Tuesday June 18, 2013
Article of the Month
What Do Major Donors Want? Part Two
Part Two – Tax-Free Sales
After passage of the American Taxpayer Relief Act on January 1, 2013, major donors realized that they had been specifically targeted. A major tax-increase target is any donor who is interested in selling appreciated property. With a new top capital gain rate of 23.8% applicable for donors who have adjusted gross incomes of $400,000 single or $450,000 married, many donors who are planning to sell an appreciated asset will find themselves in the top bracket.
There are three factors that will lead to growth in the popularity of a tax-free sale through a charitable remainder unitrust. These three factors include a large number of individuals who are transitioning to retirement, the emergence of substantial appreciation in stocks, land and businesses and dramatically-increased tax rates.
Tax-free sales through a charitable remainder trust typically occur at or near retirement. The donors quite often hold appreciated stock, land, commercial buildings or business interests. At or near retirement age, these donors would like to sell the appreciated property and receive income during retirement years.
Due to low birth rates during the Great Depression and World War II, approximately 2,800 donors turned age 65 each day during 2000-2010. However, because of the size of the baby boomer group born after World War II, approximately 10,000 persons now turn age 65 each day. The probable number of potential donors for a charitable remainder trust has approximately tripled during the past several years. Not only is there a growing group of individuals, but the growth of seniors over age 65 will continue for two decades. The sheer number of new donor prospects is likely to lead to increased use of charitable remainder unitrusts.
A second major factor is the emergence of substantial appreciated property. With the Dow Jones average now surpassing 15,000 and the S&P 500 index over 1,600, stock markets are at all-time high levels. Many individuals hold stocks and mutual funds that have benefitted from this record level of value. A substantial portion of these stocks and mutual funds are highly appreciated.
Similarly, the housing markets now have rebounded. Many housing areas in California, Arizona, Florida and other states have experienced increases in value of 20% or more from the bottom of that market. Finally, commercial real estate is likely to follow the recovery of the stock markets and housing markets.
It is also a favorable market for the sale of business interests. Major corporations responded to the 2008 downturn by building up cash reserves. Over $1 trillion in cash reserves is currently held by major corporations. They are very interested in using this cash to acquire business interests.
Many individuals have been holding stocks, real estate or businesses waiting for a better time to sell. With recovery of these markets, donors are now prepared to sell. The economics of all three types of property suggest that there now is a "return of appreciated assets" that is favorable for charitable trusts.
Major donor prospects did not find much relief in the American Taxpayer Relief Act. Rather, individuals who frequently have incomes of $100,000 or $200,000 and would like to sell a major asset are now discovering that they will be in the top brackets. For many individuals, this discovery will crystalize on April 15, 2014, which might be appropriately titled as "Tax Education Day." Many major donors who sell property this year will review their tax return on that date and state, "Now I understand!"
The tax rates for appreciated property in prior years were 15% for capital gain and 35% for income taxes. The capital gain rate increases by the 3.8% Medicare tax and, for married couples with incomes over $450,000 and single persons over $400,000, the top rate increases by another 5%. With both the Medicare tax and the increase in the top bracket, taxpayers who sell a major asset will pay federal tax of 23.8%. Taxpayers also face top federal income tax rates of 39.6% on earned income and 43.4% on interest and other investment income.
In addition, many states levy tax of approximately 3% to as high as 13.3%. A reasonable combined federal-state rate for the midpoint of this range is a capital gain rate of 28% and an income tax rate of 44%.
The higher tax rates may be illustrated through comparison of a sale by John and Mary Smith of a million dollar property. They paid $200,000 for their appreciated stock and it is now worth $1 million. Because John is age 65 and Mary is age 60, they would like to sell the stock and increase income.
Consider the difference between 2012 rates and the present. In 2012 many potential donors viewed the 15% rate and were willing to sell and pay tax. But with the higher rates, will donors feel they are still willing to sell and pay the tax? Or will they now prefer a tax-free sale?
If donors had created a charitable trust in 2012, they could have bypassed the capital gains tax of 15% and enjoyed an income tax deduction. The $800,000 bypass of capital gain saves $120,000 in tax, while the income tax deduction of $301,570 saves $105,550 in tax. The total 2012 tax savings are $225,550.
