* Due to Robert’s untimely passing, this article was posthumously finished by his brother, Timothy.
Despite recent market volatility exacerbated by the pandemic, inflation fears and the war in Ukraine, the S&P 500 was still trading in May 2022 at more than four times its value in early 2009, at the depth of the Great Recession. Between 2011 and 2022, average home prices in the United States nearly doubled.1 Rarely in U.S. history have so many individuals owned so much highly appreciated property.
A large percentage of those assets are owned by those approaching retirement age in numbers that have never been seen in U.S. history. Some 55 million Americans are now age 65 or older,2 and over 10,000 more are reaching that milestone each day.3
These realities are creating an environment in which unprecedented numbers of individuals are at a point in life when they’re looking to shift from an investment strategy primarily focused on asset growth to one centered on producing income for a retirement period that may span a period of 20 years or longer.
But at the same time, interest rates and cash yields on many other investments remain quite low, so it can be a daunting challenge to determine how to convert highly appreciated homes and other investment assets into a dependable source of retirement income with an acceptable level of risk. Add to that the concern that Congress is eyeing the wealth represented by appreciated, low yielding assets as a source of government funding to be harvested through taxes imposed either before or after the actual realization of those gains during lifetime or at death.
For example, tax proposals floated in 2021 would impose higher capital gains taxes and collect them not only when a sale or exchange occurred during lifetime but also at death or incident to certain inter vivos transfers including, for the first time, some charitable gifts made in the form of split-interest charitable trusts.
Given the fact that a large percentage of substantial charitable gifts are made each year in the form of non-cash assets, it’s important for charitably inclined individuals and those who advise them to be attuned to changes now in the air and ways to plan to take maximum advantages of opportunities that exist under current law.
Charitable Liquidity Events
This brings us to a category of planning that combines the desire of individuals who own highly appreciated property to minimize income, capital gains and estate and gift taxes while making significant charitable gifts that result in unlocking additional fixed or variable income for life or other period of time.
For our purposes here, we use the term “charitable liquidity event” (CLE) to refer to planning techniques that can, under appropriate circumstances, effectively address the combination of the above objectives. “The Need for a Charitable Liquidity Event,” p. 49, visually depicts the factors that give rise to the need for a CLE.
“The Need for a Charitable Liquidity Event” illustrates the factors to consider to help decide if a CLE is the right option. For example, consider a couple who owns a principal residence with a $500,000 tax basis that’s expected to net $1 million on a sale. While they own an asset with a sizable capital gain, the $500,000 exemption from capital gains tax on the sale of a personal residence eliminates the need for them to plan to minimize reportable gain on the sale, and other charitable gift options may be more appropriate than a CLE.
When the requisite assets and needs are present, one or more charitable gift planning techniques described in 19954 as “blended gifts” can be employed to structure significant gifts through a carefully considered CLE.
Let’s look at a number of situations in which a CLE could be the answer to what might otherwise seem to be conflicting planning goals so that both “giving” property and “keeping” a valuable interest in it can be a viable alternative to a traditional sale.
Giving While Retaining Income
Consider the case of Amanda and David, both age 70. They married in the late 1970s. They bought their first home in 1980 for $60,000, a significant sum at the time. Over the years, they purchased several primary homes and each time rolled their gains into the next residence, a practice that was encouraged by tax laws until the late 1990s. They also own a second home in Florida and would like to move there permanently. When combining the value of their primary home and the Florida residence with other assets, their net worth is approximately $15 million.
Their current principal residence was purchased in 1996 and is now valued at $2.2 million. It’s free of debt but the annual cost of property taxes, insurance and other costs associated with maintaining the home averages approximately $25,000.
The applicable cost basis in the home is $500,000, when adjusted for capital improvements and additional amounts expended for purchase of prior homes over the years. They anticipate realizing an estimated $2 million in net proceeds on a sale. This would amount to $1.5 million in capital gains that would result in a net taxable gain of $1 million after applying their $500,000 principal residence exemption. They could then owe $200,000 or more in federal and state capital gains tax.
