By Roger D. Silk, Ph.D., CFA and Evan D. Unzelman
An advisor recently approached us with a dilemma. His client, we'll call him John, set up a charitable remainder trust ("CRT") several years prior. Since then, John's circumstances had changed and he found himself in a situation where immediate liquidity was much more valuable than his CRT income interest (i.e., receiving annual payments for the rest of his life).
We suggested that John might be able to sell his income interest in the CRT, a transaction with which the advisor was unfamiliar. In the end, John not only sold his income interest, but he was also able to do so at a premium to the net present value ("NPV") of holding the CRT, and for cash. Needless to say, John was thrilled, and the advisor felt good about helping his client and adding a value-added service to his offering in the process.
CHARITABLE REMAINDER TRUSTS - PROS AND CONS
A CRT is a split-interest trust to which a client donates money or property and keeps the right to a specified cash flow each year, usually for the rest of his or her life (or joint life with a spouse). The series of cash flows from the trust is commonly referred to as the "income" or "lead" interest, and the grantor as the "income beneficiary."
There are two types of CRTs, the primary distinction being how the payout is calculated. In the case of a charitable remainder annuity trust ("CRAT"), the payment to the income beneficiary is a specified dollar amount. If the trust is a charitable remainder unit trust ("CRUT"), the payment is a percentage of the value of the trust, as valued each year.
At the end of the life of the last income beneficiary (or at the end of the specified term), the remaining assets in the trust go to charity. This amount is called the "charitable" or "remainder" interest.
THE PROS
The primary reason for creating a CRT is tax savings. A CRT allows the grantor to avoid any capital gains tax on the donated assets, to receive an income tax deduction for the amount projected to go to the charitable beneficiary, and to remove an asset from his or her estate.
A second, less common reason for creating a CRT is to benefit charity.
THE CONS
A careful analysis shows that for most clients the primary objectives are achieved very early in the life of the CRT, usually in the first year. This is when the grantor gets the charitable deduction and when the assets are diversified. These clients then have the CRT, which produces income for them, but in most cases yields no other benefits. In short, to get the tax benefits, the clients have to keep the CRT for the rest of their lives. The result is a large, valuable, but illiquid asset.
Further, the income which comes out of a CRT is usually all or mostly taxable income. At an average tax rate of 30 percent, for example, a CRT holder gets to keep 70 cents of each dollar that comes out of the CRT.
LIQUIDITY OPPORTUNITY - KEEP THE PROS, ELIMINATE THE CONS
Recently, a niche market has developed for buyers of CRT income interests. What is notable about this market is that buyers are paying attractive premiums, which is uncommon given the nature of the transaction (uncertain number of payments; no secondary market; and in the case of CRUTs, unknown payment amounts).
WHY BUYERS ARE PAYING PREMIUMS
Perhaps the most common question we are asked is how a buyer can afford to pay a premium for a CRT income interest. After all, most sales of cash flows involve the seller taking a discount. As it turns out, the answer is rooted in something with which most advisors are intimately familiar.
To an income beneficiary in the 30 percent tax bracket, each dollar from the CRT is worth 70 cents. To a buyer in a lower tax bracket, each dollar is worth some amount closer to 100 cents (in many cases this number is 100 cents). This tax rate differential allows for a potential spread of 30 cents on each dollar and drives the opportunity for the income beneficiary to sell at a premium to NPV.
Why are buyers in lower tax brackets? Beyond the obvious reason (exempt organizations), we've seen an array of tax attributes (net operating losses ("NOLs") and capital loss carryforwards, for example) lead to situations where the income interest from a CRT is worth much more to a buyer than the same interest is to an income beneficiary.
As most of us know, there is nothing unusual about tax rate differential. For instance, the principle that different potential owners of assets are distinguished by their tax status is what makes the municipal bond market possible. This makes it feasible for the seller to get a premium and the buyer to get a discount. It is a classic win-win situation.
