Howard and Miriam are contemplating selling their Palo Alto house, where they've lived for the past 30 years. But the specter of huge capital-gains taxes -- which would severely limit where they go next -- is holding them back.
They figure that if they paid $250,000 for the house that's now worth $2 million, even with a $500,000 homeowners exemption and $250,000 in improvements, they're liable for upwards of 25 percent in capital-gains taxes, once they factor in both federal and state taxes.
But that can be trimmed back radically, according to Sandeep Varma, a wealth strategist with Advanced Trustee Strategies (ATS) in Menlo Park, while speaking at a workshop in January. ATS has been offering free workshops on "How to Sell Real Estate Without Paying Capital Gains Tax" for 21 years, with Varma's office managing nearly $100 million in charitable trusts. (Varma is a registered representative with LPL Financial, an independent broker/dealer.)
"This area is very complicated and very misunderstood," he said at the beginning of his workshop. "it's not a loophole. It's a concept that's more than 40 years old."
The crux of the seminar focuses on creating charitable remainder trusts and children's trusts.
Varma likes to use hypothetical case studies (based on real people) to lay the groundwork for discussion. He begins with Howard and Miriam's family: Howard, 70, who's not fully retired; Miriam, 67, who wants to travel more; and their three adult children.
Their key assets include:
Home $1.9 million
Rental property $1.2 million
Howard's IRA $700,000
Stocks, bonds, etc. $850,000
Cash from Miriam's inheritance $215,000
Personal property $75,000
Life insurance (Howard's) $10,000
Net worth $4,950,000
Howard makes $35,000 from a pension plus another $45,000 from part-time consulting; Miriam wants to know if they'll need her inheritance to live on. They also receive about $30,000 per year from their rental property.
Next, Varma said, comes a financial analysis, where they discuss income, needs and assets. After doing the cash-flow analysis, he comes up with a net surplus of $54,000/year.
If they both died today, he said, each child would get 25 percent of the estate and 25 percent would go to the six grandchildren.
With an estate-tax exemption of $10 million, one might think there would be no taxes due, Varma said. But the actual tax liability would be $254,943 -- because much of their assets were in tax-deferred IRAs.
To offset this, Varma suggested setting up a charitable remainder trust (CRT), where Howard and Miriam would donate their assets to a charity, but during their lifetime they could still receive income from the trust's assets. They avoid capital-gains tax on the donated property and the property is removed from their estate so is not subject to estate taxes. Howard and Miriam retain control over how their donated assets are invested, and they can even change the designated charity.
Varma calls the name "charitable remainder trust" somewhat of a misnomer, because the main beneficiary is the family that ends up with two to 10 times as much money.
Varma used the example of a paid-in-full home being transferred into the trust, where Howard and Miriam are the trustees (not the charity). If they sell the property, there's no capital-gains tax or recapture of depreciation. And only on the death of the second person in the couple does the money go the charity (or private foundation) that they've designated.
People can choose to put a portion of their assets, say 50 or 75 percent of their home, in the trust. "They can leave half out and avoid capital gains," Varma said.
What the charitable remainder trust allows them to do is "pull a large block of money out without taxation. The other part stays in the trust, which spins off an income, between $50,000 and $100,000, which allows them to have a down payment (for a retirement home), or downsize," he added.
Once they've transferred property into the CRT, they must then sell it and reinvest in something else: stocks, bonds, mutual funds or whatever. That investment creates income, and they could take up to 7 percent, depending on their ages, Varma explained.
(If they didn't sell the house, there would be no income generated; if they transferred in rental property, they wouldn't have to sell it since its rental income is considered trust income, he added.)
On Dec. 31 of each year, a third-party administrator looks at the value of the account and allocates the 7 percent as their income for the year from the trust (7 percent of $1.2 million is $84,000 of taxable income).
What happens when the $1.2 million investment earns less than 7 percent, say $60,000? The following year, the value would be $1.2 million minus $24,000, and their 7 percent would be $82,320.
"If it increases in value, income will go up the next year," Varma said.
There are also fees associated with the third-party administrator -- about $2,000/year, Varma explained, but said that the administrator acts as an insurance policy just in case the IRS raises issues.
The biggest downside to a CRT, Varma said, is that it is irrevocable (meaning once it's signed no changes can be made). And the assets in the trust ultimately go to the charity, not to the heirs.
Varma also talked about a children's trust, which is also irrevocable, and can be used to shelter income while providing income for a child. Inside the children's trust is a "second-to-die survivorship" life-insurance policy, where benefits are not paid until the second person dies. For his case study, Varma advised Miriam to take her $200,000 inheritance, plus the $84,000 income from the CRT, and buy a $4 million survivorship policy.
"Instead of leaving a chunk of money to the kids tax-free, they are getting a layer of asset protection (100 percent exempt from all predators, such as a lawsuit, divorce, bankruptcy or future estate taxes," he added).
By doing this kind of planning for the family, they can leave more money; that trust can be around for close to 100 years.
Each person's life situation is a little different, he said, and his company offers free introductory one-on-one consultations to determine if some of these strategies are appropriate.
Private seminars are held in the Menlo Park office. For information on upcoming seminars, "The 7 Mistakes Trustees Often Make" and "How to sell real estate without paying capital gains tax," call Mindi at 650-243-2224.