The couple is serving on the campaign committee for a national charity devoted to preventing and curing the disease that took their only daughter’s life. They’ve been asked to make a leadership gift of $2 million to an endowment campaign to fund current and future research. They feel that $2 million is too large a percentage of their wealth to give outright at this time or to fund a gift over the 6-year campaign pledge period.
An alternative would be for them to make a binding bequest commitment of $2 million to be received at the death of the survivor. Campaign guidelines allow partial credit for pledges in the form of documented bequests, but they would really like to make a gift that could have an impact on achieving the mission of the organization prior to the end of their estimated 20-year combined life expectancy.
Their tax advisor suggested that they consider a blended gift based on the use of a charitable remainder unitrust (CRUT). They decided to transfer the home to the trust prior to a sale by the trust that’s expected to net $2 million. In the event the sale doesn’t yield a net of $2 million, they agree to make an additional contribution to make up for any shortfall.
The trust will be structured as a net income with makeup CRUT that will pay them 5% of the value of the annual value of the trust or the net income of the trust, whichever is less. In years the earnings exceed 5%, the trust can use excess earnings to make up for shortfalls in past years when the trust couldn’t distribute the full 5%.
When the dust settles, they’ll be receiving payments based on the value of the trust each year, expected to be about $100,000 the first year. Had they sold the property and reinvested the after-tax proceeds of $1.8 million at 5%, their income would have been $90,000 per year. The additional income is provided by the earnings on the portion of the sales proceeds that wasn’t reduced by capital gains taxes because of the tax-free sale by the tax-exempt charitable trust. During early discussions of tax law changes last year, it was proposed that donors be required to pay capital gains tax on a pro rata portion of the gain used to fund a CRT under these circumstances. Fortunately, that provision didn’t make it into final proposed legislation.
The payments to David and Amanda each year will be taxed according to the nature of the income when received by the trust under the tier structure of income reporting.5 To the extent that payments from the trust include capital gains that were realized by the trust when contributed assets were sold or realized on post-contribution gains, those amounts would be reportable at capital gains rates with the remainder taxed as ordinary income or received free of tax if tax-exempt or return of principal contributed.
Additional financial benefits for David and Amanda include an upfront charitable income tax deduction of $880,000. Their use of this deduction will be limited to 30% of their adjusted gross income (AGI), as the trust was funded with appreciated property. Including a deduction for the year of their gift and up to five succeeding years, they’ll be able to save as much as $250,000 in their anticipated tax bracket. In their case, this will save an average of approximately $40,000 per year for six years.
When combined with the after-tax income from the trust and the annual ownership expenses of $25,000 they must no longer pay, their spendable income will increase substantially when compared to their financial picture prior to the donation of the home to the CRUT. And they have provided for a very substantial charitable gift of the remainder interest in the trust when it terminates.
From an estate-planning perspective, this couple is, in effect, accelerating what might otherwise be a bequest of $2 million in a manner that gives rise to significant current income and capital gains tax savings. Under current law, there would be no estate tax savings, as the value of their estate is far below the current federal estate tax threshold of $24.12 million.
Enter the Blended Gift
Note that Amanda and David have addressed the need to provide a tax-efficient means to convert their home to liquid assets, while creating more lifetime income than might otherwise have been possible. But they still haven’t addressed their desire to make a significant charitable gift prior to the death of the survivor.
That can be accomplished by including a provision in their CRUT that provides that a portion of their annual income be directed to the ultimate remainder beneficiary each year. In their case, they decide to direct that 20% of the annual unitrust payment be foregone by them and instead be distributed to the organization that will receive the remainder. The first year, the charity would receive 20% of $100,000 or $20,000. This amount will pass to the charity each year outside David and Amanda’s AGI and therefore won’t be subject to tax, even in years when they may not itemize their charitable deductions.
