How a Charitable Remainder Trust Defers Capital Gains Tax

A Charitable Remainder Trust (CRT) is an irrevocable trust that allows an individual to transfer assets to the trust, which then provides a potential income stream to a beneficiary for a set period. This period can be a number of years or the beneficiary’s lifetime. When the trust term ends, the remaining assets are distributed to a chosen charitable organization.

A primary reason for establishing a CRT is to manage the tax impact of selling highly appreciated assets, like stocks or real estate. By donating the asset to the trust before it is sold, the owner can defer the capital gains tax. This strategy allows for the reinvestment of the full pre-tax value of the asset, which can generate a larger income stream over time while fulfilling philanthropic goals.

The Initial Asset Contribution and Sale

The process begins when a donor transfers a highly appreciated asset into a CRT. A key feature of a CRT is its status as a tax-exempt entity under the Internal Revenue Code. Because the trust is tax-exempt, it can sell the contributed asset without being subject to immediate capital gains tax.

For example, if an individual owns stock valued at $1 million that was purchased for $100,000, a personal sale would result in a $900,000 capital gain and a significant tax bill. This tax payment would immediately reduce the amount of money available for reinvestment. By first contributing the stock to a CRT, the trustee can sell it for its full $1 million value. Since the trust pays no tax on the sale, the entire amount can be reinvested to generate income for the beneficiary.

This process is a tax deferral, not a complete elimination of the tax. The capital gains from the sale are not erased but are instead held within the trust. The tax liability is passed on to the income beneficiary and paid over time as distributions are made from the trust, spreading the tax burden over many years.

Taxation of Payments to the Beneficiary

Distributions from a CRT are taxed according to a specific, four-tier accounting system mandated by the IRS. This system functions on a “worst-in, first-out” basis, where the most highly taxed income categories are considered distributed first.

The first tier is Ordinary Income, which includes interest, non-qualified dividends, and rents. All income in this category must be fully distributed before moving to the next tier. This income is taxed at the beneficiary’s highest personal income tax rates.

The second tier is Capital Gains, which is where the deferred gain from the sale of the initial asset resides. Once all ordinary income is distributed, subsequent payments are characterized as capital gains until the entire amount is exhausted. A large portion of payments in the early years of a CRT will often fall into this category and be taxed at long-term capital gains rates.

The third tier consists of Other Tax-Exempt Income, such as income from municipal bonds held by the trust. This income is distributed only after all ordinary income and capital gains have been paid out. Beneficiaries may not receive tax-exempt income until late in the trust’s term, if at all.

The final tier is the Return of Principal, which represents the original, non-gain portion of the contributed assets. Distributions from this tier are not taxable to the beneficiary. This is the last category of funds to be distributed, and in many CRTs, the principal is preserved for the final charitable remainder.

Key Information and Decisions for Trust Establishment

Several foundational decisions must be made before creating a CRT, which will define its structure and operation. These choices are locked in once the irrevocable trust is signed.

• Type of trust. A Charitable Remainder Annuity Trust (CRAT) pays a fixed dollar amount each year based on the trust’s initial value, and no additional contributions are allowed. In contrast, a Charitable Remainder Unitrust (CRUT) pays a fixed percentage of the trust’s value, recalculated annually, which allows payments to fluctuate and permits additional contributions.
• Payout rate and term. IRS regulations require the payout rate to be between 5% and 50% of the trust’s assets. The term can be set for a specific period not to exceed 20 years, or for the lifetime of one or more beneficiaries. The “10% remainder rule” requires the present value of the amount left for charity to be at least 10% of the initial contribution, which can limit the payout rate or term.
• Trustee selection. The trustee manages the trust’s investments, handles distributions, and files all taxes. The donor may serve as trustee, but many select a corporate trustee, like a bank or trust company, to manage the administrative duties.
• Asset information. The asset’s fair market value at the time of contribution and its cost basis must be gathered. The fair market value is used to calculate the payout, while the cost basis is needed to determine the amount of capital gain held in the trust’s second accounting tier.

Required Annual Tax Filings

Operating a CRT involves annual tax reporting for both the trust and the income beneficiary, with the trustee being responsible for these filings. The trust must file IRS Form 5227, Split-Interest Trust Information Return. This form reports the trust’s financial activities, including income, expenses, and distributions. A part of Form 5227 tracks the four-tier accounting structure to ensure distributions are characterized correctly.

Based on the information from Form 5227, the trustee prepares and sends a Schedule K-1 to each income beneficiary. The K-1 breaks down the total distribution received during the year into its specific tax components, corresponding to the four-tier system. It will state how much of the payment is ordinary income, long-term capital gain, or another income type.

The beneficiary then uses the figures from the Schedule K-1 to complete their individual income tax return, Form 1040. The amounts for each category of income are transferred to the appropriate lines on their personal return. This process ensures that the deferred gains and other income are finally taxed at the beneficiary level as they are received.