This post was authored by Salvatore M. Capizzi, Dunham's Chief Sales & Marketing Officer. If you have questions concerning today's topic, please call us at (858) 964 - 0500. Hold us to higher standards.

"The Backwards Article"

In 1997, the sitcom Seinfeld had one of the most innovative and funny episodes I have ever watched. The episode is called "The Betrayal," but it is better known as "The Backwards Episode." The entire half-hour program starts from the show's end. Even the production company's logo that typically ends each episode begins this particular 30 minutes of pure joy.

It is genius -- worthy of finding and watching if you want an entertaining escape.

Now, selling assets held for longer than a year is not a laughing matter. Depending on the type of asset and where you live, you may pay anywhere from 20% to 37.1% in tax. A charitable remainder trust can be a practical solution to consider. However, this is far from a situation you would likely encounter on a sitcom.

So, how is “The Backwards Episode” connected to an article on selling highly appreciated stock?

A discussion of trusts and taxes can, at times, be dry. So, in the spirit of making what I consider one of the most important tax topics today a bit more interesting, I will start this article from the end and work my way to the beginning.

Contact Dunham for More Information

For more information about this critical tax strategy, complete this online form or call us at (858) 964–0500 and ask for a Regional Marketing Associate who can provide you with more information.

Sounds too Good to Be True – Is There a Catch?

The charitable remainder trust was established with the Tax Reform Act of 1969 and has been a valuable tax planning tool since then. Combining this strategy with an Irrevocable Life Insurance Trust (ILIT) can potentially benefit everyone.

You benefit by:

  • Eliminating the capital gains tax when the asset is sold
  • Receiving more income compared to selling the stock and paying the taxes
  • Scooping up to 90% of the gifted asset back to you and deferring the capital gains if you optimize the charitable remainder trust in your favor and live to your life expectancy
  • Creating a bonus tax deduction you can use to save taxes on other income
  • Removing the highly appreciated assets from your estate, which can result in additional tax savings

For your family:

  • Use the IRS to help replace some or all of the assets given to charity or a donor-advised fund. We call this the “having your cake (or vegetable smoothie) and eating it too” strategy.

For your charity or donor-advised fund:

  • The charitable remainder trust provides assets to extend your legacy after you have passed away

Removing the Highly Appreciated Asset from your Estate

In 2026, the estate tax exception, the amount of assets you can leave to your family without incurring any federal estate tax, will sunset to about $6 million. That is, of course, if the current proposal to lower the exception rate in 2022 to $3.5 million doesn’t pass first.

Let us go back to our hypothetical example of Mary selling the $3 million of Tesla stock in the charitable remainder trust.

She not only eliminated the capital gains tax when she sold the stock, created lifetime income, and provided a tax deduction towards other income, but it also removed the entire $3 million of Tesla stock from the estate. Removing the Tesla stock from the estate could result in significant tax savings when the estate tax exemption decreases in 2026…or sooner.

Having Your Cake and Eating it Too!

When you pass away, the assets in your charitable remainder trust will be distributed to the charity you selected or to your donor-advised fund.

Suppose you wanted to leave something from the sale of your Tesla Stock to family members. Is there a way of receiving the benefits of a charitable remainder trust and still have something to give to your family?

What if you used the part of the tax-saving you will receive to purchase insurance on your life? If you place the insurance policy in an Irrevocable Life Insurance Trust (ILIT), you can create the most tax-efficient asset ever, free of estate, income, and capital gains tax.

In essence, you are using the IRS to replace some or all of the assets going to the charity.

You still receive all the living benefits we discussed, but you are leveraging the tax savings to purchase the life insurance in an ILIT which could provide a sizable tax-free asset in your estate.

It is like having your cake and eating it too. Or if you sport more healthy eating habits, it is like having your vegetable smoothie and drinking it too!

A Bonus Tax Deduction - Save Taxes on Other Income

In addition to the higher amount of lifetime income and the elimination of the capital gains tax when the asset is sold, you will also receive a separate tax deduction.

As a rule, the higher the distribution from the charitable remainder trust, the lower the deduction. The lower the distribution, the higher the deduction.

In the example above, Mary, our 54-year-old investor with the Tesla stock, can expect to receive around a $300,000 deduction when optimizing the charitable remainder trust, where she scoops 90% of the value of the Tesla stock from the trust during her expected lifetime.

It is important to note that the deduction is typically limited to 30% of your Adjusted Gross Income (AGI) if you are selling an asset. If cash is gifted, the deduction is limited to 60% of AGI. If you cannot use the entire deduction in the tax year the gift was made, you may carry over any unused charitable deduction for up to 5 years, creating a powerful tax savings tool.

How is Income from the Charitable Remainder Trust Taxed?

When you set up a charitable remainder trust, you must pay tax on the income stream. The IRS categorizes this income into four tiers:

1. Ordinary income and qualified dividends

2. Capital gains

3. Tax-exempt income

4. Return of principal

It is only when the higher tier of income is exhausted does the next tier apply. Typically, you may benefit from a better tax situation from the charitable remainder trust income as you get older.

Putting a Charitable Remainder Trust to Work for Mary

A charitable remainder trust allows Mary to transfer her highly-appreciated Tesla stock to the trust without incurring immediate capital gains tax when it is sold. She also receives a charitable income tax deduction to pay less taxes on other income she may have.

Then, for the rest of Mary’s life, the trust pays her income. Since we did not immediately pay the capital gains tax on the sale of the Tesla stock, Mary receives higher income than had she sold the Tesla stock and paid the tax.

Once Mary passes away, the remaining value of the trust goes to one or more charities that Mary selected or a donor-advised fund. In addition, Mary’s estate does not owe any inheritance tax on the assets in the charitable remainder trust.

A Case Study

Let us look at a hypothetical case study.

Mary, age 54, owns $3 million of Tesla stock she has held for more than a year with a cost basis of $500,000. This leaves her with $2.5 million, subject to taxation.

Living in California, if we assume Mary is in the top tax bracket, her tax situation is as follows:

Federal Capital Gains Tax:

She will owe IRS 20% of the gain, or $500,000.

Net Investment Income Tax:

This tax is 3.8% of her gain, or $95,000.

California State Tax:

If your state does not have a state tax or a lower tax, you would need to use the tax in your state. However, for our hypothetical example, Mary needs to contend with a 13.3% tax, or $332,500.

Total Tax:

$927,500.

A charitable remainder trust may be a solution.

A Tax Challenge

Today, we will examine a tax strategy that can eliminate capital gains tax on highly appreciated assets like real estate, a business (a charitable remainder trust cannot hold S-Corp stock), publicly traded stocks, or complicated assets.

We will explain how to use a charitable remainder trust. This type of trust has many benefits, but principally it is used when you want to eliminate a high capital gains tax on the sale of an asset and create a higher level of lifetime income when compared to selling the investment and paying the tax.

It also gives you a tax deduction to save taxes on other income and brings the satisfaction of providing a portion of your assets to a charity or a donor-advised fund when you pass away.

Financial Advisors: Click here to download this blog post as a white paper.

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Disclosure: This document is provided for informational purposes only by Dunham & Associates Investment Counsel, Inc. solely in its capacity as a Registered Investment Adviser and should not be construed as legal and/or tax advice. Dunham & Associates Investment Counsel, Inc. does not provide tax, legal or accounting advice. This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, tax, legal or accounting advice. You should consult your own tax, legal and accounting advisors before engaging in any transaction.

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