WHY CLIENTS ARE SELLING
Value Maximization
Clients and their advisors are doing the math and concluding that it simply makes more economic sense to convert a long and uncertain stream of payments into an immediate and certain lump sum payment at a price representing a premium to the client's NPV of holding the CRT. This reason - we'll call it value maximization - is the by far the most common reason we see for selling a CRT income interest.
Lock in current, low capital gains rates
Because the sale of a CRT income interest is a capital transaction (see "Tax/Legal Concerns" below), it is generally taxed at capital gains rates, which are now some of the most favorable rates out there. In fact, capital gains rates have never been lower over the past 70 years, as the following table demonstrates.
Historical Capital Gains Tax Rates
Period Capital Gains Tax Rate
1922 -1933 12.50%
1934 -1935 17.7%
1936 -1937 22.5%
1938 -1941 15.00%
1942 -1951 25.00%
1952 -1953 26.00%
1954 25.00%
1955 -1967 25.00%
1968 26.90%
1969 27.50%
1970 30.20%
1971 32.50%
1972 -1974 35.00%
1975 -1977 35.00%
1978 33.80%
1979 35.00%
1980 -1981 28.00%
1981 (June 20) 23.70%
1982 -1986 20.00%
1987-1992 28.00%
1993 to 1997 (May 6) 28.00%
1997 (after May 6) - 2003 (May 5) 20.00%
2003 (after May 5) 15.00%
Average 26.05%
Many advisors are skeptical as to how long these rates will remain low, however, and are encouraging their clients to sell now to take advantage of the currently low rates.
Distress
Distress can take a variety of forms. Common sources include divorce, unforeseen reversals in business, investment losses, "upside down" net income with makeup charitable remainder trust ("NIMCRUT"), fear of Medicaid/nursing home assistance ineligibility, and threatened litigation between one or more of the parties associated with the trust. There is nothing like available cash to help with these kinds of distress, and we have seen these difficult situations solved to the satisfaction of all involved by cash generated from the sale of an income interest.
Liquidity concerns (or lack thereof)
Because CRTs are usually created for high net worth individuals, many advisors fall victim to the logic that, "since my client has substantial assets and doesn't need liquidity, selling his or her CRT income interest doesn't make sense." We've seen this logic nearly hurt advisors on several occasions for the sole reason that the sale of a CRT income interest is not driven by a need for liquidity but instead by value maximization.
On one such occasion, we were working with an advisor on a $7.5 million CRT. We had located a buyer for the income interest willing to pay a 3 percent premium ($6 million) to the client's NPV of holding the income stream ($4.5 million).
The advisor presented the opportunity to his client, but cautioned the buyer and us that liquidity was immaterial to this particular client (worth well in excess of $75 million) and that a sale was unlikely.
As it turns out, the advisor was partially right. Liquidity was not important to his client. However, a 33 percent premium for the interest and a chance to put the money to work elsewhere (still under the advisor's watch, we might add) proved to be a no-brainer for his client. From the client's standpoint, the tax advantages had already been secured (and wouldn't be compromised because of the sale), he was taxed at a lower rate on the sale than he would have been on distributions from the CRT, and he liked the idea of having the advisor invest the money in several investments that having the money in the CRT would not have permitted.
FINDING A BUYER
Buying a CRT income stream is a bit like buying a bond that has no principal repayment at the end, an uncertain number of payments (because they go on as long as the life of the donor), payments of uncertain amount (in the case of CRUTs, which most CRTs are), and no secondary market.
Because of these features, the universe of potential buyers is limited. Buyers must be able to deal with the long holding period as well as the dual uncertainties of how many payments they will get and how large those payments will be.
Needless to say, unless one knows where to look, trying to find a buyer can be very frustrating. So it is probably best to enlist the assistance of someone familiar with this market.
VALUING YOUR CLIENT'S CRT INCOME INTEREST
The first step in evaluating the potential sale of a client's CRT income interest is to assign a value to your client of holding the CRT.
