I want to do. I’m ready to step in.”

Lon Dufek: Yes, that’s true. That’s true. Mm-hmm (affirmative).

Tina Colson: Gotcha. One of the things that I also think about is the beneficiaries. Many people, especially when you get into a charitable situation, the children may object. Is there any option with the CRT to make sure that the children can also benefit from the CRT moving forward with the payouts that are coming from that?

Lon Dufek: Yeah. One of the main concerns in setting up a CRT is you’re basically disinheriting the family with that property. Let me ask her the question this way, let’s look at the terms of the trust. A CRT can be set up for a lifetime or lifetimes or multiple lifetimes. It can be set up for a set term of years up to 20 years. It can be set up for lifetimes plus a term of years up to 20 years.

What I’ve seen with parents is that they say, “Okay, I want to set up a CRT for our lifetimes,” say it’s mom and dad, “Plus a term of years for the children.” Take a million dollar trust, once again. If an investor sets up a million dollar trust and they say, “Hey, I want my children to eventually receive a million dollars in income from this trust,” then you could set it up for mom and dad’s lifetime plus a 15-year period.

Just based upon projections, you will see that those children will eventually receive a million dollars in income. Basically, they replaced the asset that way. Sometimes that works out really well, because some parents don’t want to give a million dollars to their kids in one lump sum because they might just spend it, whereas if you give them income over a period of time, they like that planning strategy.

Tina Colson: Yes. I would like to know how many of you know children that would spend the money right away. One of the other thoughts that I had is with the charities involved, and again, the technical vehicle of a CRT. Do all charities except a CRT within their organization?

Lon Dufek: Sure, most charities have gift planning officers like myself, but some don’t, but all charities would be more than happy to talk with you about a CRT because ultimately the asset’s going to go to that particular charity or charities. So all charities will talk to you about that, but when you talk about the CRT process, if you will, and looking at the steps of a real estate-funded CRT, it’s actually quite complex.

You want a knowledgeable and experienced gift planning officer that can walk you through that process, because what you have is you’re looking at the drafting of a trust agreement by an attorney, you’re typically working with a title company to transfer the property into the CRT, then you have a realtor or a broker that’s going to sell the property. Then ultimately you’re going to sell the property, the proceeds are going to be reinvested by the trustee and the trust is going to last for a very long period of time. Eventually, the asset is going to go to a charity down the way.

Lon Dufek: So it’s important to work with an experienced planned giving officer or gift planning officer that knows how to do this and what the process is so that they can walk them through it and work with the professional advisors, provide projections and illustrations and those kinds of things as well, so that all their questions are answered so that they can make an informed decision upfront.

Tina Colson: Right. Now with Providence, I know that you can run illustrations, you don’t charge for your consultation, and again, that’s all free of charge to the client should they need some information from you upfront to learn more about the CRT process.

Lon Dufek: Yeah, right. That is correct. I’m a CPA and CFP by background, and so I’ve worked with a number of CPAs and attorneys as well in walking through projections. I give them the charitable tax deduction calculation so that they can run their tax projections as well. It’s very important that I work directly with their advisors so that we’re all on the same page when that decision is ultimately.

Tina Colson: Good, that’s great. Are there any other final thoughts that you would like to share with us today?

Lon Dufek: Yeah. One of the things that I emphasize when I’m talking about charitable trusts, in that there are basically three methods to sell property. You can sell property, first of all, right, and pay the capital gain tax. Two, you can use a like-kind exchange, which is a great vehicle to use, a like-kind or 1031 exchange. Then the third is the CRT, but the CRT is not very popular or understood. In fact, most brokers and a number of CPAs and attorneys have not worked with CRTs.

Therefore, when an investor has a piece of property that they go to their advisor and they ask them, “Okay, I’m going to sell this property,” and they said, “Well, you have two alternatives. You can sell it and pay the tax or do the like-kind exchange.” Well, we can always add that third option and look at that option and see if that may benefit the individual as well. Because when you look at these BIC benefits, bypass the gain, increased income and charitable deduction, people look at that and say, “Wow, that is really a nice method to sell my property.”

Lon Dufek: The last thing that I would say is that I really believe in the essence of CRT planning, primarily because you’re benefiting charity. You get to choose your charity or charity, you can name one charity, or you can name a number of charities. I have a number of CRTs that have five or six charities that will ultimately receive those assets.

Tina Colson: That’s great.

Lon Dufek: What’s nice about this is that it’s a win-win for everybody. It’s a win-win for the person because they have the nice benefits with the CRT. It’s a win-win for the charity as well, because ultimately they’re going to receive a very nice gift. I always emphasize the charitable intent behind this as well, because that’s very important. The economics are wonderful with the BIC benefits, but the actual making of a gift is a feel-good sort of situation that the investor really likes.

Tina Colson: That’s the priceless part.

Lon Dufek: Yeah, right. That’s the priceless part. I work with a donor that they had never heard of this before and they had two duplexes. When I walked through the illustration, I go, “Well, would you like to do this?” and he says, “Certainly, because I’m not only benefiting myself and my wife and not paying this huge capital gain tax, but I’m benefiting my favorite charity as well.”

Tina Colson: Yes, I love that. Great advice from the expert. Lon, you are a wealth of knowledge. I’m so glad that you came in for our Ask the Expert segment today with me. Again, I’m Tina Colson with Equity Advantage. Our special guest, Lon Dufek from Providence Foundations of Oregon. If you are an investor looking for an exit strategy, obviously this is just one more great option for you to choose from, that not only will you get a lifetime income, but also that charitable deduction and you can leave a legacy with your favorite charity.

If you would like more information on this, please reach out to us. Again, our number, 503-635-1031. Or you can go to our website at 1031exchange.com. Again, thank you, Lon.

Lon Dufek: Thank you, my pleasure.