Charitable remainder trusts: A favorable tax strategy that can be aided by higher interest rates

For those who want to mitigate income tax, move assets out of their estate and help a charity, a charitable remainder trust (CRT) can be an effective income and estate tax planning tool. A CRT is a type of irrevocable trust that benefits both you and charity. Depending how you structure the CRT, it is also one of a handful of tax strategies that become more favorable in a higher interest rate environment.

If you have charitable intent and are interested in tax planning, a CRT may be right for you. Before you decide, consider your goals and how a CRT might fit into your plans.

Start with your goals

A CRT’s appeal lies in its ability to help you achieve certain financial goals. In particular, it help you mitigate taxes, support charity and retain cash flow for your lifetime or a period of years. CRTs work well when you have an appreciated asset that you plan to sell. 

When you donate appreciated property to a CRT, it provides:

• Tax benefits.  By donating assets to a CRT, you can receive an immediate tax deduction for a portion of the donation. You also can defer the income tax from the eventual sale of the asset by the trust over the trust's term.
• An annual distribution. You can retain an annual payment from the trust, which can be structured to provide a fixed or variable amount annually for the term of the trust.
• A way to move assets out of your estate. Transferring assets to a CRT can reduce the size of your estate, which can help to minimize estate taxes. If your estate exceeds $13.61 million ($27.22 million per married couple), there is a 40% tax on anything above that amount. This amount is scheduled to be cut in half at the end of 2025, unless congress acts, making this strategy even more impactful.

How it works

With a CRT, you make a gift to a trust and retain an annual payment amount from the trust for your lifetime or a period of years. At the end of the trust term, the balance of the trust goes to a charity of your choice.

Generally, it works like this:

• You create a trust and transfer assets such as appreciated securities, real estate or ownership in a business to the trust.
• As part of creating the trust, you choose the form of the annual payment you receive from the trust, typically either a fixed amount or a fixed percentage of the trust assets' value measured each year.
• You receive an immediate tax deduction on the contribution, which is based on the value of the property contributed to the trust minus the value of your retained annual payments. 
• The trust sells the contributed assets and uses the proceeds to make the required payments to you each year for the specified period.
• The trust does not pay income taxes on the sale or its earnings. Instead, the tax burden is shifted to you as you receive the payments from the trust. The trust realizes income at different tax rates (i.e., ordinary, capital gains, tax-exempt) and its distributions will carry the highest tax liability.
• After the trust term ends, the remaining assets in the trust are distributed to the charitable organizations that you designate.

Although receiving a charitable deduction is beneficial, the extra value of a CRT typically comes from its tax deferral feature that allows you to spread the tax liability over an extended period.

Donation decisions

Assets best suited to be gifted to a CRT are those that have appreciated in value (think stocks or mutual funds, real estate, artwork or a business you own).

Appreciated assets are subject to significant capital gains taxes once they are sold. By gifting these assets to a CRT, you avoid paying capital gains taxes initially upon sale. You will, however, be responsible for the income tax as you receive payments from the trust.

Once the assets are sold, it’s important that you and your trustee understand how your CRT invests the proceeds and manages its ongoing activities. If the trust engages in certain types of business activities, it may be subject to the unrelated business taxable income (UBTI). UBTI is an excise tax on income that is not related to the trust's charitable purposes, such as income from a trade or business.

For example, if the trust sells a highly appreciated asset and then reinvests the proceeds in rental property that generates income, the trust may be subject to UBTI on that income, significantly reducing the amount of funds available for the trust's charitable beneficiaries. You will want to consult your investment and tax advisors in administering the CRT, as the tax has a punitive rate of 100%.

When setting up your CRT, your advisors can help ensure the trust is structured so that its assets are invested in a manner consistent with your goals and its charitable purposes.

Setting up your CRT

You have several options when you set up your CRT. You can define the trust terms to meet your goals and preferences for how you receive annual income, what eventually stands to go to charity, and the investment strategies that tie to your decisions.

Common options include:

1. Charitable Remainder Annuity Trust (CRAT). Pays a fixed amount to beneficiaries annually based on a percentage of the initial fair market value of the trust assets (for example, $50,000 each year calculated as 5% of an initial value of $1,000,000). Charity ultimately receives all assets over what’s necessary to pay the annuity and bears the bulk of the risk of investment performance. The trustee typically invests in a diversified portfolio designed to balance payment of the annuity amount and long-term growth for charity. Higher interest rates are more favorable for a CRAT. This is because they increase the return assumptions used by the IRS to calculate the value of the remainder interest going to charity.
2. Charitable Remainder Unitrust (CRUT). Pays a fixed percentage of the ongoing fair market value of the trust assets to beneficiaries annually (for example, 5% of the value as of the first day of each year). The payout is adjusted annually based on the performance of the trust investments, so you share in the investment risk and returns. Charity ultimately receives any growth over the fixed percentage. The trustee typically invests in a diversified portfolio balancing fulfillment of the annual percentage payment and preserving the purchasing power and possibly generating additional growth for the remainder charitable beneficiaries. Higher interest rates do not generally affect the tax benefits of a CRUT, although higher actual returns will benefit both you and charity.
3. Pooled Income Fund. Trust assets are combined with those of other donors and invested in a diversified portfolio of income-generating assets. Beneficiaries receive a variable income stream annually based on investment performance. Income is distributed to beneficiaries proportionally based on their share of the trust assets.

Example: A CRT in action

To illustrate, let’s look at a simple example. An actual CRT is likely to involve additional factors, but this example can help you understand how the strategy works.

Say you have a business worth $10 million. One option is to sell the business, pay tax on the capital gains, and invest the balance. This would require a significant tax payment in the year of sale. But you would have an investment portfolio you can access whenever you like or let grow over time.

Alternatively, you could donate the business to a CRT prior to a sale. The trust would sell the business. There would be no immediate tax liability. Instead, the tax would be stretched over the term of the trust, as you receive a stream of annual income throughout the trust term. If your payment is based on a percentage of the trust value (say 10% of the value at the end of each year), you will benefit from the annuity amount being based on sale proceeds that have not been reduced by taxes.

Of course, an annuity interest is not the same as an investment account you can draw on whenever you want. But if you accumulate your payments, you ultimately can get close (but not all the way) to the same accumulated balance as the investment account. In addition, you’ll facilitate a significant amount going to charity.

Overall, utilizing a CRT can be a powerful way to mitigate tax for yourself while giving back to charity. Rather than selling your appreciated assets outright, a CRT gives you a tax deduction and annual payment for a set period, all while setting aside funds for charity.