If John and Mary sell that property through a charitable remainder trust in 2013, they could save $190,000 in capital gains tax at the 23.8% rate and $119,422 in income taxes at the 39.6% rate. The total savings are now $309,822. This is a 37% increase in tax savings over the prior year. This approximately $84,000 in added tax savings is surely a strong encouragement for John and Mary to consider a tax-free sale. Most donors who understand these benefits will choose to fund a unitrust.
Finally, if John and Mary are in a state with a substantial tax on income and capital gains, they could be subject to the 28% capital gain bracket and 44% income tax bracket. The same trust would save $224,000 in capital gains tax and $132,691 in income taxes, for a total savings of $356,691. These donors may discover that the unitrust tax savings are now $100,000 more this year than previously. While they are patriotic Americans, many will choose the major tax savings of a tax-free sale through a unitrust.
Individuals in high tax states now enjoy another benefit that existed with the higher tax brackets before 2000. With the larger tax savings in 2013, the actual net investment cost of the $1 million unitrust is approximately $650,000 to $700,000. For John and Mary, the present value of their income stream is also $650,000 to $700,000. Their retained income interest may be similar to their net investment.
This is truly a high-leverage charitable gift. While donors should always have charitable motivation, the actual level of "charitable receptivity" appropriate for this plan is very modest. Advisors should encourage nearly all individuals with substantial appreciated properties to consider the benefits of a charitable remainder trust. It is now an extraordinary opportunity to make a major gift with very limited cost.
Many donors have considered a one or two life charitable remainder trust, but also would like cash. This may be to improve their liquidity position or to make another investment. A solution that permits both cash and charitable tax benefits is a sale and unitrust. The prorated basis is allocated and there is gain on the sale portion. However, the gain is bypassed on property transferred to the unitrust. In addition, the charitable deduction from the unitrust offsets part or all of the tax due on the sale portion.
For example, John and Mary might decide to transfer $600,000 in value to the charitable remainder trust and sell $400,000 of the stock for cash. If they have real property, the same result can be achieved through either deeding an undivided interest or, if the property is divisible, two separate deeds. In either case, there is property in the unitrust and assets withheld that will be sold for cash. With real estate, the two separate deeded properties are normally sold jointly to the same purchaser.
It is helpful to compare the 2012 result with 2013. The 2012 tax rate is 15% on capital gain and 35% on income taxes. The tax savings are $72,000 on the capital gain bypass of $480,000 (80% of the property allocated to the charitable trust), and $63,330 on the tax deduction of $180,942.
With the current 23.8% capital gain and 39.6% income tax rates, the capital gain savings are $114,240 and the income tax savings are $71,653. Finally, in a state that also has income and capital gains taxes, the 28% capital gain savings are $134,400 and the 44% income tax savings are $79,614.
Once again, the tax savings in 2013 are dramatically higher. Compared with an outright "sell and pay tax" option, many donors will choose a sale and unitrust. With a sale of 25% to 35% of the property and a unitrust for the balance, the charitable tax savings of the unitrust may (over the one to six year deduction period) completely offset the tax on the cash. This enables these donors to enjoy both cash and a tax-free sale.
An additional benefit is the ability to invest in a stock-bond portfolio and pay the donor income taxed at lower rates. If the majority of trust investments are stocks or equity mutual funds, then most of the payouts may be dividends or long-term capital gains. Under the Sec. 664 four-tier accounting rules, the ordinary income of the trust is distributed first. That may be taxed at 39.6% federal or (using our assumed state tax rate) 44% federal and state. Dividends and long-term capital gains will be distributed next and could be the majority of the unitrust payout amounts. They may be taxed at 23.8% federal and 28% federal-state rates. For high-income donors, the investment risk of an equities-based portfolio is often acceptable in order to obtain favorable tax treatment on the majority of unitrust payouts.
The obvious benefits of a tax-free sale have increased dramatically in 2013. Because there are a much larger number of donors and the stock and real estate markets have recovered, it is probable that many individuals will create charitable remainder trusts this year. Advisors for donors should recognize the dramatic increase in the attractiveness of the charitable trust. With greatly enhanced tax savings, there should be dramatically more charitable trusts created in 2013 and future years.
