Charitable Remainder Trusts: Popular REIT Investment Vehicle To Avoid The 3.8% Medicare Tax Next Year

by: Brad Thomas

In 2013, many real estate investors will find themselves paying not only a 39.6 percent income tax rate, but also a 3.8 percent Medicare tax on investment income. But significant relief can be found in Charitable Remainder Trusts for charitably inclined high-income investors.

Beginning in 2013, the 3.8 percent Medicare tax imposed by the Health Care and Education Reconciliation Act of 2010 will apply to single taxpayers whose Modified Adjusted Gross Income exceeds $200,000 a year, or $250,000 a year for a married couple filing jointly.

The tax is imposed only on "net investment income," and only to the extent that total "Modified Adjusted Gross Income" exceeds the $200,000 or $250,000 thresholds mentioned above.

Technically, the 3.8 percent tax is imposed on the lesser of:

  1. Net investment income; or
  2. The amount by which Modified Adjusted Gross Income ("MAGI") exceeds $200,000 for single taxpayers, $250,000 for taxpayers filing joint returns, and $125,000 for all other taxpayers.

Net investment income includes most types of unearned income, including passive income from real estate investments and net capital gain, but does not include distributions from qualified retirement plans, IRAs, qualified annuity plans, or tax-exempt bond or bond funds.

How Does It Work?

For example, John and Jane are married and file a joint income tax return. They have MAGI of $500,000, of which $150,000 is net investment income. The 3.8 percent Medicare tax is calculated on the lesser of net investment income of $150,000 or the excess of their MAGI over the threshold amount ($500,000 - $250,000 = $250,000). The net investment income of $150,000 is less than $250,000 and therefore the additional tax is assessed on $150,000. (150,000 x 3.8 percent = $5,700). John and Jane will owe an additional Medicare tax of $5,700 in addition to an income tax rate of 39.6 percent.

John and Jane and other charitably inclined investors should reconsider establishing charitable remainder trusts in 2013 to minimize the 3.8 percent Medicare tax and to receive an income tax deduction to save tax dollars under the higher rates.

A charitable remainder trust (CRT) can be financially structured to pay the donating Grantor more than 90 percent of the initial starting value using the time value of money rules. The charitable beneficiary can be a family-run and controlled charity that will receive any remaining trust assets after the Grantor has received his or her stream of payments, and it can then compensate family members for legitimate charitable work that they perform.

The Grantor can change the identity of the charity at any time during the retained payment turn, and may serve as trustee of the trust and take reasonable trustee fees as well. The 90 percent of value payments come out over time as a stream of annual payments, and the Grantor only has to pay income tax on the lesser of the payments received or the actual income generated under the charitable remainder trust. Many tax advisors believe that the annual payments from the charitable remainder trust will not be subject to the 3.8 percent Medicare tax, but further guidance on this issue is expected from the IRS.

For example, John is a 60 year-old, single, wealthy man and has $2,000,000 of REIT stock having a tax basis of $500,000. If he sold the stock in 2013 instead of transferring it to a CRT, he would pay capital gains and Medicare taxes of $349,400.

If he instead transfers the stock to a CRT, assuming normal rates and John retaining an annuity interest of $100,000 per year for 20 years, the contribution of the assets to the CRT is considered to be a $266,090 charitable contribution deduction for income tax purposes. If John is in the 39.6 percent tax bracket, this results in approximately $105,000 in income tax savings.

John's charitable deduction may be limited to a percentage of his adjusted gross income under current law, but he can carry forward any unused amount to apply toward future income over the next five years.

John would have to pay income tax on the annuity distributions that he receives from the trust to the extent that the trust has taxable income. When the CRT sells the donated assets the next year there is no income tax or Medicare tax imposed on it, but John's $100,000 per year payments will carry out the income stored up in the CRT to the extent of $100,000 until it has all come out to him, so his payment of tax on the $349,400 gain is deferred and spread out over four or more years.

Consider Holding REIT Shares in the Form of Charitable Remainder Trusts

Charitable remainder trusts will therefore be a great match with REIT investments in 2013 if Congress and the President do not change what the law is now set to be.

If the REIT interest is sold during the term of the charitable remainder trust, the capital gains income is stored up in the charitable remainder trust and will not be taxed until all ordinary income has been paid out.

After the CRT term has expired or the income beneficiary dies, the assets in the trust pass to charity. Additional estate planning may be necessary to ensure that enough assets remain for family members. For example, life insurance can be purchased in a life insurance trust with some of the tax dollars saved so that will be something there for the family when the remainder interest in the CRT passes to the charity.

The CRT REIT will therefore be a home run for many taxpayers, especially those who sincerely want to benefit charities. For those of you who missed my article earlier this week, REITs Poised To Become More Attractive In 2013 And Beyond (an all-time record for number of page views), I have summarized my picks as follows: Federal Realty (NYSE:FRT), Tanger Factory Outlets (NYSE:SKT), Urstadt Biddle Properties (NYSE:UBA), Essex Property Trust (NYSE:ESS), National Healthcare Investors (NYSE:NHI), Omega Healthcare Investors (NYSE:OHI), Realty Income (NYSE:O), Taubman Centers (NYSE:TCO), Monmouth REIT (NYSE:MNR), Kimco Realty (NYSE:KIM), Regency Centers (NYSE:REG), CapLease (NYSE:LSE), Weingarten Realty Investors (NYSE:WRI), American Campus Communities (NYSE:ACC), Extra Space (NYSE:EXR), Retail Opportunity Investment Corp. (NASDAQ:ROIC), Excel Trust (NYSE:EXL), Healthcare Trust of America (NYSE:HTA), American Realty Capital Properties (ARCP), STAG Industrial (NYSE:STAG), and AmREIT Inc. (NYSE:AMRE).

Source: All of the above and more is explained in the new book entitled The Annihilation of Wealth. This book is written by well-known Florida tax lawyers Alan S. Gassman, JD, LL.M. and Erica G. Pless, J.D. LL.M and is available on Amazon and Smashwords by hard copy or electronically for $24.95. Click here to purchase.

The book goes into significant detail on all aspects of what will happen in 2013 under the present tax law, and gives dozens of planning ideas while identifying traps for the unwary and helping to show how the budget for increased taxes.

Brad Thomas is a regular contributor to Forbes, The Street, and Seeking Alpha and he has over 25 years of experience in commercial real estate investing. He has a South Carolina real estate license and he is a well-known writer, speaker, and author on the topic of REIT investing. Each taxpayer should seek advice from an independent tax advisor with respect to any Federal tax issue(s), transaction(s) or matter(s) addressed, discussed or referenced herein based upon his, her or its particular circumstances.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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