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Tax Tactics is a bi-monthly column devoted to technical tax topics and strategies. Written by a recognized expert, this is a must-read for tax planners. 

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Pooled Income Funds Can Mean Bigger Deductions for Every Dollar of Gift

Clients selling appreciated assets such as securities, real estate, or closely held businesses sometimes balk when they realize how much tax it will cost them. That’s where we come in.

A charitable remainder trust (CRT) can help you avoid tax here. At the risk of oversimplifying, typically this involves contributing the asset to the trust in exchange for a lifetime income. At your death, your designated charity gets whatever is left in the trust. You’ll take an up-front deduction for your contribution to the trust, based on the value of the contribution and the income you can expect to take back. The trust can sell the asset without paying tax because the ultimate beneficiary is a charity. Typically, this is appropriate (i.e., cost-effective) for gains of $250,000 or more.

If you’re comfortable with exchanging your cash or appreciated asset for a lifetime income, then leaving the rest to charity, there’s an alternative that might accomplish the same goal with less effort. It’s called a pooled income fund (PIF), and it’s what you’d get if you crossed a charitable remainder trust with a mutual fund. These have traditionally been used by smaller donors who can’t justify the cost of establishing and maintaining a charitable remainder trust. However, the current low interest rate environment makes them a potentially powerful tool for any donors who want a bigger deduction for each dollar of contribution than with a charitable remainder trust.

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Determining When To Use a Pooled Income Fund

Here are some issues to consider before deciding a pooled income fund is right:

  • Most donors choose an income that lasts for their life, or their joint life with their spouse. You can also choose a class of beneficiaries (such as your children) or a consecutive interest (such as yourself, then your children). However, you can’t choose a fixed term of years. And naturally, the longer your expected income lasts, the less your charitable deduction will be.
  • Some pooled income fund sponsors let you choose from among different funds with different investment options. For example, you might choose between a current income fund (designed to produce high current income primarily from fixed-income securities) or a growth and income fund (designed to produce rising income over time by adding equities into the mix). The choice you make will affect the income you get from the fund and may also affect your up-front charitable deduction.
  • Pooled income funds have to pay out their income at least annually. However, many pay quarterly or even monthly to make day-to-day budgeting easier.

 

Finally, you should be aware that if you transfer debt-encumbered property to a pooled income fund (like mortgaged real estate), you’ll have to pay tax on a fraction of your gain equal to the percentage of the indebtedness that you eliminate when the fund sells the asset. For example, if your property is worth $1 million, your basis is $500,000, and your mortgage is $250,000, you’ll owe tax on 25% of your gain (because the $250,000 mortgage balance equals 25% of the property’s fair market value).

Now, here’s where things get interesting – and where the pooled income fund really shines. As with a charitable remainder trust, your deduction is based on the amount you contribute to the fund minus the discounted present value of the expected income you retain. Ordinarily, you’ll calculate this based on three factors:

  1. The birthdate of the income beneficiary or beneficiaries (which establishes the actuarial duration of that income),
  2. The fair market value of the asset/s you transfer into the fund (which establishes the principal generating the income), and
  3. The fund’s highest rate of return during the preceding three years (which establishes the return on that principal).

 

However – if the fund you choose is less than three years old, you can substitute an assumed rate for that third factor. You’ll start by taking the average annual §7520 rate (rounded to the nearest 2/10ths) for each of the three years preceding the year of the transfer. Then you’ll subtract one percent to arrive at your final rate.

With today’s low interest rates are, this may let you claim significantly higher deductions for contributions to a new pooled income fund than you might otherwise claim for those to a “seasoned” fund or charitable remainder trust. In fact, many pooled income fund sponsors open new funds periodically to take specific advantage of this opportunity. For 2021, the rate for new pooled income funds is just 2.2% — far lower than the income most funds are actually paying. That means, when it comes time to calculate your charitable contribution, you can deduct much more of the principal going into the fund.

Let’s say you’re age 60, with $100,000 in a single stock, paying no dividend, and a $10,000 basis. You’d like to sell that stock to generate a monthly income. If you do, you’ll owe tax on $90,000 of gain. If you had contributed it to a charitable remainder trust paying 5% in March, 2021 (with the discount rate at 0.8%), you’ll avoid tax on the gain and get a $38,019 deduction. If you contribute it to an unseasoned pooled income fund paying the same amount, you’ll also avoid tax on the gain – but your deduction climbs to $64,039. Your future income will depend on the pooled income fund’s future performance, rather than a flat 5%. But the pooled income fund avoids the cost and effort involved in establishing a trust, managing assets, and preparing trust tax returns.

In the end, using the IRS assumed rate – rather than a seasoned fund’s actual performance or a charitable remainder trust’s specified rate – generally gives you more deduction bang for your up-front gift dollar. And that, in turn, is why a pooled income fund can be so much more effective than a charitable remainder trust, where your income interest is calculated according to the actual percentage you designate to take in annual income.

Pooled income fund contributions are treated as gifts to public charities. This means you can deduct up to 60% of your adjusted gross income for cash contributions, or 30% for appreciated assets, and carry any excess forward for up to five years.

Tax Master Network’s Tax Operating System® can help with a referral to our preferred pooled income fund sponsor, as well as with everything you need to report pooled income fund income properly on your clients’ returns. And as always, presenting the concept to your client gives you credit for proactively looking out on their behalf, whether they choose to take advantage of it or not. So make sure the pooled income fund is part of your planning portfolio. The clients who can take advantage of it tend to be your best clients for your other services, too.

Edward Lyon

Edward Lyon

Edward A. Lyon is CEO of the Tax Master Network, where he's coached tax professionals to add planning and financial services to their business since 2005. Go here to join the network. Go here to upgrade your membership or discuss opportunities in financial services.
Edward Lyon

Edward Lyon

Edward A. Lyon is CEO of the Tax Master Network, where he's coached tax professionals to add planning and financial services to their business since 2005. Go here to join the network. Go here to upgrade your membership or discuss opportunities in financial services.

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