After passage of the American Taxpayer Relief Act on January 1, 2013, major donors realized that they had been specifically targeted. A major tax-increase target is any donor who is interested in selling appreciated property. With a new top capital gain rate of 23.8% applicable for donors who have adjusted gross incomes of $400,000 single or $450,000 married, many donors who are planning to sell an appreciated asset will find themselves in the top bracket.
There are three factors that will lead to growth in the popularity of a tax-free sale through a charitable remainder unitrust. These three factors include a large number of individuals who are transitioning to retirement, the emergence of substantial appreciation in stocks, land and businesses and dramatically-increased tax rates.
Demographics – Many More Age 65 Donors
Tax-free sales through a charitable remainder trust typically occur at or near retirement. The donors quite often hold appreciated stock, land, commercial buildings or business interests. At or near retirement age, these donors would like to sell the appreciated property and receive income during retirement years.
Due to low birth rates during the Great Depression and World War II, approximately 2,800 donors turned age 65 each day during 2000-2010. However, because of the size of the baby boomer group born after World War II, approximately 10,000 persons now turn age 65 each day. The probable number of potential donors for a charitable remainder trust has approximately tripled during the past several years. Not only is there a growing group of individuals, but the growth of seniors over age 65 will continue for two decades. The sheer number of new donor prospects is likely to lead to increased use of charitable remainder unitrusts.
The Return of Appreciated Property
A second major factor is the emergence of substantial appreciated property. With the Dow Jones average now surpassing 15,000 and the S&P 500 index over 1,600, stock markets are at all-time high levels. Many individuals hold stocks and mutual funds that have benefitted from this record level of value. A substantial portion of these stocks and mutual funds are highly appreciated.
Similarly, the housing markets now have rebounded. Many housing areas in California, Arizona, Florida and other states have experienced increases in value of 20% or more from the bottom of that market. Finally, commercial real estate is likely to follow the recovery of the stock markets and housing markets.
It is also a favorable market for the sale of business interests. Major corporations responded to the 2008 downturn by building up cash reserves. Over $1 trillion in cash reserves is currently held by major corporations. They are very interested in using this cash to acquire business interests.
Many individuals have been holding stocks, real estate or businesses waiting for a better time to sell. With recovery of these markets, donors are now prepared to sell. The economics of all three types of property suggest that there now is a "return of appreciated assets" that is favorable for charitable trusts.
ATRA – Tax Relief or Tax Targeting?
Major donor prospects did not find much relief in the American Taxpayer Relief Act. Rather, individuals who frequently have incomes of $100,000 or $200,000 and would like to sell a major asset are now discovering that they will be in the top brackets. For many individuals, this discovery will crystalize on April 15, 2014, which might be appropriately titled as "Tax Education Day." Many major donors who sell property this year will review their tax return on that date and state, "Now I understand!"
The tax rates for appreciated property in prior years were 15% for capital gain and 35% for income taxes. The capital gain rate increases by the 3.8% Medicare tax and, for married couples with incomes over $450,000 and single persons over $400,000, the top rate increases by another 5%. With both the Medicare tax and the increase in the top bracket, taxpayers who sell a major asset will pay federal tax of 23.8%. Taxpayers also face top federal income tax rates of 39.6% on earned income and 43.4% on interest and other investment income.
In addition, many states levy tax of approximately 3% to as high as 13.3%. A reasonable combined federal-state rate for the midpoint of this range is a capital gain rate of 28% and an income tax rate of 44%.
Tax-Free Sale Unitrust
The higher tax rates may be illustrated through comparison of a sale by John and Mary Smith of a million dollar property. They paid $200,000 for their appreciated stock and it is now worth $1 million. Because John is age 65 and Mary is age 60, they would like to sell the stock and increase income.
Consider the difference between 2012 rates and the present. In 2012 many potential donors viewed the 15% rate and were willing to sell and pay tax. But with the higher rates, will donors feel they are still willing to sell and pay the tax? Or will they now prefer a tax-free sale?
If donors had created a charitable trust in 2012, they could have bypassed the capital gains tax of 15% and enjoyed an income tax deduction. The $800,000 bypass of capital gain saves $120,000 in tax, while the income tax deduction of $301,570 saves $105,550 in tax. The total 2012 tax savings are $225,550.
If John and Mary sell that property through a charitable remainder trust in 2013, they could save $190,000 in capital gains tax at the 23.8% rate and $119,422 in income taxes at the 39.6% rate. The total savings are now $309,822. This is a 37% increase in tax savings over the prior year. This approximately $84,000 in added tax savings is surely a strong encouragement for John and Mary to consider a tax-free sale. Most donors who understand these benefits will choose to fund a unitrust.
