Charitable Remainder Trusts: Income Now, Charity Later, Deduction Today

Key takeaways

The trust sells the appreciated asset tax-free, so the full pre-tax value produces income; the donor receives a partial deduction now and pays tax on distributions as they come out.
The charity must be projected to receive at least 10% of the initial value, and the annual payout must be between 5% and 50%.
It fits a charitably inclined household with a large, low-basis asset, typically $500,000 or more, that wants income rather than a lump sum.
It is irrevocable; the remainder is gone, and the trust costs money to set up and administer, so it is not a tax trick for the mildly charitable.

Of all the tools for dealing with a large appreciated asset, the charitable remainder trust is the one that gives people three things they want at once: no immediate tax on the sale, an income from the proceeds, and a gift to charity. It really does deliver all three. The price is the remainder, which is gone for good. Whether that's a fair trade depends almost entirely on how much the household wanted to give in the first place.

How it works

The donor moves an appreciated asset (concentrated stock, real estate, a business interest) into an irrevocable trust. The trust is tax-exempt, so it sells the asset without paying capital gains tax and reinvests the full proceeds. Each year it pays the donor (or the donor and spouse, or someone else) a set amount, for life or for a term of up to 20 years. When the payments stop, whatever's left goes to the charities named in the document.

The donor gets an income tax deduction in the year of the gift equal to the present value of the charity's remainder interest, worked out with IRS tables and the Section 7520 rate. That deduction typically lands between 20% and 40% of the asset's value, depending on the payout rate, the term, and the beneficiaries' ages. It's subject to the AGI limits for gifts of appreciated property (30% of AGI for public charities, with a five-year carryforward).

The two types

Charitable remainder annuity trust (CRAT). Pays a fixed dollar amount each year, set at inception as a percentage of the initial value. Simple and predictable, but you can't add to it later. CRATs also have to pass a test that there's no more than a 5% probability of exhausting the trust, and at low interest rates that test knocks out a lot of designs.

Charitable remainder unitrust (CRUT). Pays a fixed percentage of the trust's value as revalued each year, so payments rise and fall with the investments and the income can keep pace with growth. Additional contributions are allowed. There are variations: the net income unitrust (NICRUT) pays the lesser of the percentage or the trust's actual income, and the "flip" unitrust starts as a net-income trust while it holds something illiquid, then converts to a standard unitrust once that asset sells. Most trusts today are CRUTs. And the flip CRUT is the standard design for real estate or a business interest that's going to take a while to sell.

The rules

The payout rate has to be at least 5% and no more than 50% of the trust's value. The present value of the charity's remainder has to be at least 10% of the initial contribution. The term is either the lives of the income beneficiaries or a fixed term of up to 20 years. The trust files its own return, and distributions are taxed to the recipient under a four-tier system: ordinary income first, then capital gains, then tax-exempt income, then return of principal. In practice, a trust funded with a low-basis asset spits out capital gain for many years, so the donor pays that tax gradually as income arrives instead of all at once at the sale. Deferred and spread, not erased. Keep that in mind.

When the math works

Say a couple, both 65, hold $2 million of stock with a $200,000 basis. They're charitably inclined and they want retirement income. A direct sale costs about $430,000 in federal tax (20% plus 3.8% NIIT on $1.8 million), leaving $1.57 million to invest. A 5% CRUT sells the stock tax-free, invests the full $2 million, pays the couple 5% of the annual value for their joint lives, and hands them a deduction of roughly $500,000 to $600,000 in year one (depending on the 7520 rate), worth perhaps $200,000 in tax saved. Their income from the trust starts at $100,000 and tracks the portfolio from there. When both have died, the remainder goes to their charities.

Compared to selling and investing, the couple has a bigger income base and a big deduction, and they've given away the remainder. Whether they come out ahead personally depends on how long they live and how the trust performs. The charity comes out ahead unless the trust runs dry. If the couple had no charitable intent at all, the direct sale, with the after-tax proceeds going to the kids, is usually the better answer for the family. The CRT is for households where the gift is already a goal, and the income and deduction are simply the reasons to make it this way rather than at death.

Pairing with life insurance

A common add-on is a life insurance policy owned by an irrevocable life insurance trust, funded with part of the income and tax savings, to replace for the children what went to charity. People call it a wealth replacement trust. It can work. It also bolts a permanent insurance policy onto the plan, and that policy should be evaluated on its own merits rather than waved through as part of the package.

The versions that don't work

Promoters have sold CRTs, and their cousins, in ways the IRS has challenged again and again: payout rates so high the remainder is a rounding error, trusts funded with assets already sold under a prearranged deal (the gain then gets taxed to the donor under the assignment of income doctrine), and "charitable LLC" schemes promising deductions with no real gift behind them. If the pitch leads with the tax benefit and treats the charity as paperwork, we're not interested, and you shouldn't be either.

Costs and alternatives

A CRT costs several thousand dollars to draft and needs annual accounting, tax returns, and trustee administration, so it starts making sense around $500,000 and up. For smaller gifts, a donor-advised fund funded with appreciated stock gets the full deduction and avoids the gain with no ongoing cost, though you give up the income stream. A charitable gift annuity from a large charity provides a fixed income and a deduction with no trust at all, for gifts in the tens of thousands. Our charitable giving overview compares them side by side.

Where we come in

For clients with a concentrated position and charitable goals, we model the CRT against a direct sale, a donor-advised fund, and holding for a step-up, using the household's own life expectancies and tax picture. If the CRT wins, we work with the client's estate attorney on the design and serve as the trust's investment manager, because the payout rate and the portfolio have to be designed together. It's a piece of estate planning that only a minority of clients need. The right minority benefits substantially.

Frequently asked questions

Can I be the trustee?

Yes, and many donors are, with a professional handling the accounting. Just remember the trustee owes fiduciary duties to the charity as well as to the income beneficiary.

Can I change the charity?

Most trusts let the donor change the charitable remainder beneficiary among qualified charities. The income terms can't be changed.

What happens if I die early?

The trust ends at the last beneficiary's death and the remainder passes to charity. The estate gets a charitable deduction for the remainder, and the income interest isn't part of the taxable estate.

Does a CRT avoid the NIIT?

The trust itself is exempt, but distributions carry net investment income out to the recipient under the tier rules. The tax gets deferred and spread, not eliminated.

Joseph G. Valerio, CFP®, EAFounder and Lead Advisor at Valerio Wealth Management, a fee-only, fiduciary virtual family office in Miami, Florida. One advisor, credentialed in both financial planning and federal tax. About Joseph

This article is general education, not individualized advice, and it is not tax, legal, or accounting advice. Figures reflect federal law for the year stated and can change. Valerio Wealth Management does not prepare or file tax returns. Speak with a qualified professional about your own situation before acting.