Real estate is a popular asset for seasoned pros and new investors alike, and for good reason: The barriers to entry are low, it’s an asset class that has typically grown substantially over time, and there are a long list of tax benefits, including depreciation, the mortgage interest write off, and, most relevant for our purposes, the 1031 exchange. Before we get deep on other alternatives, let’s quickly review what is a 1031 exchange.
What is a 1031 exchange?
The 1031 exchange is a tax planning strategy that allows you to sell an investment property, roll the proceeds into another property, and defer any capital gains — and the associated taxes you would have owed. As a result, real estate investors are able to get out of underperforming assets, sell while property values are inflated — or, put simply, sell when they want — without worrying about the tax implications.
That’s an incredible deal. But it’s not always the right fit. Especially given the current uncertainty in financial markets — and the potential blowback for housing — we are hearing from clients that they would like to get out of investments that have performed well, and they want to diversify rather than roll their proceeds into another real estate investment.
What tax advantaged alternatives for real estate are there?
Fortunately — and unsurprisingly if you’ve been following this space — there is a solution that carries many of the same tax benefits of the 1031 exchange, but with more flexible reinvestment options: the Charitable Remainder Trust.
As our regular readers will know, a Charitable Remainder Trust (CRUT) is a tax-advantaged account kind of like a traditional IRA. When you place an appreciated asset into a CRUT and then sell it, you owe no capital gains taxes. Instead, you get to keep your gains and reinvest them for the long term. Then, when you take distributions from the trust, you’ll pay those taxes. It’s a powerful tax-deferral move that can earn you an extra 50% or more.
How can a Charitable Remainder Trust can help you earn millions more when you sell appreciated real estate?
Our client Laura invested in a Los Angeles property 13 years ago with her partner. She paid $750,000 — those were the days! — and it’s now worth $3,500,000. Laura would like to sell her property, and while she has considered further real estate investments in the past, given the current climate she’d rather invest her gains in a diversified portfolio of assets. (Though, importantly, she can always return to real estate over time; the investment options out of a CRUT are virtually endless. More on that in a bit).
Laura will earn about $2,750,000 in capital gains from her sale. If She just sells the property outright, she’ll owe about $1,000,000 in federal and state taxes on those gains. That number is too big to stomach, so Laura would like to do some tax planning. She has considered a 1031 exchange, but the gains from this sale are a large portion of her net worth, and she doesn’t want to invest that amount solely in real estate right now, so she has ruled out a straight exchange, as well as the relatively illiquid (and high-cost) Opportunity Zone for the same reason. Instead, she has chosen to set up a Charitable Remainder Trust.
How would that work? Let’s jump into the numbers.
BTW, check out our comprehensive guide on CRUTs for a good grounding in how these can help real estate investors with their tax bill.
Recapping the numbers
Cost basis: $750,000
Current value / Expected sale price: $3,500,000
Capital gains: $2,750,000
Chosen trust: A NIMCRUT that runs for Laura’s life and then after she passes away the shorter of 20 years or both of her kids’ lives
Distribution plan: Laura and her family plan to withdraw about 5% of the trust’s assets per year and then a lump sum at the end of the trust. (They chose a NIMCRUT instead of a Standard CRUT because they want the option to defer distributions in the early years in order to significantly increase their returns.)
Additional after-tax earnings over 45 years: $6.2 million, or 40% additional distributions
Immediate Charitable Deduction
The first benefit Laura will receive when she puts her property into a CRUT is an immediate tax deduction. There’s some complicated math here mandated by the IRS, but the bottom line is simple: She’ll get to deduct about 10% of the current value of the property she puts into the trust. In this case, that’s a $350,000 deduction on her ordinary income. Since she lives in a high-tax state, the tax savings are substantial: That $350,000 deduction translates into cash savings of about $175,000.
No Taxes On Sale
So Laura starts about $175,000 ahead of the game. The biggest benefit of a CRUT, though, is that Laura gets to defer all of the taxes—state and federal—she would otherwise have owed on her big gain. Instead of paying that $1,000,000 we calculated above, she’d get to keep that money and invest it inside the trust.
We’re starting to see the numbers take shape, but there’s one more important data point we haven’t gotten to yet: How does Laura plan to use her money?
One of the first questions our customers ask us is the following: “These massive absolute gains are great, but will my money be locked up for the entire term of the trust? The answer, emphatically, is “No.”
There are many ways to get liquidity out of a CRUT, and we discuss them in some depth here. But the simplest answer is that, due to the structure of NIMCRUTs, Laura will have access to a growing share of her money every year, starting as soon as she sells her property.
Assuming, for the reasons we discussed above, that Laura chooses a NIMCRUT, how much money would she have at her disposal every year? The answer is actually pretty simple: Every year after she sells her property, she’ll be able to cash out a set percentage of the trust’s current value. For a term trust, it’ll be around 11%; for a lifetime trust, it depends on her age, but it’ll probably be between 5% and 8%. That’ll mean that, with a lifetime trust, she’ll be entitled to a payout of around $200,000 per year, and more as she reinvests her earnings and the trust’s value grows.
One technical—but very important—note here: Because Laura chose a NIMCRUT, these annual withdrawal allowances are cumulative; if she decides not to pull out in any given year, that amount goes into her “make-up account,” and she can draw on it in a future year. So if she doesn’t touch her money until year 5, she’ll actually have more than $1 million at her disposal (the sum of the available payouts in years 1 to 5). Within 10 years, it’ll be more than $2.5 million.
What would all of these tax savings, investment gains, and withdrawals mean for Laura’s bottom line? After 45 years (the expected length of the trust based on IRS estimates), if Laura has her money in a Charitable Remainder Trust, she and her family will end up with about $21.8 million in total payouts. If, instead, Laura had kept her money in a regular, taxable investment account, she would have instead ended up with about $15.6 million.
In other words, by leveraging a CRUT, Laura and her family are able to pocket an extra $6.2 million. In addition, Laura and her family will create an additional $11 million that they will use — consistent with the CRUT’s charitable mandate — to support causes they believe in.
For investors looking to exit their investments and diversify beyond real estate, Charitable Remainder Trusts can be a great tax advantaged option that can benefit the investor, future generations, and important charitable causes.
Find out which assets are a good fit for a Charitable Remainder Trust! Access our tax saving calculator to evaluate the potential return on investment given your situation. And if you have any questions, contact us through our chat button below, or scheduling a meeting with us.
We have built a platform to give everyone access to the tax planning tools of the ultra-rich like Mark Zuckerberg (Facebook founder), Phil Knight (Nike founder) and others. Valur makes it simple and seamless for our customers to utilize the tax advantaged structures that are otherwise expensive and inaccessible to build their wealth more efficiently. From picking the best strategy to taking care of all the setup and ongoing overhead, we make take care of it and make it easy.