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Guide to Tax Planning for Realized Gains and Ordinary Income from Valur

Why is tax planning important

Tax planning helps you keep more of your hard-earned gains by reducing your applicable taxes. Unfortunately, most people are unaware of how impactful tax planning could be and that it could boost their investment returns by 40% or more! The goal of tax planning is to make sure there is tax efficiency and it should be essential for anyone´s financial plans, but what exactly is it?

Tax planning is the process of analyzing and preparing a financial plan or a situation from a tax perspective that helps you to legally minimize how much you pay in taxes to help you keep more of your earned money, both for your use over time and to build your wealth for the long term.

How does Valur come in?

We know there’s nothing simple about taxes, so Valur is here to help by taking the sophisticated tax planning and asset protection tools of the ultra-rich and making them seamless and accessible to everyone.

If you have received a large amount of income from selling an asset or just received a lot of income this year, Valur can help you set up the right tax planning structure for you. (Even if you’re still holding your assets and you’ve got a big gain coming, please check out our Unrealized Income Guide for details of this scenario)

In this guide, we’ll focus on the characteristics of three different structures commonly used for these situations, and we’ll also use an example to help you understand the benefits and the tradeoffs of each one.

Realized Income

Realized income is the appreciation that you receive as a result of a sale of any financial asset or from your salary. Critically, when you realize income you are subject to taxes.

On the other hand, unrealized gains are the potential profit (current price – the price you bought the asset at) that you would gain from selling any investment.

Tax strategies for realized gains

We are going to walk through a few tax planning structures for realized gains:

  • Grantor Charitable Lead Annuity Trusts (CLATs)
  • Exchange Funds
  • Opportunity Zones

Grantor Charitable Lead Annuity Trusts

CLATs are tax-exempt accounts that can earn you additional returns of 50% or more even if you’ve already sold your assets.

With a CLAT, you can:

  1. Reduce your taxable income now: With a CLAT you can reduce your taxable income now, defer your tax bill for the future and reinvest those tax savings but you limit your access to the assets for a number of year
  2. Use your money to make the same investments you would make if you had a regular taxable account.

With Grantor CLATs you gift assets to the trust and in exchange can receive a charitable deduction of up to 100% of your assets value to reduce your income that year. Every year, the trust gives a donation to charity and then you receive the remainder after that final contribution.

Overview of how a Charitable Lead Annuity Trust works

An important trade off for CLATs is that the money is locked away for the entirety of the trust’s term, much like a retirement savings account or IRA. At the same time, you are responsible for the taxes on the trust’s income, so this means that you may have to pay taxes on that income out of pocket each year. But this shouldn’t be a huge concern, as the amounts we’re talking about are small.

You can choose the length of your trust. Typically people set up CLATs for a minimum of 15- or 20-years to take advantage of the compounding tax mitigation benefits (depending, of course, on your assets, how quickly you expect your money to grow, and other details).

Interested in learning more about these structures? Visit our article where we explain how they work and in what sorts of situations they might prove valuable and check out your own potential tax savings with our online calculator

Opportunity Zones

Opportunity Zones are an economic development tool that allows you to invest in distressed areas in the United States and gain tax benefits.

Investments in Opportunity Zones are eligible for preferential tax treatment if they are made through a Qualified Opportunity Fund (QOF), which is an official designation for investment vehicles that commit to investing 90% or more of its assets in Qualified Opportunity Zones.

These structures can be a good fit if you have already realized a big capital gain. If you roll your eligible realized capital into a Qualified Opportunity Fund within 180 days of realizing the gain, two forms of tax incentive are available:

  1. Capital gains rolled into a QOF may be deferred until the investment is sold or exchanged, or the end of 2026, whichever comes earlier.
  1. You can save even more through an adjustment in cost basis of your investment. If you hold the QOF investment for at least 10 years, you can avoid taxes entirely on the sale of the Opportunity Zone investment.

The main downsides of Opportunity Zones include the following:

  1. High fees vs more traditional investments (typically at least 1.5% annually)
  2. A long period of illiquidity: money has to stay in a QOF for at least five years from the fund close to realize the tax reduction benefits and ten years from the fund close to realize the basis adjustment benefit.
  3. Exposure to concentrated assets.
  4. Uncertain returns: We don’t have historical returns for QOFs as they were only created by law in 2017

If you’d like to read more about Opportunity Zones, please visit our blog post on this topic here.

