Real Estate Shelter Trusts

 

The following information is an excerpt from

 

Capital Gains Exit Ramp:

Use Trusts to Solve Tax Problems, Capture Hidden Wealth

 

By Roger D. Silk, Ph.D.

Sterling Foundation Management, LLC

 

 

Disclaimer

This book discusses the use of advanced trust strategies, including but not limited to the trusts offered by or through Sterling Foundation Management, LLC. The information presented is intended solely for educational purposes and to facilitate informed discussions between readers and their legal, tax, and investment advisors. Sterling Foundation Management, LLC (“Management”) and Sterling Donor Advised Fund, Inc. (“Fund”) and affiliates (collectively referred to as “Sterling”) provide this material for educational and illustrative purposes only. Any implementation of a trust strategy—whether involving Sterling or otherwise—should be based on a formal, written trust agreement and carefully considered in light of your individual financial, tax, and legal circumstances. All references to “you” or “your” are directed to individuals or retirement account holders who may be contemplating the funding of a trust through qualified or non-qualified assets. The economic and tax implications of such a decision depend on numerous variables, including your age at death, the age and health of your beneficiaries, trust payout rates, investment performance, and prevailing tax laws. The types of trust structures discussed involve risks— potentially including mortality risk, market risk, and changes in tax treatment—that may materially affect the outcome. Any illustrations of investment returns or tax rates in this book are hypothetical, not predictive, and do not guarantee any specific result. Trust distributions and their tax consequences are uncertain and may be subject to future changes in law, policy, or regulatory interpretation. Trusts may incur administrative, legal, investment, or custodial fees. Any fee examples presented herein are believed to reflect current practices, but are not guaranteed. Nothing in this book should be construed as tax or legal advice. Neither Sterling nor any person or organization affiliated with this book is offering legal or tax counsel hereby. Readers are advised to consult their own legal, tax, and fiduciary advisors before making any decisions regarding trust structures, IRA or retirement plan assets, or other estate planning tools.

 

 

Real Estate Shelter Trusts

 

Escape the Tax Trap—And Build a Lasting Income

One of the biggest frustrations for real estate owners is the tax trap. You’ve built

wealth in your properties, but when it’s time to sell, the government takes a huge cut.

What if you could sell your property, skip the tax bill entirely, and reinvest all of your proceeds? A Real Estate Shelter Trust allows you to do exactly that…

 

You can sell highly appreciated real estate without paying any capital gains tax. The trust reinvests the full amount, grows tax-free, and provides income to you and your family for years to come. It’s also a great tool for protecting your assets from creditors and

creating a charitable legacy.

 

I’ve spoken with many property owners who feel stuck. They want to sell, but the tax hit makes them feel like they’re better off holding on.

A Real Estate Shelter Trust can be the way out. With this trust, you can sell

appreciated real estate with no capital gains tax. The trust reinvests the proceeds into a diversified portfolio, which grows tax-free.

The best part? You and your family can draw income from the trust for generations. It also provides strong asset protection and helps create a lasting charitable legacy.

A Real Estate Shelter Trust is an irrevocable, tax-exempt trust. Contributions of

appreciated real estate to such a trust are tax-free, and the trust can then sell the real

estate, immediately, with no tax due. The trust then can reinvest the entire proceeds into a diversified portfolio. Furthermore, as long as the assets remain in the trust, there is no tax on income or capital gains realized by the trust. The grantor, and up to three generations of the grantor’s family, may receive income from the trust. In addition, the contributor of real estate to a Real Estate Shelter Trust may receive a tax deduction for a portion of the value of the assets contributed.

 

Case Study: Harry Lyons

Harry Lyons, a 71-year-old apartment investor, had long enjoyed success in real estate. However, with the arrival of his grandchild, he began considering slowing down to spend more time with family. Managing his properties became more burdensome than

rewarding. Initially, Harry contemplated a tax-free exchange into lower-maintenance

triple-net leases, but the government’s COVID-related eviction moratorium accelerated his decision to act.

Frustrated by the CDC's intervention in landlord-tenant agreements, Harry sought alternatives to reduce his real estate exposure. Harry contacted Sterling Foundation Management, the creator of the Real Estate Shelter Trust, to explore options that would align with Harry’s goals of reducing risk, diversifying investments, and

simplifying his life.

