This article shows readers how a charitable remainder trust can be used to eliminate the 3.8% surtax, defer income taxation of assets, provide an income stream to the grantors, and benefit charity.

A “new” federal tax was passed to help pay for the Affordable Care Act’s cost. This tax has been in effect since January 1, 2013. The tax is an additional 3.8% tax on “net investment income.” Net investment income (“NII”) is the income received from investment assets such as bank accounts, bonds, stocks, mutual funds, loans, and other investments. This would include interest, dividends, annuities, royalties, and rents, which are not derived in the ordinary course of trade or business. NII would also include capital gains from the sale of appreciated investments. The 3.8% tax is on top of the regular income tax or capital gain tax that would be paid.

The 3.8% tax applies to individuals with adjustable gross income over $200,000 (if filing individually) or $250,000 (if married filing jointly). For taxpayers who meet this threshold, the tax is imposed on NII above the threshold income limits. For instance, an individual with adjusted gross income of $225,000, which includes $50,000 of NII, would have $25,000 of NII subjected to the 3.8% tax ($225,000 AGI – $200,000 threshold = maximum of $25,000 subject to 3.8% tax). But an individual with a $300,000 adjusted gross income, including $50,000 of NII would have the whole $50,000 of NII subjected to the extra tax burden ($300,000 AGI – $200,000 threshold = maximum of $100,000 subject to 3.8% tax). 

Let’s look at an example. John and Mary Doe have an adjusted gross income of $200,000. They have a rental apartment worth $1 million, which they are contemplating selling. The apartment is fully depreciated, so they have a tax basis of zero in the property. This means they would have a capital gain of $1 million if they sold the property. The first $50,000 of the gain would be taxed at 15% (because they are still under the $250,000 NII threshold). The next $220,000 of gain would be taxed at 18.8% (15% + 3.8%). The remainder of the gain would be taxed at 23.8%. Federal taxes would total over $220,000 on the sale. To that would be added any state income tax that would be due. In states with high capital gain rates, such as California, Minnesota, New Jersey, New York, Oregon, and Vermont, the combined tax rate can be 11% greater.

Charitably minded clients can use a special planning technique known as a “charitable remainder trust” (“CRT”) to avoid the 3.8% tax (potentially) and reduce or defer the federal and state capital gain taxes. John and Mary could contribute their apartment to a CRT. The CRT lists their favorite animal charity as a beneficiary upon the survivor’s death or the both of them. The trustee of the CRT sells the apartment, rather than John and Mary doing so.

By placing the apartment in the CRT, John and Mary would receive a charitable income tax deduction, AND the trustee of the CRT would pay them an income stream for their lifetimes. The income must be at least 5% of the value of the asset contributed. The charitable tax deduction will depend on the amount of income desired by John and Mary, John and Mary’s respective ages, and the interest rates when John and Mary create and fund the CRT. In this case, John and Mary are 72 years old, and they desire an income of $50,000 per year. Given those factors and the current applicable federal rate (an interest rate published by the IRS monthly), the charitable tax deduction would be approximately $320,000. Suppose John and Mary cannot use the full $320,000 tax deduction in the first year (due to their income level and limitations on the amount of charitable deduction that can be taken). In that case, any excess deduction can be carried forward for five years. 

By engaging in this strategy, John and Mary will have avoided the 3.8% tax in its entirety, assuming their income is below $200,000 in future years, apart from the CRT’s income. They have reduced their overall taxes due to the charitable income tax deduction they will receive. They now have an income of $50,000 per year for the rest of their lives included in their taxable income. The income likely will be taxed in part as ordinary income and part as capital gain income. It is possible, but not likely, that a portion of the income would be considered a return of principal and be tax-free. As such, they have postponed paying the taxes on the sale of the apartment until receiving the income in the future. 

Upon their deaths, the trust assets would be distributed to the animal charity named by them, fulfilling John and Mary’s desire. Suppose one or both of them are in good health, and they also wish to benefit their children or other beneficiaries. In that case, John and Mary could purchase a life insurance policy and pay the premiums with a portion of the $50,000 annual income they receive from the CRT. In that case, the life insurance death benefit would go income tax-free, and potentially estate tax-free, to the designated beneficiary(ies) upon the death of the insured spouse(s).

Our office focuses on estate, charitable, and tax planning strategies. We work with clients of all ages, incomes, and wealth levels. As a member of the American Academy of Estate Planning Attorneys, our firm is kept up-to-date with information regarding estate planning and tax savings strategies. You can get more information about scheduling a complimentary estate planning appointment and our planning and administration services by calling our office.

Copyright © 2002 American Academy of Estate Planning Attorneys, Inc. All rights reserved.