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Historically low interest rates can generate historic tax benefits.
At least one of these tax benefits can be reaped without giving up immediately any cash or property: a charitable contribution of a remainder interest in a home, vacation home, or farm.
Ownership of property can be divided into two portions. A lifetime interest, or life estate, can be created. That gives a person the right to full enjoyment of the property for the rest of his or her life. The other portion is called a remainder interest. The owner of the remainder interest, or remainder estate, receives full ownership of the property after the life estate ends.
Contributing a remainder interest in property to charity can provide you with a substantial tax deduction today while allowing you to enjoy the property for the rest of your life. Because of today’s extremely low interest rates, the tax benefits of this strategy are greater than they’ve ever been.
Under the tax code, when you change the title of a property so that you have a life estate and a charity (or charities) has a remainder interest, you receive a charitable contribution that is tax deductible in the year you created the remainder interest.
The amount of the tax deduction is the estimated present value of the charity’s remainder interest. In other words, the deduction is an estimate of the value the charity will receive in the future. Tables and formulas in the IRS regulations are used to determine the present value. The amount of the tax deduction varies with your age and current interest rates.
You deduct a percentage of the property’s current value.
There are two general rules to know. The older you are, the greater the percentage of the property’s value you’ll be able to deduct. Also, the lower current interest rates are, the greater the percentage of the property’s value you’ll be able to deduct.
That means 2020 is a great year to consider setting up a charitable remainder interest in real estate. Interest rates haven’t been lower, and they can’t decline much more.
Here’s an example of how the strategy can work.
Max and Rosie Profits both are 75 and they jointly own a vacation home worth $300,000. In June 2020 they created a remainder interest in their home for a charity. They retained a joint life estate, so they can continue to enjoy the home and use it as their own for the rest of their lives.
When the remainder interest was created, the Profits’ tax adviser calculated that based on their age and current interest rates they qualified for a charitable contribution deduction equal to 76% of the fair market value of the property, or $228,000. The deduction will be taken on their individual income tax return for 2020 as part of their itemized expenses.
The interest rate used to calculate the deduction was 0.6%. If the interest rate had been 2%, as it was not too long ago, the Profits would have been able to deduct only 56% of the home’s value, or $168,000. That would still be a good benefit, but not as good as is available in 2020.
The interest rates used to calculate the tax deduction change each month in line with market interest rates for U.S. Treasury debt. The new rates are issued by the IRS each month and called the “applicable federal rates.”
By creating the charitable remainder interest, the Profits generated substantial cash right away by reducing their federal (and probably state) income taxes. If they can’t use all of the tax deduction in 2020, the unused amount can be carried forward to future years.
Of course, creating the remainder interest means the Profits’ children won’t inherit the property or any part of its value. That’s why the strategy is ideal for people who have other assets or life insurance benefits to leave legacies for their loved ones. An advantage for the children is they don’t inherit the property jointly and have to agree what to do with it.
Also, the gift of the remainder interest to charity is permanent and irrevocable.
Though some people use charitable remainder gifts for their principal residences, it probably is best to use the strategy for other properties such as vacation homes, second or third homes, and other leisure properties such as farms or ranches.
Another advantage of the strategy for those whose estates might be subject to the federal estate tax is that the value of the property isn’t included in your federal taxable estate, though you have full use of it during your lifetime.
You can create the remainder interest for multiple charities or for only one. The organizations must be recognized as charities (also known as 501(c)(3) organizations) by the IRS. After you pass away, the charity probably will sell the property and use the proceeds for its charitable purposes.
There’s never been a better time to use a charitable remainder gift because of today’s low interest rates. If you want to generate a big tax deduction today and benefit a charity in the future, meet with an estate planner to discuss the details.