If you could remove up to 99% of capital gains on highly appreciated assets, reduce your Adjusted Gross Income (AGI) or taxable income by 50% for 6 years, and create a tax-free income stream from that donated asset, you might question my sanity.
While some may still question my sanity, the above stated strategy is entirely possible. Mark Zuckerburg used a very similar strategy which eliminated billions he would have owed in capital gains tax. There are have also been demands for tax returns from politicians who've boasted about not paying any federal income tax. While we cannot verify it, its a fair guess that those individuals may be using a similar strategy as well.
We call this strategy a Charitable Estate Replacement Plan (C.E.R.P.) and it is ideal for people who fit the following:
- Are charitably minded
- Have unleveraged (no debt) assets with a low-cost basis and are valued at $500,000+ ($1,000,000+ is better!)
- Are currently paying a significant amount in federal income taxes
While all the above 3 requirements do not need to be fulfilled to qualify, this strategy is just more enticing to those who fit all 3. At a minimum the asset needs to be unleveraged and have a value of $500,000+.
There is quite a bit of proprietary information, so I will give the 60,000-foot view of this strategy. I’ve highlighted the key benefits of this strategy below.
- A current income tax deduction which avoids up to 50% of your total tax (with a 5 year carry forward)
- Assets contributed grow without tax
- Appreciated assets contributed can be sold or liquidated without tax
- Assets are exempt from gift and estate tax
- Assets are creditor and divorce protected
- Client and heirs maintain total control over the assets in a C.E.R.P.
- Client and heirs will make substantial charitable gifts to their preferred designated charities
Essentially, we give/promise the asset (or the value of it) to a 501(c)(3). We do have to collateralize the asset and I’ll explain in the next paragraph. I would strongly recommend that it’s a public charity that you are not on the board of, or you do not have a financial tie to. This isn’t required but offers better tax benefits.
By guaranteeing (promising) that asset to a public charity, you can not only remove 99% of the capital gains tax, but you can give yourself a tax write off up to 85% of the value of that asset. So, if the asset is worth $1,000,000.00 you can potentially give yourself an $850,000 tax write off with a 5 year carry forward. Which potentially could be 6 years’ worth of tax write offs that can reduce your AGI, or taxable income, by 50%.
The kicker to strategy is, you can still access the value of it tax free. If we collateralize that asset, normally done with a large permanent life insurance policy, you can borrow against it. As I’m sure you are aware, you do not pay tax on a loan. The IRS is going to require you to pay interest on that loan, but it’s a relatively low rate, normally between 2-4% which is substantially less than you would pay in taxes. That large life insurance policy will pay back the principle loan amount. Its possible that we can over insure the assets to replace the value of it and pay back the loan in order to pass the asset along to an heir.
While a permanent life insurance policy, that has a guaranteed death benefit to be paid, could potentially be expensive, we just created 6 years’ worth of tax write offs, and eliminated 99% of capital gains, which may justify the cost of the insurance policy. There's also the ability to greatly reduce the cost of insurance premiums through premium financing. In some cases, up to 95% of insurance premiums can be covered through premium financing.
In an ideal world, we also structure these policies in which they can be fully paid, meaning no more premium payments are due, after 7 to 10 years. Doing so makes the economics of this strategy much more appealing.
The below example shows the tax benefits for someone making $500k a year and liquidating a $1,000,000 asset with a $100 cost basis in year 1. The left shows the tax liability if they don’t use a C.E.R.P., and the right shows the benefits if they do. The below example is only accounting for federal income, federal capital gains and the Net Investment Income Tax. We have excluded any state and local taxes (SALT) and the Alternative Minimum Tax (AMT).
The above example shows a conservative estimate of the tax savings of $677,000. If we were to include SALT and/or the AMT, the tax savings would be even greater.
This strategy is particularly ideal for real estate and is, in many cases, better than doing a 1031 Exchange. However, we require that the assets be unleveraged, so it won’t apply to all real estate assets. If you do have leveraged real estate assets, we do have another strategy to add some flexibility to that process.
I’m sure this article/newsletter may have brought up some questions, which we are happy to answer. If you’d like to set up time for a review or see if this strategy may be ideal for you and/or your clients, feel free to reach out to our office on our website here. You can also reach out to me directly at my contact info listed below.