Donor-advised Funds

A Donor-advised Fund (DAF) is a giving account established at a public charity; it exists for the purpose of supporting charitable organizations, by offsetting or eliminating a big tax bill while retaining flexibility in timing and recipient of donations.

Donors can contribute to the fund as frequently as they like, and then recommend grants to their favorite charitable organizations whenever it makes sense for them.

The main benefits of DAFs are:

  1. Eligibility to take an immediate tax deduction when you contribute cash, stocks or non-publicly traded assets such as private business interests, cryptocurrency and private company stocks, just as if you had donated the funds directly to a charity.
  1. Versatility: these structures allow you to give when, what, how, and where is most favorable for yourself. You have the chance to contribute immediately, build a philanthropic strategy and donate when you’re ready.
  1. Possibility to invest the funds, they’ll grow and you can give the additional gains to charity in the future, tax free.

Downsides include the following:

  1. You don’t completely decide which charities receive your donation.
  2. Donations are irrevocable: the funds cannot be returned to the donor or any other individual or used for any purpose other than grantmaking to charities.
  3. DAFs have some minimum donation requirements

Charitable Lead Trusts vs. Opportunity Zones vs. Donor-Advised Funds

As you might guess, each structure has its own set of positive and negative trade-offs. Choosing which structure to use is a personal decision that depends on your family circumstances, your financial goals, and what you want your life to look like for the next years.

Below, we’ll compare each across several useful metrics, including, most importantly, the bottom line: how much you’ll earn over your lifetime using each.

Comparing the Return on Investment (ROI) of each structure:

We understand that this can be a lot to digest, and while the qualitative trade-offs above are important, it’ll be helpful to walk through an example to see the ROI of each structure.

Let’s assume a time lapse of 10 years (Any payouts that might happen after 10 years are discounted by the time value of money to calculate their net present value in 10 years)

Like a lot of our Customers, Sara is 35 years old, based in California, with $1m of appreciated assets at a $0 cost basis. She expects a 35% tax rate (assuming long-term capital gains tax rates) and for the stock market to grow 10% annually, while an opportunity zone investment would appreciate 9% annually (after fees).

The order of returns by strategy would be as follows:

  • Charitable Lead Annuity Trust (30-year term): $1,971,897 – additional 44% return
  • Opportunity Zone: $1,828,845 – additional 33% return
  • Donor-Advised Fund (DAF): there are no returns; although you will save significantly on this year’s taxes, those savings are more than offset by the donation amount.
  • No Tax Planning: $1,373,934 – 0% return

You can also find more detailed information about the three structures and their trade-offs in this article.

In conclusion, Charitable Lead Trusts, Opportunity Zones, and Donor-Advised Funds are all viable options for tax planning, with each offering its own merits.

  • While CLATs allow you to reduce your taxes after selling an asset, tend to have high ROI in the long term but have the longest path to liquidity
  • Opportunity Zones also have a good ROI, offer more initial liquidity but less diversification than CLATs and they also allow you to reduce your taxes after the fact and in future tax years.
  • DAFs instead give charitably inclined individuals the freedom to donate (and take a tax deduction) now without committing funds to a particular charity, and the funds can be invested in the meantime.

There’s no “one size fits all” solution, and the right choice will be depend on your personal preferences and tax position. But don’t worry! Valur is here to help.

About Valur and how we can help

Valur has a singular goal: to help our customers access tax planning structures that are otherwise inaccessible to them. From picking the best strategy to organizing your distributions and other important financial events, we’ll be with you the whole way.

We have built a system to streamline the tax planning tools of the ultra-rich to make them seamless, affordable and accessible to everyone. We’re the only providers of crypto-focused, technology-first tax planning tools.

What we offer:

  • Simplicity and speed: comprehensive trust structuring to maximize tax protection and completed, vetted legal documents to establish the trust.
  • Trust administrative management (federal and state filings, trust accounting and distribution management)

If you would like to learn more, please feel free to check out our Frequently Asked Questions section, our Learning Center, check out your potential tax savings with our online calculator or schedule a time to chat with us!