After discussions, Harry emphasized his frustration with tenant nonpayment during the moratorium. He saw concentrated real estate holdings as an “excess risk” that left him exposed. Tax implications also loomed large. His properties, acquired in the early 1990s in Phoenix with a cap rate of about 7%, had appreciated significantly, now valued at around $15 million. However, his adjusted tax basis was nearly zero, and

depreciation recapture, combined with capital gains taxes, would trigger a $4.5 million tax bill upon sale. “I’d rather die!” Harry exclaimed at the thought of such a liability.

 

Holding the properties until death for a stepped-up basis wasn’t a viable solution given Harry’s desire to enjoy life now. Harry, being a seasoned real estate investor, knew all about 1031 exchanges. He rejected a 1031 exchange because he wanted to diversify

out of real estate, and 1031 requires that you keep all your capital in real estate.

 

Harry chose to create and fund Real Estate Shelter Trust with Sterling. This approach allowed him to create two tax-exempt trusts, providing income for him and his wife, then continuing for his children.

 

Lyons Roar LLC was formed to hold Harry’s properties. Upon sale, it realized over $15.1 million, now invested in a diversified portfolio. Harry can draw up to $756,000 annually, with payments deferred to reduce immediate tax liability. The trust ensures growth,

benefiting his family for generations.

 

 

The Two Sources of Taxable Gains on Real Estate

In the U.S., at the federal level, real estate sales are subject to taxes on two types of

gains: appreciation in the property’s market value and gains from depreciation recapture. Many states also impose taxes.

 

The first source of taxable gain is the increase in a property’s market value between purchase and sale. For instance, a property bought for $1 million and sold for $2.2 million results in a $1.2 million gain, which is taxed at capital gains rates. As of this

writing, the top federal capital gains rate is 23.8%, with an average state tax rate of 6.2%, making the combined top rate around 30%. However, inflation impacts the real gain, as a property must appreciate just to keep pace with rising prices. For example, over a decade ending in 2022, inflation eroded the dollar’s value by 22%, meaning a $1 million

property in 2012 would need to be worth $1.275 million in 2022 just to break even. Despite this, the government taxes the inflationary gain, effectively imposing a hidden tax.

 

The second source of taxable gain arises from depreciation recapture. Depreciation

reflects the economic decline in an asset’s value due to wear, usage, and obsolescence.

For tax purposes, businesses can deduct depreciation from their income, reducing

taxable income. In real estate, depreciation applies to buildings, not land, with residential buildings depreciated over 27.5 years and commercial buildings over 39 years.

When a property is sold, previously deducted depreciation must be “recaptured” and taxed. Depreciation recapture on real property is taxed at 25%, plus a 3.8% surtax for high-income earners, totaling 28.8%. Depreciation on certain components, such as HVAC systems, may be taxed at ordinary income rates if a cost segregation method was used.

 

For example, a $3 million apartment building with $2.75 million in depreciable property would generate about $100,000 in annual depreciation. After ten years, the owner’s

basis would be $2 million. If the property were then sold for $3 million, the owner has no real gain but must pay depreciation recapture taxes on the $1 million depreciation

taken. At 28.8%, this results in a $288,000 tax bill. If faster depreciation methods like cost segregation were used, parts of the depreciation could be taxed at ordinary income rates, further increasing the tax liability.

 

Depreciation recapture creates a significant tax burden for real estate investors, even in cases where there is no real gain on the sale, making it a crucial consideration in tax planning for the sale of real estate.

 

 

Real Estate Shelter Trust

A Real Estate Shelter Trust is often the best solution for an investor selling real estate, because the trust can allow the seller to avoid gain on the sale.

To qualify as a tax-exempt trust, the trust must meet certain rules.²³ Key among these rules is rule that the contributor retain the right to an income stream, not less than 5%

per year, from the trust for a period that can last a very long time, but generally not more than about sixty years. The contributor gives up the right to the trust principal, and keeps the right to the income stream. At the end of the trust term, which will usually be well

after the end of the contributor’s life, the balance remaining in the trust can be used to establish a charitable legacy for the contributor.

 

Asset Protection

In addition to the tax benefits of a Real Estate Shelter Trust, because it is a trust, a Real Estate Shelter Trust can include language designed to protect the trust assets from any claims that might be brought against the trust income beneficiaries. This asset protection benefit can be combined with the tax benefits of the Real Estate Shelter Trust.