From the charity’s standpoint, if it customarily spends 4% of its endowment in furtherance of its mission, the $20,000 trust payment would represent the equivalent of $500,000 in additional endowment beginning in the year the CRUT is funded. If the trust achieves an annual total return in excess of 5%, that amount will remain in the trust free of income tax and will lead to a proportionate increase on the annual payment to charity as the base against which the 5% payout percentages is applied grows. This plan can be a very effective way of creating a blended gift that results in both current revenue and future endowment at the termination of the trust.
Amanda and David are pleased with the multiple financial benefits of their blended gift as a way to structure a meaningful gift through a charitable liquidity event and are contemplating making periodic additions to the trust in the future as a way of diversifying other assets they hold in the form of highly appreciated low yielding securities.
The charitable beneficiary of this gift is surprised to benefit from both a current income stream and an irrevocable remainder interest in the future in lieu of a charitable bequest commitment that may or may not come to fruition at an unpredictable future time.
The Balanced Sale
Another way to diversify highly appreciated securities that may make up a disproportionate share of an investment portfolio but don’t produce the level of income desired is through the use of what might be called a “balanced sale.” Using this technique, a donor can make a significant gift using appreciated securities (or other property such as appropriate real estate) whereby a portion is donated, and the remainder is sold. If the donated and sold amounts are correctly “balanced,” the tax savings from the contribution may serve to offset all or a portion of the capital gains tax that would otherwise be due on the portion that was sold.
Take the case of Harry, a successful entrepreneur who’s amassed an investment portfolio worth over $10 million after many years of setting aside a large portion of the profits from his business enterprises.
He owns stock in a start-up company (ABC Corp.) that recently went public. His shares are worth $1 million and pay a dividend of 1%. His cost basis in the securities is just $100,000. He believes it’s time to take some profits in the stock but doesn’t like the idea of paying over 25% in state and federal capital gains taxes.
Harry’s AGI is over $650,000, and he can therefore make use of charitable deductions of close to $200,000 this year. He typically contributes about $50,000 to charity each year and has outstanding capital pledges of $140,000.
His tax advisor suggests he harvest half the profits in his ABC stock through a plan that eliminates capital gains tax on those profits, funds all of the charitable gifts he wishes to make this year and leaves a substantial amount of cash available to diversify with a new current value cost basis.
In his case, $310,000 worth of the stock is sold and $190,000 is donated to a donor-advised fund (DAF). The sponsor of the DAF sells the stock free of capital gains tax and uses the cash proceeds to make charitable gifts as advised by Harry.
Had Harry sold the securities, he would have realized capital gains of $450,000 and been subject to state and federal tax on that amount of $112,500. His net cash sales proceeds would have been $387,500.
As a result of the balanced sale described above, he would report capital gains of $279,000 on the sales portion of $310,000, resulting in a capital gains tax of $69,750. This tax would, however, be offset by the $70,300 in tax savings he enjoys as a result of the $190,000 stock donation.
When the dust settles, he has $310,000 in cash to reinvest as he sees fit, some $76,950 less than if he had sold and not made the charitable gifts. Through this charitable liquidity event, however, he’s been able to make gifts of $190,000 at an after-tax cost to him of just $76,950, resulting in the gifts costing $.41 per dollar donated.
If Harry had made gifts totaling $190,000 in the form of cash in his 37% marginal tax bracket, the cost would have been $.63 per dollar donated. This additional savings is made possible in part by the fact that funds that would have been paid in capital gains tax are instead donated voluntarily to charitable purposes, a result that’s contemplated and encouraged by federal tax policy and that of most states.
Bargain Sales
Another way to structure a charitable liquidity event is through a time-tested technique known as the “bargain sale.” A bargain sale can offer a way for a client with a highly appreciated asset to make a gift of a portion of the appreciation, while recovering a percentage of the value of a property through a sale of the property to the charitable recipient for less than its fair market value (FMV).
