Tactics To Reduce Your Capital Gains Tax And Your Estate Tax

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The Biden Administration and Congress have proposed sweeping changes to the way long term capital gains are taxed both during your lifetime and after your death. Although none of these proposals are final, and may never become final, they do raise the question of what tactics are available to reduce or defer the taxes on appreciated property. One likely strategy that has been suggested to blunt the cumulative effect of both the capital gains tax and the estate tax changes, which will consume more than 75% of any estate with over $3.5 million and consists of mainly highly appreciated property, is to harvest the capital gains each year. That is, have a transaction that realizes capital gains each year, in an amount that keeps the taxpayer’s income below the $1 million level where the highest tax is triggered. When the gains are realized, the assets transacted get a new cost basis. The challenge then is how to reduce or defer the tax due on these transactions. Fortunately, there are existing, proven tactics for doing so.

Here is a review of the tactics that are now available; and, unlike 1031 like-kind exchanges, Donor Advised Funds, Pooled Income Funds and the like, are not on the table as needing changes in the proposed tax laws. 

Charitable Remainder Trusts are the best way to defer paying capital gains tax on appreciated assets, if you can transfer those assets into the trust before they are sold, to generate an income over time. 

 When a Charitable Remainder Annuity Trust (CRAT) is established, your gift of cash or property is made to an irrevocable trust. The donor (or another non-charitable beneficiary) retains an annuity (fixed payments of principal and interest) from the trust for a specified number of years (up to twenty years) or for the life or lives of the non-charitable beneficiaries. At the end of the term, a qualified charity you specify receives the balance of the trust property. 

   Gifts made to a CRAT qualify for income and gift tax charitable deductions; and, in some cases an estate tax charitable deduction for the remainder interest gift, only if the trust meets the legislative criteria. The annuity paid must either be a specified amount expressed in terms of a dollar amount (e.g., each non-charitable beneficiary receives $500 a month) a fraction, or a percentage of the initial fair market value of the property contributed to the trust (e.g., beneficiary receives 5% each year for the rest of his life).  You will receive an income tax deduction for the present value of the remainder interest that will ultimately pass to the qualified charity. Government regulations determine this amount, which is essentially calculated by subtracting the present value of the annuity from the fair-market-value of the property and/or cash placed in the trust. The balance is the amount that the grantor can deduct when the grantor contributes the property to the trust.  

   A Charitable Remainder Unitrust (CRUT) is the same as a Charitable Remainder Annuity Trust except that instead of a fixed dollar amount or percentage of the original gift amount, the annuity is a specific percentage of the balance of the trust assets as of the beginning of the year the payments are to be paid. 

Charitable Lead Trusts

A Charitable Lead Trust is the best way to accelerate charitable deductions to both reduce the negative effects of the new limitations on itemized deductions and to offset up to 50% of your Adjusted Gross Income in any tax year. It can also be used as a way to eliminate gift or estate taxes on transfers to children or other beneficiaries. 

   A CLAT is created by transferring cash or other assets to an irrevocable trust. A charity receives fixed annuity (principal and interest) payments from the trust for the number of years you specify. At the end of that term, assets in the trust are transferred to the non-charitable remainder person (or persons) you specified when you set up the trust This person can be anyone, yourself, a spouse, a child or grandchild even someone who is not related to you. 

   You can set up a CLAT during your lifetime or at your death. Both corporations and individuals may establish lead trusts, which is useful when you need to take appreciated assets out of a business tax-free. 

   If you are the beneficiary, then you will receive an immediate and sizeable income tax deduction. In the second and following years, you must report the income earned by the trust, less the amounts actually paid to the charity in the form of an annuity.

   One advantage of the CLAT is the acceleration of the charitable deduction in the year you make the gift, even though the payout is spread out over the term of the CLAT. For example, if you have sold a very highly appreciated asset this year, but you can reasonably expect that in future years, your income will drop considerably you can have a very high deduction in a high bracket year, even if you have to report that income in lower bracket years.  In effect, you are spreading out the income (and the tax) over many years. 

