Over the nearly thirty years of practice in financial planning and banking, I have been approached by many clients seeking to avoid paying taxes on highly appreciated real estate investments. There are a few options available to investors and some are better than others. It all depends on the facts presented and the goals of the client. In other posts, I've spoken about some alternative strategies. Now, I'll focus on one of those options. Here's how to legally avoid paying taxes when selling investment real estate. [By the way, this strategy may be used when selling highly appreciated businesses, stock portfolios, and other assets, not only real estate.]
There are several options including 1031 Exchanges, Installment Sales, newer options like Opportunity Zone bonds, and various trusts. Here, we'll focus on one trust strategy: Charitable Remainder Unitrust (CRUT) as described in the Internal Revenue Code Section 644.
While 1031 Exchanges are a good way to defer taxes, they do not offer the opportunity to get out of real estate entirely. It is a "replacement" strategy with a way to defer taxes. But deferral is not avoidance, and you still end up owning real estate even if you're trying to get out of the business of dealing with toilets, tenants, and trash. Other options provide the ability to get out of real estate and even avoid paying taxes.
A CRUT strategy can eliminate taxes on the sale. Assuming that a property doesn't have a mortgage on it (or can have the mortgage paid off from other resources prior to the property's sale), then the CRUT can be a powerful tool.
Not all CRUTs are created equal. There are six players in the CRUT strategy: the donor, the trustee, the income beneficiary, the remainder beneficiary, the trust administrator, and the investment manager.
An Example of the CRUT in Action
Let's use the example of a $1,000,000 piece of property with a basis of only $100,000. The potential tax the client is facing is about $300,000 by the time he factors in federal and state capital gains taxes leaving him only $700,000 to invest.
First, the Donor. If the property is owned individually or jointly there is no problem. In cases where it was owned by different family members and with larger dollars, then you'll use different CRUTs or make gifts of an undivided interest.
Second, the Trustee. The Trustee could be any charity or university or non-profit, and all are eager to fulfill that role. Here is a crucial "no-no." Never go this route because all control will be lost. The IRS has no problem with a self-trusteed CRUT as long as you cross the "t"s and dot the "i"s properly. It's easier to make the Trustee the client and his wife jointly. Later, as years go on, the ability to have either sign makes an adviser's life easier. But you could have the spouse be successor Trustee if you wanted.
Third, the Income Beneficiary. This should be the husband and the wife. The period of the CRUT can be a number of years or a single life or joint lives. The best practice is to use "lives" so the CRUT will continue paying income for the life of his wife even if the donor dies soon after the gift. So, now the owner of the property has given the property to himself as Trustee, and instructed the Trustee (he and his wife) to pay an income stream to the Income Beneficiary (he and his wife) until the last one dies. Also, since the CRUT is legally a split-interest trust paying income to a human and the principal to a charity, the Trustee (himself) can sell the $1,000,000 property to the buyer totally tax-free. The CRUT functions like any church or university as the seller.
Fourth,the Remainder Beneficiary. This can be any non-profit found on the IRS list. It can be multiple charities. But here again, is a "no-no" to watch out for. When the Donor creates the Trust document, he should never make the Beneficiary irrevocable. Instead, the donor should always give the Trustee the power to change the Beneficiary from one charity to another. Personally, I prefer to even make the Remainder Beneficiary a Donor Advised Fund which we call a Perpetual Family Foundation to be advised by his children, grandchildren, and future heirs making gifts to all the non-profits the Donor had in his heart.
Fifth, the Administrator. It may seem to be too good to be true. We have a way to sell his real estate 100% tax free by giving it to himself as Trustee and instructing himself to choose whatever investments to diversify he wants and the pay himself an income stream for life. Then even after his death, he is leaving it to a so-called "Family Foundation" to be administered on behalf of his family by his children and grandchildren. Again, the IRS has no problem with the self-trusteed CRUT as long as you continue to cross the "t"s and dot the "i"s prudently. So, the Trustee is given instruction/power to hire an independent Administrator to report all transactions and produce the tax return. Of course, make sure your Trustee has the power to also change administrators if needed.
Sixth, and last, is the Investment Manager. This can be any Registered Investment Adviser like Clear View Wealth Advisors, LLC. But the Trust document gives the Trustee the power to fire and replace the Investment Manager. Now, the $1,000,000 property was sold and the $1,000,000 is in cash in the CRUT Money Market fund. By using this strategy there is more to invest because less was lost to taxes.
A fiduciary investment adviser, like Clear View Wealth Advisors, can make suitable recommendations for this portfolio. Maybe the $1,000,000 is invested in 6 or 7 conservative mutual funds, or maybe 7 mutual funds and a non-traded income producing REIT. Or perhaps one of the MarketFlex Model Portfolios of Exchange Traded Funds and Dividend-Paying Stocks that Clear View Wealth Advisors oversees. Or, better yet, we can use a dividend-income model based on higher-yielding Closed-End Funds to generate 5%, 6%, 7% or more in dividend income. This is an effective strategy for many different investors and situations from as small as $500,000 to as large as $30,000,000.
But the keys takeaways for clients are these:
- Clients get 100% tax avoidance,
- Clients get more safety of investments through diversification, and
- Clients never give up any control.
This is how to legally avoid taxes when selling investment real estate or any other highly appreciated asset through proper use of a CRUT trust strategy.
To discuss how a CRUT strategy may fit into your plans, call the fiduciary advisers at Clear View Wealth Advisors, LLC at 617-398-7494.