Finally, if John and Mary are in a state with a substantial tax on income and capital gains, they could be subject to the 28% capital gain bracket and 44% income tax bracket. The same trust would save $224,000 in capital gains tax and $132,691 in income taxes, for a total savings of $356,691. These donors may discover that the unitrust tax savings are now $100,000 more this year than previously. While they are patriotic Americans, many will choose the major tax savings of a tax-free sale through a unitrust.
Individuals in high tax states now enjoy another benefit that existed with the higher tax brackets before 2000. With the larger tax savings in 2013, the actual net investment cost of the $1 million unitrust is approximately $650,000 to $700,000. For John and Mary, the present value of their income stream is also $650,000 to $700,000. Their retained income interest may be similar to their net investment.
This is truly a high-leverage charitable gift. While donors should always have charitable motivation, the actual level of "charitable receptivity" appropriate for this plan is very modest. Advisors should encourage nearly all individuals with substantial appreciated properties to consider the benefits of a charitable remainder trust. It is now an extraordinary opportunity to make a major gift with very limited cost.
Sale and Unitrust
Many donors have considered a one or two life charitable remainder trust, but also would like cash. This may be to improve their liquidity position or to make another investment. A solution that permits both cash and charitable tax benefits is a sale and unitrust. The prorated basis is allocated and there is gain on the sale portion. However, the gain is bypassed on property transferred to the unitrust. In addition, the charitable deduction from the unitrust offsets part or all of the tax due on the sale portion.
For example, John and Mary might decide to transfer $600,000 in value to the charitable remainder trust and sell $400,000 of the stock for cash. If they have real property, the same result can be achieved through either deeding an undivided interest or, if the property is divisible, two separate deeds. In either case, there is property in the unitrust and assets withheld that will be sold for cash. With real estate, the two separate deeded properties are normally sold jointly to the same purchaser.
It is helpful to compare the 2012 result with 2013. The 2012 tax rate is 15% on capital gain and 35% on income taxes. The tax savings are $72,000 on the capital gain bypass of $480,000 (80% of the property allocated to the charitable trust), and $63,330 on the tax deduction of $180,942.
With the current 23.8% capital gain and 39.6% income tax rates, the capital gain savings are $114,240 and the income tax savings are $71,653. Finally, in a state that also has income and capital gains taxes, the 28% capital gain savings are $134,400 and the 44% income tax savings are $79,614.
Once again, the tax savings in 2013 are dramatically higher. Compared with an outright "sell and pay tax" option, many donors will choose a sale and unitrust. With a sale of 25% to 35% of the property and a unitrust for the balance, the charitable tax savings of the unitrust may (over the one to six year deduction period) completely offset the tax on the cash. This enables these donors to enjoy both cash and a tax-free sale.
Low-Tax Income
An additional benefit is the ability to invest in a stock-bond portfolio and pay the donor income taxed at lower rates. If the majority of trust investments are stocks or equity mutual funds, then most of the payouts may be dividends or long-term capital gains. Under the Sec. 664 four-tier accounting rules, the ordinary income of the trust is distributed first. That may be taxed at 39.6% federal or (using our assumed state tax rate) 44% federal and state. Dividends and long-term capital gains will be distributed next and could be the majority of the unitrust payout amounts. They may be taxed at 23.8% federal and 28% federal-state rates. For high-income donors, the investment risk of an equities-based portfolio is often acceptable in order to obtain favorable tax treatment on the majority of unitrust payouts.
Conclusion
The obvious benefits of a tax-free sale have increased dramatically in 2013. Because there are a much larger number of donors and the stock and real estate markets have recovered, it is probable that many individuals will create charitable remainder trusts this year. Advisors for donors should recognize the dramatic increase in the attractiveness of the charitable trust. With greatly enhanced tax savings, there should be dramatically more charitable trusts created in 2013 and future years.
Published June 1, 2013
Print
Email
Subscribe
BookmarkPrevious Articles
What Do Major Donors Want? Part One
Gifts of "C" Corporations Part III - Charitable Bailouts
Charitable Benefits of the American Taxpayer Relief Act of 2012