Ya don’t need to understand much about baseball to know that if you can’t protect a lead in the 9th inning, you’re not gonna win as much as you’d like. The Padres team of recent vintage, especially the ’98 team, understood this principle well. They not only had a great (Hall of Fame?) closer in Trevor Hoffman, they had guys who set him up in the 7th and 8th innings. If you didn’t have your foot on the Padres’ throat by the end of the 6th inning, your chances of winning that game were significantly reduced — in fact stats showed they were drastically minimized. During one stretch, Hoffman came into games over 50 consecutive times without giving up the lead.
That’s a reliable exit strategy — it allowed average to better than average teams to achieve won/loss records seemingly above their pay grade.
An exit strategy I don’t recommend for the vast majority of people is the Charitable Remainder Trust. On the surface it seems like a pretty good deal. A relatively successful investor with $3 Million in equity may find themselves with comparatively high income but sans long gone tax shelter (depreciation). Furthermore, as detailed in the excellent post by Richard Warren on these pages, a CRT can be better than nothing.
Here’s what folks see.
- An immediate and humongous tax deduction in the amount of the donation — in this case $3 Million.
- Escape from capital gains taxes from the sale of long held properties — a potential savings of a few hundred grand.
- An income devoid of personal management for the rest of their lives — very attractive.
Beware — here comes the segue where I bash your dreams with some harsh realities.
Many think the huge tax deduction will shelter the annual income they receive from the CRT — not entirely true — not by a long shot.
Reality: By definition the tax deduction can only be used against 30% of your income — income from any source — but only 30% per tax year.
Reality: Even that has a shelf life of just five years. Then it’s poof! like steam in the wind. The rest of your retirement is spent receiving all that cool income while being stark raving naked every April 15th.
Reality: If you choose to take out most of the principal donation as income the IRS will come at you with serious intent.
Bonus Reality: Those thinkin’ they’ll get a life insurance policy so their heirs will not be left out upon their death, think again. Who’s gonna pay those monster premiums at your age? You? The insurance fairy? Remember, the investor did this cuz they needed the income, didn’t want the real estate anymore, and couldn’t or didn’t wanna pay the cap gains taxes.
CRTs simply aren’t the be all end all to exit problems for real estate investors. I do have a patch for ya though, if you’ve found yourself inexorably hurtling towards this dilemma.
Using the $3 Million example above, let’s say the yield produced is 6%, which is conservative as per my CRT consultant. That would generate a $180,000 annual income. What with Social Security (Hey, no laughin’ in the cheap seats!), and a small annuity his wife has, he believes he can live off of $100,000+ after tax.
He then takes $25,000 a year for the next 10 years and puts it toward his own EIUL. (Equity Indexed Universal Life) My in-house expert on the subject did some numbers for me using this example. Turns out after 10 years this EIUL will generate a tax free income of roughly $50-70,000 annually — for five years past his life expectancy of 85. (Assumed in this example.)
If he was able to keep up the annual premiums for a total of 20 years, his tax free income would’ve been $170,000 yearly. The 20 year option doesn’t make much sense for someone startin’ out at 65, but if they’d been 55 or so? A real alternative. Also, upon his death at 90, his heirs would receive some serious tax free cash, as monies from the EIUL wouldn’t be part of his estate — how much would depend upon the way he structured the EIUL at inception, among other factors (age, health, etc.)
The takeaway here is that CRTs are best used when the charitable donation is the primary reason for the strategy — not an exit strategy for real estate investors. At best it’s a weak Plan B that’s better than no plan, and not much else. So much is said about planning, and end games, but so little is actually done towards those ends. If you don’t have a viable exit strategy, one which I’ll detail next week as an example, Uncle Sam will be glad to give you a Plan B.
Also remember, in Richard Warren’s post, that it was as a result of the investor’s strategy that he found himself in this unenviable situation. I think that post may have helped an impressive number of investors to avoid the same predicament.