Updated: Jan 31, 2019
Reprinted by permission of the Financial Outcome©
Capital Gains Taxes are tearing away your assets.
Bypass that tax predator with a trust that will increase your assets.
In this issue we will examine two scenarios, in which the objective is to find a way to maximize the income from a frozen asset. The question is, which strategy is best? Should the assets be sold the traditional way, or should they be transferred to a capital gains bypass trust?
Scenario #1. Harold Greenfield, age 58, owns a house which originally cost him $100,000. Today, 20 years later, the fair market value is $800,000. Due to rent control, Harold is only able to rent the house for $1,500 per month. He indicated he is tired of owning and managing the property, and would like to sell it and reinvest the proceeds. In selling the house, Harold’s desire is to pay the least amount of capital gains taxes as possible.
Unaware, Harold sells the property in the traditional manner, paying federal income taxes at a rate of 28%. Capital gains taxes amount to $196,000, and will be subtracted from the total proceeds of $800,000. Harold then reinvests the balance of $604,000 with a professional money manager, who projects a total return of 10% per year for the rest of Harold’s life, which is expected to be 29 more years. Harold is in the 36% personal income tax bracket, and he has estimated that if his money manager performs well he will accumulate $3,650,431 on his investment of $604,000. Harold also has the choice of taking an income of $60,400 per year.
This was a good strategy on Harold’s part, to be sure. But could he have done better? The answer is yes.
Notice that Harold was taxed to the tune of nearly $200,000, twice the amount he originally paid for the house.
As in Harold’s case, most people feel that the only way to unlock their frozen assets is to sell them, pay the capital gains taxes due, then reinvest the balance. That is, unless a Capital Gains Bypass Trust (CGBT) is used to protect the assets from the capital gains tax. In fact, a CGBT allows for the sale of highly appreciated assets to bypass 100% of the capital gains taxes. A CGBT, also known as a Charitable Remainder Trust (CRT), is an irrevocable, qualified trust that pays income during the life of the owner, then distributes the assets to tax-exempt charitable beneficiaries.
Since 1969, thanks to Section 664 of the Internal Revenue Code, the use of a CRT has provided relief from capital gains taxes for individuals selling their highly appreciated assets. In addition, it provides an increased income from the sale of the assets, since 100 cents on the dollar can now be invested. A CRT also creates a current income tax deduction and will avoid any future estate tax.
Yield, or the rate of return, is usually increased whenever highly appreciated assets are reinvested by the CRT. Using the full market value of the assets increases the yield by as much as 28%-35%. This enables a person currently earning a relatively low rate of return to have it “beefed up” two or three times.
Scenario #2: John Weltman, also age 58, owns the house down the street, which also cost $100,000 in 1970. John’s house has also appreciated to $800,000, and John is also interested in selling his investment. However, instead of selling his property the traditional way, as Harold did, John, upon consultation with his financial advisor, has decided to transfer the asset to a Capital Gains Bypass Trust. The trustee, who in this case happens to be John, will sell the house and then reinvest the proceeds with a professional money manager, who projects a total return of 10% a year for John’s life expectancy.
A bonus to this transaction is that John will not have to pay any capital gains tax. Instead, John will receive, through the trust, 100% of the proceeds. Through his professional money manager, he’ll receive a 10% total return, equivalent to $80,000 per year, as contrasted with Harold’s income of $60,400 per year, a 32.5% increase per year in income.
In addition, John will also receive a charitable income tax deduction equivalent to approximately $199,000. This will provide him with an additional $71,640 of income tax savings. During John’s lifetime, he will receive an additional $640,000 of total income over what Harold will be receiving and, upon John’s death, will pass on to the charity of his choice an additional $800,000.
Who are the beneficiaries of a CGBT?
In the case of a Capital Gains Bypass Trust, the beneficiaries can be both the grantor or someone whom the grantor chooses, such as his or her children, brother, sister, spouse or anyone else the grantor desires. According to the wishes of the grantor, the recipients can receive income for any period of time, such as their lifetime, or two lifetimes (including spouse and children).
At the end of the term of the trust, the grantor’s chosen qualified charitable organization, or his or her private foundation will become beneficiaries.
Who are the Trustees?
There are three types of trustees:
A qualified corporate trustee, such as a bank or commercial trust company. Although more expensive than other options, the commercial trustees provide the highest degree of independence and stability.
The grantor may name any competent individual to become the trustee, including him or herself.
A qualified charitable organization, with trust powers granted by the state, can be chosen to serve as the trustee.
In all three situations, it is the trustee’s sole responsibility to manage the trust assets, including receiving, selling and reinvesting the assets while distributing income to the income beneficiaries.
What types of assets are best suited for a Capital Gains Bypass Trust?
The best assets to place in a CGBT are assets that are greatly appreciated and ready to be sold by the owner. Another advantage of using a CGBT is that the assets may be placed in an existing trust that may have been set up previously. And a Capital Gains Bypass Trust may be used for future retirement planning.
When deciding to sell highly appreciated assets, it is in your best interest to explore all of the options available, in an effort to achieve the greatest benefit with the least amount of taxes. One of the best options that we have found, one that offers the best financial outcome, is the use of a Capital Gains Bypass Trust.
Traditional Sale $800,000
Capital Gains Tax $196,000
Available for Reinvestment $604,000
Annual Income $60,400
Lifetime Income $1,751,600
Traditional Sale $800,000
Capital Gains Tax -0-
Available for Reinvestment $800,000
Annual Income $80,000
Lifetime Income $2,320,000