 

 

Ability to Provide for Children, Grandchildren

A Real Estate Shelter Trust can be structured so that after the grantor and spouse (if there was one) die, the contributor’s children can receive the income. In some cases, even the contributor’s grandchildren can be in line to receive income. There is no stated maximum possible term for a trust, but the expected life of most Real Estate Shelter Trusts is in the range of fifty to sixty years.

 

²³ The rules are in section 664 of the Internal Revenue Code.

Payouts and Trust Term

The property owner who contributes stock to a Real Estate Shelter Trust can decide who is eligible to receive payouts from the trust. Typically, the owner will retain the right to receive payouts, usually 5% of the trust value each year, for life. The owner’s spouse can also be a beneficiary, and in the vast majority of cases the trust can last for at least

the longer of the spouses’ lives.

 

In addition, in most cases, the owner and/or spouse can also name one or more children, or nieces or nephews (or anyone, really) to be a successor income beneficiary. In some cases, depending on the ages involved, grandchildren can also become beneficiaries

after their parents and grandparents are no longer living.

 

The expected term of most Real Estate Shelter Trusts is determined by the length of the lives of the beneficiaries, and by reference to actuarial tables. In the typical case,

the expected life of the trust will be 50 to 60 years. At the conclusion of the trust term, the trust assets can be used to fund a legacy charitable endowment, which can be

administered by the owner’s grandchildren.

 

Deferral Option

A properly constructed and properly managed Real Estate Shelter Trust can provide a period of tax-free deferral during which no payments are made to the beneficiaries, and instead the assets grow, inside the trust, tax-free.

 

When this deferral is in place, the trustee maintains a bookkeeping account called an accumulation account. Each year while deferral is occurring, the amount that would have been eligible to be paid, but wasn’t, is added to the accumulation account. For example, if a trust could have paid out $50,000 a year but is in deferral mode for five years, after five years there would be $250,000 in the accumulation account. If after

five years deferral was no longer desired, this accumulated amount could then be paid, in whole, or in part, in one year or over multiple years. In addition, the annual payment from the trust could be paid on top of the accumulated amount.

 

Professional Management

Real estate shelter trusts should be managed by professionals. The management is frequently split between a trustee who attends to all the trust-specific compliance, accounting, reporting, and tax returns, and an investment manager who handles

the investments.

 

Tax Reporting

A Real Estate Shelter Trust is a separate tax-reporting entity. Even though the trust

itself is tax exempt, it must file tax returns. These returns might be quite complex, but such complexity does not affect the income beneficiary.

 

Each income beneficiary will receive a tax form K-1 from the trust. These forms are typically one page of information.

Tax Treatment of Payments

Section 664 provides that a Real Estate Shelter Trust keep track of four tiers or categories of

income. These tiers, roughly speaking, are 1) ordinary income 2) long-term capital gains 3) tax- exempt income and 4) trust capital.

 

When a trust earns income, that income goes (in an accounting sense) into the appropriate

bucket. When the trust makes a payment to an income beneficiary, the tax law says that those payments are deemed to come first from ordinary income, until that bucket is empty, then from long-term capital gain until that bucket is empty, and so on.

 

Limitations

The income beneficiaries of a Real Estate Shelter Trust do not have access to trust principal. For example, if an owner contributes $1 million to a trust, that owner will have the right to the income payout, usually 5%, for life, and the life of a spouse, and then potentially the lives of

one or more children, and even grandchildren. But the trust principal itself is no longer belongs to the owner.

 

In other words, after the owner contributes real estate to the Real Estate Shelter Trust, the owner goes from owning the real estate outright to owning the right to a stream of payments from the trust. This stream of payments is a capital asset. There is a secondary market for streams of trust income, and under some circumstances it is possible to sell this right.

 

Turn Tax Trouble into a Family Legacy

Imagine selling a property you’ve owned for decades, but instead of facing a massive tax bill, you pay nothing. You get to reinvest the full proceeds, growing your wealth and providing

income for yourself and your family for generations—all tax-free.

 

That’s exactly what a Real Estate Shelter Trust can do. It’s a unique tool designed to help property owners sell highly appreciated real estate without triggering capital gains tax. The

trust reinvests your sale proceeds in a diversified portfolio, which continues to grow without being taxed.

 

Best of all, the trust can pay you and your family income for decades, and when the trust ends, it can create a charitable legacy in your name.

 

 

For more information or for a financial consultation, please contact BUBAN FINANCIAL SERVICES.

 

BUBAN FINANCIAL SERVICES               www.bubanfinancial.com                   800-545-8308