   Another advantage of the CLAT is that it allows a "discounted" gift to family members. Under present law, the value of a gift is determined at the time the gift is made. The family member remainder man must wait for the charity's term to expire; therefore, the value of that remainder man’s interest is discounted for the "time cost" of waiting. In other words, the cost of making a gift is lowered because the value of the gift is decreased by the value of the annuity interest donated to charity. 

   When the assets in the trust are transferred to the remainder man, any appreciation on the value of the assets is free of either gift or estate taxation in your estate. 

   A Charitable Lead Unitrust Trust is the same as a Charitable Lead Annuity Trust except that the payout to charity is a percentage of the trust assets at the beginning of the year in which the annuity payments are to be made.   

Qualified Opportunity Zone Funds

The Qualified Opportunity Zone Fund is new but it has the potential to be a powerful tool to both defer capital gains and get a tax-free return on investments. 

A new provision in the 2017 Tax Cuts and Jobs Act creates the Opportunity Zone Program, a program intended to drive long-term investment of capital to distressed communities by providing tax benefits on investments in QOFs. Originally introduced in the Investing in Opportunity Act (IIOA) – this is the first new community development tax incentive program introduced since the Clinton Administration.

 A QOF is a passive investment fund that invests 90% of its capital in new opportunities in Opportunity Zones. Treasury certified QOFs can pool and deploy investment capital in Opportunity Zones by investing in stock, partnership interests, and business properties. U.S. investors in the QOF receive a tax deferral for a minimum of five, and a maximum of seven years, and other tax benefits on unrealized capital gains invested in the Fund. Additionally, any appreciation on the investment that remains in the fund for more than ten years can be cashed out tax-free.  The benefits of investing realized capital gains into a QOF include:

●       The tax on realized capital gains reinvested in an Opportunity Fund is deferred until the investment is disposed of, or by December 31, 2026, whichever is sooner.

●       The basis for capital gains reinvested in an Opportunity Fund. The basis is increased by 10%, if the investment in the Opportunity Fund is held by the taxpayer for at least 5 years, and by an additional 5% if held for at least 7 years, thereby excluding up to 15% of the original gain from taxation, and

●       A permanent exclusion from taxable income of capital gains from the sale or exchange of an investment in an Opportunity Fund, if the investment is held for at least 10 years. This exclusion only applies to gains accrued after an investment in an Opportunity Fund.

 A few Funds do exist but are investing in specific projects (e.g., a hotel) or location (e.g. Detroit or Seattle) and have only begun taking investors. Of those, funds use the Private Equity, “Hedge” Funds structure that is:  1) limited partnership interests, 2) restricted to “qualified investors”, 3) investors have no control over the investment decisions, 4) funds are locked-up for five to ten years, and 5) annual fees of 2% or more. That said, there is very little restriction on who and how someone can start a fund on their own.

Deferred Sale Trust

A Deferred Sale Trust is where you sell a highly appreciated asset to an irrevocable trust in return for an installment note. The Trust then sells the asset to a third party. Under IRC section 453, you only pay tax on the gains and the interest as they are paid out to you. The Trust pays no tax on the sale of the assets to the third party, as the trust received a new cost basis when installment sale occurred. The trust can then reinvest the proceeds into other assets or a wealth replacement vehicle (such as life insurance), the death benefit being triggered at the same time the term of the note ends, such as your death. 

Conclusion:

My recommendation to those who have highly appreciated assets and expect their estates to exceed $3.5 million, is to be better educated about these tactics and their advantages and disadvantages. Also, consider setting up a “Plan B”, such as an alternative gift in an estate to a Charitable Lead Trust, to reduce or eliminate the estate taxes due, if there are highly appreciated assets in the estate, or selecting and researching a QOZ Fund as a way to defer gains. In either case, these cannot be set up in a rush and require planning for the alternatives.  if the actual changes to the tax laws are different from the proposals.