Martin, age 82, purchased 1,000 acres of land in 2010 during the recession for $800 an acre. The property recently appraised for purposes of securing a loan at an estimated net of $3,000 an acre in the event of a sale. Assuming Martin’s $800,000 investment is now worth a net of $3 million, he would realize capital gains of $2.2 million on a sale.
He’s made a charitable gift commitment of $1 million to his alma mater to create a scholarship fund in memory of his recently deceased wife. Martin would like to use $1 million worth of the value of the land to fund his gift but doesn’t want to sell the property, generate tax on the full capital gains and then make a deductible gift of a portion of the sales proceeds. He likewise doesn’t want to transfer acres with a value of $1 million to the school and then enter into a sales process in which both owners would have to participate in and agree to the terms of any sale.
An alternative is a sale of the entire property to the university for $1 million less than its appraised value. Martin would realize capital gains of $1.46 million allocated to his $2 million in proceeds from the sale.
He would be entitled to a charitable deduction for the FMV of the property less the amount received, or $1 million. The university uses $2 million from its endowment to purchase the land and immediately sells it to a potential buyer discovered during a due diligence period for an amount sufficient to net $3 million. The university replaces the $2 million in endowment funds and uses the remaining $1 million in proceeds from the subsequent sale to create the scholarship fund Martin would like to establish.
To summarize, Martin enjoys income tax savings of $370,000 as a result of the $1 million gift to the university, which is more than enough to offset an estimated $367,000 in capital gains tax due on the sale portion of the transaction. He’s credited by the university with an immediate gift of $1 million and pays no capital gains tax on the $2.2 million net appreciation on his $800,000 initial investment.
As a result of making his gift in the form of a bargain sale, Martin nets a total of just over $2 million from a combination of the sales proceeds of a portion of the property and the income tax savings as a result of donation of the remaining value. This amount represents tax-free appreciation of just under 8% a year over the time he owned the property.
Charitable Basis Step-up
Finally, there can be instances in which an investor owns publicly traded securities that have greatly appreciated in value and would like to continue to own that investment. They would also like to eliminate tax liability on capital gains that would be due if the increase in value were to be realized through a sale.
In that case, the most effective course of action may be to donate the securities to charity and use cash to repurchase the security at the current market price immediately following the gift.
As an example, Janet owns shares of tech stock that’s appreciated 20-fold since she purchased them in the early 1990s. She believes the stock will remain a good investment, but she would like to hedge against a possible decline in value. A sale would still result in a significant capital gains tax liability, so Janet instead makes a donation of $500,000 worth of the stock with a cost basis of $25,000. Her AGI is $500,000, so she can use the charitable deduction to eliminate tax on a total of $500,000 of income in the year of the gift and a carry forward period of up to five future years.
She uses $500,000 of cash reserves to repurchase the same stock. She now owns stock with the same value as before, but her basis has been increased from $25,000 to $500,000. Because she gave away the value of the capital gains prior to the gift, she’ll now owe less capital gains tax on a future sale at a higher value, and instead of still owing tax on remaining gain from a sale at lower value, she may now be able to benefit from a loss on a future sale should the stock value decline.
These are just a few of the many ways to structure a charitable liquidation event through various combinations of current and future gifts. All are based on elements of U.S. tax law designed to encourage charitable giving that have been a part of the nation’s Tax Code for many decades. The transactions described above simply use those incentives when a donor has true donative intent but isn’t in a position to give the entire value of an asset or needs to retain all or a portion of the “wool” from a donated “sheep” for life or other period of time.
Endnotes
1. www.statista.com/statistics/275159/freddie-mac-house-price-index-from-2009/.
3. www.fool.com/retirement/2017/07/29/9-baby-boomer-statistics-that-will-blow-you-away.aspx.
4. Robert F. Sharpe, Jr., “The Emergence of Blended Gifts,” Trusts & Estates (May 2016).
5. See Internal Revenue Code Section 664(b), https://codes.findlaw.com/us/title-26-internal-revenue-code/26-usc-sect-664.html.