With Rising Interest Rates, Charitable Remainder Trusts Are Gaining Popularity

January 03, 2023

By Lisa Cappiello

Every taxpayer’s financial situation is unique, and some donors may be looking for a more sophisticated approach to charitable giving. A charitable remainder trust (“CRT”) can be an effective tool for accomplishing your philanthropic goals while also creating a source of income for yourself and your family. CRTs may qualify for a partial charitable deduction, provide a predictable income stream, allow the deferral of income taxes on the sale of the assets transferred to the trust, minimize exposure to estate taxes, and enable the taxpayer to plan for significant grants to a charity of choice. Unlike certain other approaches, CRTs become more attractive as interest rates soar because higher rates can reduce the actuarial value of the taxable gift. CRTs are extremely effective in the current environment and are a great tool to provide income through the retirement years while offsetting taxes and ultimately benefiting a charity.

The Nuts and Bolts of a CRT

A donor transfers property, cash or other assets, which may include publicly traded securities, certain closely held stocks, artwork and/or real estate, to an irrevocable trust.

Because the trust is irrevocable, the assets contributed to the CRT are removed from the donor’s estate.

When the CRT is created, the grantor may qualify for a charitable income tax deduction. This deduction is equal to the present value of the charitable organizations’ remainder interest, which are the assets that will pass to the charitable beneficiaries. After the value of the remainder is determined, there are several complex rules which can further limit the allowable amount of income tax deduction based on the type of property transferred, the type of charity selected and the grantor’s adjusted gross income. These complex limitations apply to all charitable donations and not just CRTs.

Upon the creation of the CRT, if it designates a non-spouse/non-charitable beneficiary to receive the income, there is a taxable gift to the non-spouse beneficiary when the CRT is funded. This taxable gift is reduced by the present value of the future income payments.

The trustee sells the assets in the trust at full market value and reinvests the proceeds in income-producing assets. No capital gains taxes are paid by the trust on the sale of the assets and any capital gains tax will be deferred until the time the trust distributes income to the beneficiary.  

The CRT will pay out to the donor and/or other beneficiaries, either a fixed amount (annuity amount) or a percentage of the trust’s yearly asset value (unitrust amount), providing a stream of income over the term of the trust. The pay-out methodology is determined by the terms of the trust instrument.

CRTs are classified into two categories based on how they pay the beneficiaries, each with its own set of advantages and disadvantages:

A charitable remainder annuity trust (CRAT) does not accept new donations once it has been funded and pays out a specific dollar amount each year ranging from 5% to 50% of the trust's initial value when established.

A charitable remainder unitrust (CRUT) permits extra donations in addition the initial funding and pays out a specified proportion varying from 5% to 50% of the fair market value of the assets, valued annually.

A major benefit of both the CRAT and the CRUT is that the donated assets are no longer part of the estate, thus reducing future estate tax liabilities. A major disadvantage is that the trusts are irrevocable and cannot be changed and the donor no longer has control of the assets in the trust. The benefit of CRATs is that the payments are consistent, despite changes in the trust's value. CRUTs, on the other hand, permit pay-outs to keep up with inflation because they rise in value along with the trust. If the assets appreciate, the required payments increase; if they depreciate, the payment is reduced. This is determined on an annual basis since the trust assets are revalued once a year. A CRUT's possible drawback is that if the trust's value drops, dividends will likely be reduced.

The term of the trust can be for a specific term of up to 20 years or for the life of the income beneficiary/beneficiaries.

The remainder value, which must be at least 10% of the fair market value of the donor’s initial contribution to the CRT, is then donated to the designated charity at the end of the trust’s term.

The computation of the remainder interest and the charitable deduction is based on designated IRS tables, and a number of other factors. The basis for the deduction for any gift of real property, however, is the fair market value of the property. This must be determined using a “qualified appraisal” if the value of the property is over $5,000.

CRTs Perform Better in High-Interest Rate Environments

IRS guidelines stipulate that the present value of the charitable beneficiaries' remaining interest must equal at least 10% of the value of the trust assets at the time of contribution for a CRT to qualify as a legal vehicle for charitable giving. Determining the present value of the residual interest is difficult and can be accomplished by estimating the present value of the yearly disbursements from the trust and deducting that sum from the value of the assets provided. There are several variables that come into play when performing this computation including the duration of the trust term (or the beneficiaries' ages, if distributions are paid for life), the number of yearly pay-outs, and an IRS-mandated IRC Sec. 7520 rate. Shortening the trust period or lowering the payment percentage may be options if you need to enhance the value of the residual interest to reach the 10% requirement.

In recent years, record-low interest rates have made it challenging, if not unattainable, for many CRTs to qualify. Increasing yearly disbursements or the trust term without rejecting the trust gets easier when interest rates climb, making it simpler to reach the 10% requirement.

As interest rates increase, so does the IRC Sec. 7520 rate. A higher rate provides a greater charitable deduction using the assumption that the money in the CRT will grow more quickly, thereby resulting in a larger charitable deduction when the income interest, based on the terms of the agreement, comes to an end. Longer terms result in a smaller charitable deduction while shorter terms result in a larger charitable deduction.

Advantages of Donating Appreciated Property to a CRT

If a taxpayer disposes of appreciated property it will immediately trigger a taxable capital gain plus net investment income tax and possible state taxes. However, if these same assets are contributed to a CRT and then sold, the trustee can sell them tax-deferred and then reinvest the proceeds.

Capital gains are not completely eliminated, but instead a portion of the income earned by the trust is taxable to the beneficiaries when paid out

The IRS sees each disbursement as coming from regular income (up to the trust's current and cumulative ordinary income), followed by capital gains, tax-exempt income, and a tax-free return of principal.

The CRT must not be misused to evade taxes or illegally benefit their beneficiaries

In June 2022, the IRS had released its annual warning to taxpayers about the "Dirty Dozen" tax frauds they should watch out for in 2022.  This year, it listed the "Use of Charitable Remainder Annuity Trust (CRAT) to Eliminate Taxable Gain" as the top fraud. When a taxpayer transfers appreciated property to a CRAT and falsely claims they are entitled to a step-up in basis to the fair market value, this increases the basis of the asset and fraudulently reduces or eliminates the gain on the sale.  Using the proceeds from the sale, the CRAT then buys a single premium instant annuity and the beneficiary reports a minimum amount of income while classifying the remainder as return on investment and thus, avoids income taxes on this income. This conversion of capital gains to a tax-free return on investment is unlawful.  

Time For a CRT is Right Now

With the steady increase in the IRC Sec. 7520 rate, and the expectation that it will continue, the efficacy of CRTs as a tool for your financial and philanthropic planning has greatly improved.

About Lisa Cappiello

Lisa provides tax consulting and compliance services to high net worth individuals, family offices, trusts, corporate executives and pass-through entities.