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Need an alternative to the 1031 exchange? Consider a CRT.

APOTENTIAL ALTERNATIVE to the traditional 1031 exchange is the guaranteed lifetime income trust; technically, a charitable remainder trust. The CRT strategy includes several benefits that often outweigh those of the 1031. This strategy also provides substantial income and estate tax benefits and the potential to receive an increased income compared to selling property, paying taxes and reinvesting proceeds.

The current scenario

Consider a married couple that owns $1,000,000 of income-producing rental real estate as part of an investment and income portfolio. The couple purchased the building 20 years ago for $200,000 and they receive monthly rents of $5,000. ($60,000 annually, or 6%). After accounting for maintenance ($5,000), property taxes ($2,500) and combined federal and state income taxes totaling 40%, the couple may receive net spendable income of about $31,500.

Over time, the couple decides to sell the property to avoid dealing with tenant problems, building upkeep and costs. If they were to sell the house today, they would incur capital gains resulting in nearly $200,000 in taxes (federal and state), leaving about $800,000 to reinvest. An alternative that may be appropriate is to use a charitable remainder trust.

How the CRT works

The Tax Reform Act of 1969 provided IRS code section 664, which listed the requirements a trust must meet to qualify as a CRT. Since its passage, Congress has allowed deductions and forgiveness of tax to those who plan their affairs to include a charitable beneficiary. This beneficiary could be a cause or a family foundation managed by one's children or grandchildren. The mechanics and "math" behind the CRT alternative are described below.

Once the property owners have established a CRT, naming themselves or a corporate entity as trustee(s), they deed the property into the CRT to be sold. This transfer results in zero dollars paid in capital gains as a result of the sale. Since a portion of the value of the property will go to a charity, the owners are entitled to an immediate charitable deduction (depending on their age and other factors, this amount could be between $200,000 and $400,000).

When the property is sold, all proceeds ($1,000,000) can be reinvested in a diversified, conservative portfolio. The trust will provide an income stream based on a preset percentage of the year-end account valuation, the income continuing for the lives of the couple or until the account is exhausted.

Suppose, for example, the couple chooses to draw 7% of the account value per year ($70,000). If the investment account is managed properly, this income will be taxed at long-term capital gain rates (a combined federal and state rate of approximately 22%), resulting in $54,600 net spendable income.

The income from the CRT is almost two times the net amount from the rental asset. Upon the death of the last spouse, the remaining assets of the CRT go to the charitable entity the couple has chosen. This gift avoids all gift and estate taxes that may have been imposed on the property if the couple intended to leave it for children or grandchildren.

An additional strategy that removes the uncertainty of the income stream and the amount left to charity includes a variable annuity as the investment vehicle. Using the income and death benefit guarantees of the annuity allow for a steady and potentially increasing income stream during the term of the CRT and guarantees an amount for the charitable remainderman. However, this income will be taxed at ordinary rates and must be weighed against the potentially more favorable taxation to be realized using a traditional managed account.

For most of our client families, the increase in income, reduction in tax rate, tax deduction, and freedom from the responsibilities of property management are reasons to take advantage of this strategy. However, most families do not want to "disinherit" their heirs.

To address this, we often use a portion of the income from the CRT to purchase a life insurance policy that is held outside the client's estate, the proceeds of the policy passing directly to heirs without taxes or delay. In our example, the couple's original $31,500 annual property income has increased to $54,600, a net annual increase of $23,100.

If the spouses purchase a $1,000,000 life insurance policy on themselves for $12,000 per year to replace the value of the real estate asset, they will provide their heirs with the original inheritance benefit and still have a net increase in monthly income of $11,100. The "asset replacement trust" strategy thus lets donors leverage up the inheritance to heirs by allocating more of the increased income to the ILIT, thereby increasing the corresponding death benefit on a tax-free basis.

Tabulating the benefits

For those interested in an alternative to continual deferral through a 1031 exchange or avoiding paying the capital gain tax, the CRT provides a number of advantages, including:

* No capital gains tax on the sale of property.

* A substantial tax deduction.

* The ability to re-invest proceeds in a tax-free entity.

* Diversification from real estate investments.

* A substantially higher net income.

* Elimination of real estate management time and headaches.

* The ability to design an estate plan that benefits heirs and favorite charitable causes; and that gives the client control needed to minimize or eliminate estate taxes.

The CRT strategy is not an ideal option for those who:

* Desire to continue to participate in the appreciation of the real estate market via 1031 exchange rules.

* Require access to the principle of the CRT above and beyond the income stream provided for in CRT documents.

* Do not wish to make an irrevocable charitable gift.

In sum, the CRT is a great niche strategy that offers significant benefits to clients, their families and cherished causes. When supplemented by an asset replacement trust funded with diversified managed accounts, variable annuities or life insurance, the CRT also affords clients greater control and options than does holding an appreciated (and potentially under-performing) asset subject to income, capital gain and estate taxes.


Why A Charitable Remainder Trust?


* Create a charitable legacy, make a difference

* Cause your children to be recognized (community appreciation)

* Favor a special cause

* Disinherit the IRS as a major beneficiary of your estate

* Achieve a real sense of satisfaction and well-being


* Avoid capital gains taxation

* Control income distributions (amount)

* Tax-free compounding on CRT asset growth

* Lifetime guaranteed income

* Significant tax refund - charitable tax deduction

* Accommodates diversification of assets

* Totally eliminate estate tax assessment

* Protect assets from litigators and creditors

* Upon death, direct assets (trust corpus) to Family Supporting Organization 509(a)3 (wonderful family attributes)

* Charitable tax refund and income from saved capital gains furnish resources to replace CRT charitable gift for heirs.

Benjamin Hill, CFP, CLU, CSPG, is president of Wealth Enhancement & Preservation, Inc., Westlake Village, Calif. He can be reached via e-mail at
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Title Annotation:FOCUS: ESTATE/TAX PLANNING; charitable remainder trust
Author:Hill, Benjamin
Publication:National Underwriter Life & Health
Geographic Code:1USA
Date:Feb 15, 2010
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