The value of an income interest to a client is the after-tax net present value of the cash flows which he or she expects to receive. So to value an interest, it is first necessary to estimate these cash flows. The cash flows will last until the end of the trust, which is either the end of the last lead beneficiary's life (life trust), or the stated term of the trust (term trust). For a term trust, the expected duration number can be calculated with a calendar. For a life trust, a life expectancy can be looked up in a table.
Once the expected number of payments has been determined, the next step is to estimate the amount of each one. This amount depends on the returns earned by the trust assets and the payout rate of the trust. For trusts with payout rates higher than the annual return, the amount of each payment will decline over time.
We now have an identified number of known payments. Next, we apply the usual discount analysis to bring each payment to a present value. Then we add up each payment to get a pre-tax NPV. Finally, we apply the appropriate income tax rate to get an after-tax value.
Consider this example: We begin with the assumptions that the trust has a current value of $1,000,000, a 7 percent payout, that there are two lifetime income beneficiaries who are both 70 years old, and that their effective tax rate on trust income is about 35 percent. Based on these assumptions, and assuming that the trust earns an average return of 6 percent per year going forward, we calculate that the after-tax NPV to the clients of the expected trust income is in the range of $400,000 to $460,000. (See the middle column highlighted below.) The calculations are shown below for differing effective tax rates and discount rates. (Please see our comments at the end of the article for a fuller discussion of an appropriate discount rate. Also, note that the NPV is not very sensitive to the rate of return going forward.)
Calculation of Value of Annuity Holder's Interest in a CRT
Life Expectancy (given age) 18
Age 1 70
Age 2 70
Beginning Balance 1,000,000
Payout Percentage 7.00%
Return 6.00%
After-Tax Net Present Value Given Tax and Discount Rates
Effective Tax Rate
Discount Rate 30% 35% 40%
6% $495,343 $459,962 $424,580
7% $461,272 $428,324 $395,376
8% $430,745 $399,977 $369,210
If the client is willing to let the buyer select the ultimate charitable beneficiary (and assuming there are no other barriers in the trust), this interest may command a price of $800,000 pre-tax. After commission, usually 6 percent, the client would receive $752,000. The sale of the interest is a capital gains type transaction. Even if the client has zero basis, after paying capital gains taxes at an assumed rate of 20 percent (reflecting the federal capital gains rate at 15 percent plus an assumed additional 5 percent for net state tax) the client would net $601,600.
This is a terrific price. It represents a premium over NPV of between 30 percent and 50 percent, depending on the discount rate used to calculate NPV. In dollars, it represents an immediate, cash, net after-tax gain of between about $140,000 and $200,000, again depending on the discount rate used to calculate it.
These values are illustrated in the graphs below. The first graph, "Sale of CRT vs. Hold and Collect Annual Payments," shows in graphical format the value today of the lump sum, after-tax payment versus the value of each future year's payment, after-tax and discounted to a present value. It shows graphically that a payment 15 years or so from now is not worth very much today.
The second graph, "Sale of CRT vs. Holding," stacks up all these future payments, at today's value, and again illustrates that all together they are worth significantly less than the amount the clients would net today by selling. In addition, as clients age, of course, there is a significant risk that they will not collect some or all of the anticipated payments.
TAX/LEGAL CONSIDERATIONS
Our firm retains the counsel of a nationally-recognized law firm to advise us on CRT law. After a period of intense study, they have determined that there are no legal barriers to the sale of CRT income interests, although each case must be looked at individually because each trust is different.
In addition, although each taxpayer must evaluate his or her own situation, the sale of a CRT lead interest is generally considered a capital transaction. The IRS has issued several private letter rulings on this matter. We usually direct advisors to private letter ruling ("PLR") 200127023, which provides that a sale of an income interest in a trust is a sale of a capital asset within the meaning of sections 1221 and 1222 of Rev. Rul. 72-243, 1972-1 C.B. 233.
PLR 200127023 goes on to say that the holding period for purposes of determining whether gain or loss from the disposition of an income interest is long-term or short-term commences on the date the taxpayer first held such interest. In other words, if a seller has held his interest for more than a year, the sale may be a long-term capital gain, which is taxed at one of the most favorable rates available.
