05 Jun 2012

Avoiding Capital Gains Taxes By Borrowing A Charity’s Tax Exemption

It is important to be mindful of opportunities to minimize taxes and retain your hard earned money and assets for you and your family rather than sharing those assets with Uncle Sam. One such opportunity arises when you have appreciated capital assets (such as stock, mutual funds, bonds, real estate or collectibles) that you wish to sell. A capital asset is considered an “appreciated asset” when its current fair market value is greater than its basis (generally, the asset’s basis is what you paid for it). There is an opportunity to avoid a capital gain tax on the sale of the appreciated capital asset by contributing it to a charitable remainder trust and selling the appreciated capital asset through the trust. This blog article will explain how this strategy may save you from paying a significant amount in capital gains taxes and allow you to retain the use of the funds that would have been used to pay those taxes.

Tax on Net Capital Gain. With the sale of an appreciated capital asset, there is a potential tax on the “capital gain,” which is the difference between the asset’s sales price and its basis (generally, the price paid to acquire the asset). The capital gain realized on the sale of a capital asset may be reduced by any capital losses the seller has on the sale of any other capital assets. To the extent the seller has more capital gains than capital losses; there is a tax on the “net capital gain,” which tax is referred to as a “capital gains tax.”

How Much is the Capital Gains Tax? The amount of the capital gains tax varies depending on the seller’s income tax bracket and the length of time the seller owned the asset. The tax rates that apply to net capital gains are typically lower than the tax rates that apply to other income (such as salary, interest, and ordinary stock dividends, which are subject to tax rates ranging from 10% to 35%). If a capital asset is held for less than a year, the capital gains tax is based on the higher ordinary income tax rates (i.e., from 10% to 35% depending on the seller’s income tax bracket). However, if the capital asset has been owned for a year or more, there is a special long term capital gains tax rate.

Currently, the maximum long term capital gains tax rate for most people is 15%. For individuals in a lower income tax bracket (i.e., the 10% to 15% income tax bracket), the rate may be 0% on some or all of the net capital gain. Special types of net capital gain can be taxed at 25% (for gains recognized on the sale of depreciated real estate) or 28% (for gains recognized on the sale of collectibles, such as art).

It’s important to note that the favorable tax rates currently in effect for long-term gains and qualified dividends will expire on December 31, 2012. Starting in 2013, the tax rate on long-term capital gains will be 20% (or 10% if a taxpayer is in the 15% income tax bracket). Also starting in 2013, the current distinction made between ordinary and qualified dividends will end, and all dividends will be subject to the ordinary tax rates (which rate is based on the taxpayer’s income tax bracket).  In addition, in 2013, capital gain income will be subject to an additional 3.8% Medicare tax. So, there is incentive to avoid or minimize any potential capital gains taxes.  One way to do this is to contribute the appreciated asset to a charitable remainder trust and sell the assets through the trust.

Use of a Charitable Remainder Trust. A charitable remainder trust is an irrevocable trust. The creator of the trust (the grantor) contributes property or money to the trust and designates one or more charities as the remainder beneficiaries of the trust. The trust provides that one or more non-charitable individuals (usually the grantor and the grantor’s spouse, if there is a spouse) have the right to receive an income stream (either as an annual annuity or a unitrust payment, the amount of which is subject to certain limitations) for a term of years (not to exceed 20 years) or for the life or lives of the income beneficiaries. Upon the termination of the income interest, the remaining assets in the trust are distributed to the charitable remainder beneficiary or beneficiaries.

The grantor avoids any capital gains tax on the donation of appreciated assets to the charitable remainder trust, and also receives a current charitable income tax deduction for the fair market value of the assets that will pass to the trust’s charitable remainder beneficiaries at a future date. If the appreciated assets contributed to the trust are sold by the charitable remainder trust, no capital gains tax is imposed on the sale. Essentially, the grantor is borrowing the trust’s charitable remainder beneficiary’s or beneficiaries’ tax exemption, which allows the capital gain on the sale to be ignored for tax purposes. In addition, the assets contributed to the charitable remainder trust are removed from the grantor’s estate for estate tax purposes, and thereby reduces the amount of estate taxes that will be imposed on the grantor’s estate when the grantor dies.

Here’s an example of the benefit of establishing a charitable remainder trust to sell appreciated assets. Assume Bob Smith owns stock with a value of $1,000,000 and a basis of $200,000. For purposes of this example, let’s assume that this is qualified stock that Bob has owned for 20 years, that he has no losses to offset the gain on the sale, and that gain on the sale of this stock is subject to a 15% capital gains tax rate. If Bob sold the stock himself, he would have a capital gain of $800,000 on the sale (i.e., $1,000,000 – $200,000 = $800,000). The gain would be subject to a 15% capital gains tax resulting in a tax due of $120,000 (i.e., $800,000 x 15% = $120,000). If, instead of selling the stock himself, Bob transfers the stock to his newly created charitable remainder trust, he would receive a current charitable income tax deduction for the value of the portion of the trust that will ultimately pass to the charitable remainder beneficiary or beneficiaries, and he would not have to pay a capital gains tax on the sale of the stock by the trust. Bob has saved $120,000 in taxes by selling the stock through the charitable remainder trust. In addition, Bob will receive annual income distributions from the charitable remainder trust based on the value of the proceeds of the stock he contributed to the trust (including the amount of assets that did not have to be paid in capital gains taxes to the government). Upon Bob’s death, the remaining assets in the trust will pass to the charitable remainder beneficiary or beneficiaries and he will not be subject to estate taxes on these assets upon his death. This works out to be a substantial tax savings for Bob and he has also benefited his favorite charities through the trust.

Please call us if you are interested in discussing how a charitable remainder trust would compliment your estate plan and save you taxes.

If you would like to discuss this or other trusts and estates issues, please contact the attorneys at Drucker Law Offices, 468 North Camden Drive, 2nd Floor, Beverly Hills, CA 90210, 310.285.5375 Tel, 310.444.9754 Fax, www.druckerlaw.com

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