Federal estate tax rates begin at 37% and rise very quickly to an effective rate of 60%. While no tax is due on the first $650,000 of property, the remainder is taxed very heavily. And the tax has to be paid fast – within 9 months of a person’s death. Poorly planned estates can lose over half of everything they own to the government … and it happens all too frequently.
The solution to that problem – the way to keep your property in your family and not let it go to the government – is by taking firm steps now to reduce estate taxes to the smallest reasonable amount and then to develop a way to pay them.
Sometimes the best way to reduce your estate taxes and protect your assets is to give them away to a charity. That may sound funny … how can you keep something by giving it away?
Let’s imagine that your own a piece of property that’s turned into a real pain in the neck … almost everyone does. Maybe the property’s become hard to manage – like an apartment house. Or maybe it’s paying a very low return compared to its value. Or you might have all of your eggs in one basket – one kind of stock or one piece of real estate – and you want to diversify your assets for the safety that provides.
You’d sell that asset in a minute if it wasn’t for the capital gains tax. But, it’s gone up a lot in value … you’ve probably had it for a long time … and the idea of losing up to a third of it in income tax just kills you. Is this starting to sound familiar? If it is, here’s a way out of that problem.
Trapped by leaking toilets Let’s visit Harry and Catherine Baxter. They’re both in their early 70s and they have a $5 million estate. They’re in a 36% income tax bracket and a 55% estate tax bracket. They want to start taking life a little easier, except they can’t. They’re trapped by an apartment house which Catherine inherited from her father 30 years ago.
The apartment house is worth $1 million dollars but its upkeep and management takes an awful lot of their time. And with the costs of repair, property taxes and other expenses, they don’t really make very much money from it … only about $30,000 per year. “A 3% return and I have to fix the toilets!” mutters Harry.
They’d sell the apartments in a minute but there’s a catch. Since it was only worth $100,000 when Catherine inherited it from her dad, if they sell it they’ll have to pay a capital gain tax on the $900,000 gain. Add a 28% federal capital gain tax rate to maybe a 5% state income tax rate and you have a tax of $300,000.
“$300,000!” said Catherine, “I’ll take that place to my grave before I’ll give the IRS $300,000!” Catherine, as you can tell, does not like to pay taxes.
Actually, she’d be better off if she did. Remember, they’re only getting $30,000 a year from the apartment house now. If the Baxter’s just paid the tax and reinvested the remaining $700,000 at, say, 8% – they’d get $56,000 of income a year. But that doesn’t matter … Catherine just can’t stand paying $300,000 in taxes so she’s not going to sell it. Looks like poor Harry will still have to keep fixing the toilets.
Well, maybe not. In fact, there’s a solution that eliminates all of the tax, all of the headaches and leaves both the Baxter’s and their family much better off financially.
The Charitable Remainder Trust The solution is for the Baxter’s to establish a Charitable Remainder Trust. Here’s how that works. The Baxter’s establish a trust that has four parties: the Trustmakers – that’s them; the Trustee – they can be the trustees too; the Income Beneficiaries – that’s the Baxter’s again; and the Remainder Beneficiaries – that’s one or more of their favorite charities.
Once the trust is established, the Baxter’s transfer the apartment house to it. And once it’s in the trust, they sell the apartments for $1 million. Neither they nor the trust pays any income tax on the gain.
Next, they invest the proceeds in a portfolio of stocks and bonds – a portfolio which produces a return of 8% or about $80,000 per year. That’s $50,000 more a year than they were getting from the apartments.
Every year the trust will pay $80,000 to the Baxter’s and they won’t have to lift a finger. And they won’t have to pay a dime of capital gains tax, either. In fact, assuming that the applicable federal interest rate is 7% when they make their gift, they’ll get a charitable deduction of about 351,000. Since they’re in a 36% tax bracket, that deduction will create up to $126,000 in income tax savings. The exact amount of the deduction will depend on the amount of the gift, the amount of income they keep, their ages and the prevailing federal interest rate at the time of their gift.
So, here they’ll be, with no capital gains tax, no more toilets to fix, $50,000 more income per year than they’ve ever had before and up to $126,000 in income tax savings. So far, how does it sound?
“Well, OK,” you say. “But what happens to the $1 million portfolio when the Baxter’s die?” That’s easy. The $1 million will go to the charities that were named as the Remainder Beneficiaries in the trust. The charities could be their college, their church or even a local hospital; they just need to have 501(c) 3 federal tax status.
The Wealth Replacement Trust “Yes, but what about the kids?” you say. “If Harry and Catherine give away their apartment house, won’t the children be left out?”
We can take care of the children very neatly. In fact, they’ll wind up in much better shape if their parents give the apartments away to the charity than if they keep them or sell them. Here’s why.
If the children get the $1 million apartment house along with the rest of their parent’s estate, they’ll pay an estate tax of $550,000 on the apartment house by itself. That will leave them with only $450,000.
If Harry and Catherine sell the apartments and pay the $300,000 capital gain tax, the kinds will eventually get the $700,000 portfolio but, after paying $385,000 of estate taxes on it, they’ll end up with only $315,000.
But if Harry and Catherine establish an Irrevocable Life Insurance Trust, at the same time they created the Charitable Remainder Trust and have the Insurance Trust buy a $1 million policy on their lives to replace the $1 million apartment house which they put in the Charitable Trust, then the kids will wind up getting $1 million in cash. And when they do, they won’t pay a dime in either income tax or estate tax.
The insurance policy isn’t free. Since the Baxter’s are in their early 70’s, they premium on a $1 million policy will be about $30,000 per year. But the Baxter’s will also have an additional $50,000 per year in income and tax savings of about $126,000. So, even they make the gifts to the trust to pay the premiums, they’ll still be way ahead.
If they sell the apartments and the children get the stock portfolio, they’ll only net $315,000. But if they get $1 million from an insurance trust, they won’t pay a dime of income tax or estate tax and they’ll have a full $1 million. In cash. Guess which choice the kids vote for?
Finally, if the Baxter’s either keep the property or sell it, their charity won’t get a dime. But if they put the apartments in the charitable trust, their charity will get $1 million, just like the kids did. Again, no income tax and no estate tax.
And the charity will probably name a new wing or building after them. Baxter Hall … has kind of a nice ring doesn’t it?
The bottom line is that Charitable Remainder Trusts are one of the best estate planning tools in existence. It’s a tool where the donors win, their families win and their charities win. So, if you’re serious about keeping money in your family … if you don’t want to send it to Washington, then the Charitable Remainder Trust is an option which you have to consider.
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