These letters are the source of the determination that the sale of a CRT lead interest may be a capital transaction.
BENEFITS FOR THE ADVISOR
From an advisor's standpoint, the benefits of providing a client with liquidity for CRT interests are multi-faceted. Initiating this kind of transaction provides a valuable and needed service to the client, and ultimately keeps him or her happy. It also prevents the client from going to a competitor with a problem the advisor could not solve.
In addition, a number of advisors will find that merely being able to discuss the possibility of this type of transaction will heighten their esteem in clients' eyes.
Discount Rate Cannot Be Lower Than the Expected Rate of Return
This is an assumption based on a logical analysis, which follows. A discount rate answers the question: "How much would I have to receive in one year to make it worth waiting a year instead of taking one dollar now?" The proposition we want to demonstrate is that an investor's discount rate cannot be lower than the expected rate of return he believes he can earn on investable funds. To demonstrate this, let's suppose that it is not true. Suppose my discount rate is 10 percent and I can invest risk-free and earn 11 percent. Clearly, I will not trade my $1.00 today, which will be worth $1.11 in a year for $1.10 in a year.
Now let's put this in a CRT context. If the investments available to me are the same inside a CRT as outside it, then the discount rate can never be less than the expected rate of return. Again, let's proceed by assuming the opposite of what we want to demonstrate. To clarify and simplify, let's suppose the CRT will last only one year and will pay out the entire balance at the end of that year. Suppose the CRT has $1.00 now. If I believe the CRT's investments will earn 11 percent, and my discount rate is only 10 percent, I am saying that I value the future payment from the CRT at $1.01 (i.e. 1.11/1.1, rounded). But this is absurd because I would never pay $1.01 for the future CRT payment when I could instead take just $1.00, invest it the same way as the CRT, and end up with the same $1.11 I would have gotten from the CRT.
In fact, the discount rate should probably be higher than the expected rate of return because the CRT payment stream is not liquid. Everything else equal, most investors prefer having free access to their money over waiting for it.
An advisor recently approached us with a dilemma. His client, we'll call him John, set up a charitable remainder trust ("CRT") several years prior. Since then, John's circumstances had changed and he found himself in a situation where immediate liquidity was much more valuable than his CRT income interest (i.e., receiving annual payments for the rest of his life).
We suggested that John might be able to sell his income interest in the CRT, a transaction with which the advisor was unfamiliar. In the end, John not only sold his income interest, but he was also able to do so at a premium to the net present value ("NPV") of holding the CRT, and for cash. Needless to say, John was thrilled, and the advisor felt good about helping his client and adding a value-added service to his offering in the process.
CHARITABLE REMAINDER TRUSTS - PROS AND CONS
A CRT is a split-interest trust to which a client donates money or property and keeps the right to a specified cash flow each year, usually for the rest of his or her life (or joint life with a spouse). The series of cash flows from the trust is commonly referred to as the "income" or "lead" interest, and the grantor as the "income beneficiary."
There are two types of CRTs, the primary distinction being how the payout is calculated. In the case of a charitable remainder annuity trust ("CRAT"), the payment to the income beneficiary is a specified dollar amount. If the trust is a charitable remainder unit trust ("CRUT"), the payment is a percentage of the value of the trust, as valued each year.
At the end of the life of the last income beneficiary (or at the end of the specified term), the remaining assets in the trust go to charity. This amount is called the "charitable" or "remainder" interest.
THE PROS
The primary reason for creating a CRT is tax savings. A CRT allows the grantor to avoid any capital gains tax on the donated assets, to receive an income tax deduction for the amount projected to go to the charitable beneficiary, and to remove an asset from his or her estate.
A second, less common reason for creating a CRT is to benefit charity.
THE CONS
A careful analysis shows that for most clients the primary objectives are achieved very early in the life of the CRT, usually in the first year. This is when the grantor gets the charitable deduction and when the assets are diversified. These clients then have the CRT, which produces income for them, but in most cases yields no other benefits. In short, to get the tax benefits, the clients have to keep the CRT for the rest of their lives. The result is a large, valuable, but illiquid asset.
