Gifting to Charitable Lead Annuity Trusts (CLATs) and investing in short-term rental real estate are two popular strategies for offsetting ordinary income tax. How do you know which one is right for you? This article explains what these strategies are and when they make sense.

Key Highlights and Takeaways

• Two Ordinary Income Tax Strategies: Both strategies can offset ordinary income tax at least to some extent.
• CLATs Yield Tax Savings with Some Potential Upside: When a donor contributes to a conventional charity, he or she receives a charitable deduction, typically equal to the fair market value of the amount contributed. With a CLAT, a donor can also realize a future return for either themselves or their loved ones.
• Investing in Short-Term Rental Real Estate Yields Tax Savings and Returns: Short-term rentals can yield large deductions as well as ongoing income from the rentals. The material participation requirements are less strict than the material participation requirements for other types of real estate investing.

What are Charitable Lead Annuity Trusts?

A Charitable Lead Annuity Trust (CLAT) is an irrevocable trust designed to provide annual distributions to a charity for a specified period, after which the remaining assets are distributed to non-charitable beneficiaries, typically family members but sometimes the donors themselves. In most cases, the CLAT is structured so that the taxpayer receives a charitable deduction equal to the value he or she contributes to the trust. In this way, gifting to a CLAT is similar to gifting to a conventional charitable vehicle, like a Donor Advised Fund. The difference is that, with a CLAT, the donor or his or her family can keep the charitable vehicle’s investment returns to the extent they exceed the IRS hurdle rate, which is typically 2-5% per year. If you contribute $1 million to a CLAT and the CLAT generates 10% annual returns, you may be able to not only claim a $1 million deduction upfront but also walk away with a six-figure or even seven-figure remainder interest at the end of the term.

Factors that Influence the Desirability of a CLAT

CLATs tend to work best if some combination of these factors are true:

Benefits of CLATs:

Drawbacks of CLATs:

What is an Ideal Use Case?

Benjamin, a married California resident, earns $1,200,000 per year. Because his annual tax bill is $550,000, Benjamin is focused on tax mitigation. Benjamin is charitable; going forward, he hopes to give $120,000 a year to his religious institution. He could give away $120,000 outright each year. Or, he could set up a CLAT in a year when he has a particularly high income, and then use the resulting charitable deduction to offset a substantial chunk of his income in that year while also setting up a $120,000 annual income stream for charity. In this way, he’ll be able to accelerate his charitable deductions while also potentially keeping a portion of the excess returns on the amount that puts into the CLAT. Compared to some other tax-mitigation strategies, CLATs tend to have a lower ROI because the donor is giving away a chunk of his or her assets. But they have a higher ROI than simply gifting to a Donor Advised Fund or most other charitable vehicles, so they make a lot of sense for people who are charitably inclined. You can estimate your potential returns here!

What are Short-Term Rentals?

Short-term rentals are residential properties that are rented out for a short duration, often through platforms like Airbnb or VRBO. These rentals can generate income while offering substantial tax benefits, including deductions for depreciation, mortgage interest, and other expenses.

How are Short-Term Rentals Treated for Tax Purposes?

Income generated from short-term rentals is considered active income, which allows property owners to deduct ordinary expenses such as property management fees, maintenance costs, utilities, and mortgage interest. Additionally, property owners can depreciate a property over time, further reducing their taxable income. If the property owner actively participates in the rental activities, they may be able to offset other forms of active income with losses from the rental property.

Benefits of Short-Term Rentals:

1. Income Generation: Renting out a property for short durations can generate substantial income, often more than traditional long-term leases (but with higher volatility).
2. Lower Material Participation Standard: If the average length that your tenants stay in your property is less than seven days, you can meet the material participation standard by spending either 100 hours on the rental activity each year (and more than anyone else spends on the rental) or a total of 500 hours working on the rental business throughout the year. The typical real estate professional standard for material participation requires either 500 hours spent on the rental activity or a total of 750 hours spent on the business.
3. Tax Deductions: Property owners can deduct a wide range of expenses, including mortgage interest, property taxes, repairs, and depreciation.

Drawbacks of Short-Term Rentals:

1. Management Burden: Managing a short-term rental can be time-consuming, involving frequent tenant turnover, cleaning, and property maintenance.
2. Regulatory Risks: Many cities and municipalities have strict regulations regarding short-term rentals that are rapidly changing, which can impact the viability of these investments.
3. Income Volatility: Beyond regulatory risks, rapidly changing supply, demand, and platform take rates can dramatically change the income and value of these properties.

What is an Ideal Use Case?

Peter, a married New Yorker earning $1,200,000 per year, has historically invested only in stock indexes. Tired of paying $550,000 of tax on his salary each year, Peter purchases a $500,000 house and lists it on Airbnb. He deducts 60% of this amount as depreciation in the first year, reducing his taxable income by $300,000 that year. If his marginal tax rate is 51%, that will save him close to $153,000, effectively reducing his taxes this year from $550,000 to under $400,000 (not including the income he generates from the rental).

Why Choose One Strategy or the Other?

Gifting to Charitable Lead Annuity Trusts and investing in short-term rentals accomplish different things. Both provide upfront tax deductions. But CLATs support charities, while short-term rentals generate investment returns. When choosing between these two strategies, the key question is: What are you trying to accomplish? If you are looking to support charities as tax efficiently as possible, CLATs are a great option. If your goal is to maximize total returns, short-term rentals may be a better choice.

Conclusion

Gifting to Charitable Lead Annuity Trusts and investing in short-term rentals are both viable tax strategies, but they serve different objectives. Hopefully this article has given you a better idea of what each strategy entails, and whether one or the other might be a better fit.

About Valur

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