Further, the income which comes out of a CRT is usually all or mostly taxable income. At an average tax rate of 30 percent, for example, a CRT holder gets to keep 70 cents of each dollar that comes out of the CRT.
LIQUIDITY OPPORTUNITY - KEEP THE PROS, ELIMINATE THE CONS
Recently, a niche market has developed for buyers of CRT income interests. What is notable about this market is that buyers are paying attractive premiums, which is uncommon given the nature of the transaction (uncertain number of payments; no secondary market; and in the case of CRUTs, unknown payment amounts).
WHY BUYERS ARE PAYING PREMIUMS
Perhaps the most common question we are asked is how a buyer can afford to pay a premium for a CRT income interest. After all, most sales of cash flows involve the seller taking a discount. As it turns out, the answer is rooted in something with which most advisors are intimately familiar.
To an income beneficiary in the 30 percent tax bracket, each dollar from the CRT is worth 70 cents. To a buyer in a lower tax bracket, each dollar is worth some amount closer to 100 cents (in many cases this number is 100 cents). This tax rate differential allows for a potential spread of 30 cents on each dollar and drives the opportunity for the income beneficiary to sell at a premium to NPV.
Why are buyers in lower tax brackets? Beyond the obvious reason (exempt organizations), we've seen an array of tax attributes (net operating losses ("NOLs") and capital loss carryforwards, for example) lead to situations where the income interest from a CRT is worth much more to a buyer than the same interest is to an income beneficiary.
As most of us know, there is nothing unusual about tax rate differential. For instance, the principle that different potential owners of assets are distinguished by their tax status is what makes the municipal bond market possible. This makes it feasible for the seller to get a premium and the buyer to get a discount. It is a classic win-win situation.
WHY CLIENTS ARE SELLING
Value Maximization
Clients and their advisors are doing the math and concluding that it simply makes more economic sense to convert a long and uncertain stream of payments into an immediate and certain lump sum payment at a price representing a premium to the client's NPV of holding the CRT. This reason - we'll call it value maximization - is the by far the most common reason we see for selling a CRT income interest.
Lock in current, low capital gains rates
Because the sale of a CRT income interest is a capital transaction (see "Tax/Legal Concerns" below), it is generally taxed at capital gains rates, which are now some of the most favorable rates out there. In fact, capital gains rates have never been lower over the past 70 years, as the following table demonstrates.
Historical Capital Gains Tax Rates
Period Capital Gains Tax Rate
1922 -1933 12.50%
1934 -1935 17.7%
1936 -1937 22.5%
1938 -1941 15.00%
1942 -1951 25.00%
1952 -1953 26.00%
1954 25.00%
1955 -1967 25.00%
1968 26.90%
1969 27.50%
1970 30.20%
1971 32.50%
1972 -1974 35.00%
1975 -1977 35.00%
1978 33.80%
1979 35.00%
1980 -1981 28.00%
1981 (June 20) 23.70%
1982 -1986 20.00%
1987-1992 28.00%
1993 to 1997 (May 6) 28.00%
1997 (after May 6) - 2003 (May 5) 20.00%
2003 (after May 5) 15.00%
Average 26.05%
Many advisors are skeptical as to how long these rates will remain low, however, and are encouraging their clients to sell now to take advantage of the currently low rates.
Distress
Distress can take a variety of forms. Common sources include divorce, unforeseen reversals in business, investment losses, "upside down" net income with makeup charitable remainder trust ("NIMCRUT"), fear of Medicaid/nursing home assistance ineligibility, and threatened litigation between one or more of the parties associated with the trust. There is nothing like available cash to help with these kinds of distress, and we have seen these difficult situations solved to the satisfaction of all involved by cash generated from the sale of an income interest.
Liquidity concerns (or lack thereof)
Because CRTs are usually created for high net worth individuals, many advisors fall victim to the logic that, "since my client has substantial assets and doesn't need liquidity, selling his or her CRT income interest doesn't make sense." We've seen this logic nearly hurt advisors on several occasions for the sole reason that the sale of a CRT income interest is not driven by a need for liquidity but instead by value maximization.
On one such occasion, we were working with an advisor on a $7.5 million CRT. We had located a buyer for the income interest willing to pay a 3 percent premium ($6 million) to the client's NPV of holding the income stream ($4.5 million).
The advisor presented the opportunity to his client, but cautioned the buyer and us that liquidity was immaterial to this particular client (worth well in excess of $75 million) and that a sale was unlikely.
As it turns out, the advisor was partially right. Liquidity was not important to his client. However, a 33 percent premium for the interest and a chance to put the money to work elsewhere (still under the advisor's watch, we might add) proved to be a no-brainer for his client. From the client's standpoint, the tax advantages had already been secured (and wouldn't be compromised because of the sale), he was taxed at a lower rate on the sale than he would have been on distributions from the CRT, and he liked the idea of having the advisor invest the money in several investments that having the money in the CRT would not have permitted.
FINDING A BUYER
Buying a CRT income stream is a bit like buying a bond that has no principal repayment at the end, an uncertain number of payments (because they go on as long as the life of the donor), payments of uncertain amount (in the case of CRUTs, which most CRTs are), and no secondary market.
Because of these features, the universe of potential buyers is limited. Buyers must be able to deal with the long holding period as well as the dual uncertainties of how many payments they will get and how large those payments will be.
Needless to say, unless one knows where to look, trying to find a buyer can be very frustrating. So it is probably best to enlist the assistance of someone familiar with this market.
VALUING YOUR CLIENT'S CRT INCOME INTEREST
The first step in evaluating the potential sale of a client's CRT income interest is to assign a value to your client of holding the CRT.
The value of an income interest to a client is the after-tax net present value of the cash flows which he or she expects to receive. So to value an interest, it is first necessary to estimate these cash flows. The cash flows will last until the end of the trust, which is either the end of the last lead beneficiary's life (life trust), or the stated term of the trust (term trust). For a term trust, the expected duration number can be calculated with a calendar. For a life trust, a life expectancy can be looked up in a table.
Once the expected number of payments has been determined, the next step is to estimate the amount of each one. This amount depends on the returns earned by the trust assets and the payout rate of the trust. For trusts with payout rates higher than the annual return, the amount of each payment will decline over time.
We now have an identified number of known payments. Next, we apply the usual discount analysis to bring each payment to a present value. Then we add up each payment to get a pre-tax NPV. Finally, we apply the appropriate income tax rate to get an after-tax value.
Consider this example: We begin with the assumptions that the trust has a current value of $1,000,000, a 7 percent payout, that there are two lifetime income beneficiaries who are both 70 years old, and that their effective tax rate on trust income is about 35 percent. Based on these assumptions, and assuming that the trust earns an average return of 6 percent per year going forward, we calculate that the after-tax NPV to the clients of the expected trust income is in the range of $400,000 to $460,000. (See the middle column highlighted below.) The calculations are shown below for differing effective tax rates and discount rates. (Please see our comments at the end of the article for a fuller discussion of an appropriate discount rate. Also, note that the NPV is not very sensitive to the rate of return going forward.)
Calculation of Value of Annuity Holder's Interest in a CRT
Life Expectancy (given age) 18
Age 1 70
Age 2 70
Beginning Balance 1,000,000
Payout Percentage 7.00%
Return 6.00%
After-Tax Net Present Value Given Tax and Discount Rates
Effective Tax Rate
Discount Rate 30% 35% 40%
6% $495,343 $459,962 $424,580
7% $461,272 $428,324 $395,376
8% $430,745 $399,977 $369,210
If the client is willing to let the buyer select the ultimate charitable beneficiary (and assuming there are no other barriers in the trust), this interest may command a price of $800,000 pre-tax. After commission, usually 6 percent, the client would receive $752,000. The sale of the interest is a capital gains type transaction. Even if the client has zero basis, after paying capital gains taxes at an assumed rate of 20 percent (reflecting the federal capital gains rate at 15 percent plus an assumed additional 5 percent for net state tax) the client would net $601,600.
This is a terrific price. It represents a premium over NPV of between 30 percent and 50 percent, depending on the discount rate used to calculate NPV. In dollars, it represents an immediate, cash, net after-tax gain of between about $140,000 and $200,000, again depending on the discount rate used to calculate it.
These values are illustrated in the graphs below. The first graph, "Sale of CRT vs. Hold and Collect Annual Payments," shows in graphical format the value today of the lump sum, after-tax payment versus the value of each future year's payment, after-tax and discounted to a present value. It shows graphically that a payment 15 years or so from now is not worth very much today.
The second graph, "Sale of CRT vs. Holding," stacks up all these future payments, at today's value, and again illustrates that all together they are worth significantly less than the amount the clients would net today by selling. In addition, as clients age, of course, there is a significant risk that they will not collect some or all of the anticipated payments.
TAX/LEGAL CONSIDERATIONS
Our firm retains the counsel of a nationally-recognized law firm to advise us on CRT law. After a period of intense study, they have determined that there are no legal barriers to the sale of CRT income interests, although each case must be looked at individually because each trust is different.
In addition, although each taxpayer must evaluate his or her own situation, the sale of a CRT lead interest is generally considered a capital transaction. The IRS has issued several private letter rulings on this matter. We usually direct advisors to private letter ruling ("PLR") 200127023, which provides that a sale of an income interest in a trust is a sale of a capital asset within the meaning of sections 1221 and 1222 of Rev. Rul. 72-243, 1972-1 C.B. 233.
PLR 200127023 goes on to say that the holding period for purposes of determining whether gain or loss from the disposition of an income interest is long-term or short-term commences on the date the taxpayer first held such interest. In other words, if a seller has held his interest for more than a year, the sale may be a long-term capital gain, which is taxed at one of the most favorable rates available.
These letters are the source of the determination that the sale of a CRT lead interest may be a capital transaction.
BENEFITS FOR THE ADVISOR
From an advisor's standpoint, the benefits of providing a client with liquidity for CRT interests are multi-faceted. Initiating this kind of transaction provides a valuable and needed service to the client, and ultimately keeps him or her happy. It also prevents the client from going to a competitor with a problem the advisor could not solve.
In addition, a number of advisors will find that merely being able to discuss the possibility of this type of transaction will heighten their esteem in clients' eyes.
Discount Rate Cannot Be Lower Than the Expected Rate of Return
This is an assumption based on a logical analysis, which follows. A discount rate answers the question: "How much would I have to receive in one year to make it worth waiting a year instead of taking one dollar now?" The proposition we want to demonstrate is that an investor's discount rate cannot be lower than the expected rate of return he believes he can earn on investable funds. To demonstrate this, let's suppose that it is not true. Suppose my discount rate is 10 percent and I can invest risk-free and earn 11 percent. Clearly, I will not trade my $1.00 today, which will be worth $1.11 in a year for $1.10 in a year.
Now let's put this in a CRT context. If the investments available to me are the same inside a CRT as outside it, then the discount rate can never be less than the expected rate of return. Again, let's proceed by assuming the opposite of what we want to demonstrate. To clarify and simplify, let's suppose the CRT will last only one year and will pay out the entire balance at the end of that year. Suppose the CRT has $1.00 now. If I believe the CRT's investments will earn 11 percent, and my discount rate is only 10 percent, I am saying that I value the future payment from the CRT at $1.01 (i.e. 1.11/1.1, rounded). But this is absurd because I would never pay $1.01 for the future CRT payment when I could instead take just $1.00, invest it the same way as the CRT, and end up with the same $1.11 I would have gotten from the CRT.
In fact, the discount rate should probably be higher than the expected rate of return because the CRT payment stream is not liquid. Everything else equal, most investors prefer having free access to their money over waiting for it.
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