The purpose of estate tax planning is to maximize the assets you pass on to future generations by minimizing gift and estate taxes. Estate-tax strategies revolve around the use of irrevocable trusts. This article discusses the most common types of irrevocable trusts that are used to minimize gift and estate […]
Conservation easements and Charitable Lead Annuity Trusts (CLATs) are two popular tools 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.
A conservation easement is a legal agreement between a landowner and a qualified organization, such as a land trust or a government agency, that restricts the development of the land in perpetuity, protecting wildlife habitats or preserving historic sites even if the property is later sold or passed down to future generations. Conservation easements, in short, are a way for landowners to protect property from future development, no matter who ends up in control of the land in the future.
Conservation easements are also a tax tool. When you agree to restrict the use of your land for conservation reasons, the government considers that a type of charitable donation, and you get a charitable deduction based on the lost value of the land. In practice, taxpayers often claim a value that is a multiple of the value at which the land was purchased. This deduction can be used to offset ordinary income up to 30% of the donor’s adjusted gross income (AGI), with any excess carried forward for up to five years.
Because a number of players in the space are unscrupulous, the IRS has become concerned in recent years that the tax code’s conservation easement rules are being exploited. Certain types of conservation easements are now considered “listed transactions” that must be flagged for the IRS. Sen. Ron Wyden, chair of the Senate Finance Committee, has been consistently critical of conservation easements, which he describes as “a tax shelter gold mine.”
Gabriel, a single New Jersey resident, earns $1,200,000 per year. His annual tax bill is $550,000. Gabriel happens to be an avid conservationist with an appetite for risk. Tired of paying so much tax on his salary, Gabriel purchased a $100,000 property fours years ago and this year he put a conservation easement on the land to protect it from future development. The easement is valued at $350,000 and he is allowed to deduct this entire amount from his income, reducing his taxable income by $350,000 this year. If his marginal tax rate is 50%, that will save him close to $175,000, effectively reducing his taxes this year from $550,000 to under $375,000.
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.
CLATs tend to work best if some combination of these factors are true:
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!
Creating conservation easements and gifting to CLATs are both potentially attractive tax strategies. Both generate upfront deductions and require no work on the taxpayer’s part. Conservation easements subject the taxpayer to legal risk, unlike CLATs, and generate no cashflow. CLATs don’t generate cashflow either but do generate potentially significant remainder interests for the donor or the donor’s family. The right strategy for any given person will depend on a person’s risk tolerance as well as how they assess the pro’s and con’s of each approach.
Conservation easements and CLATs are popular strategies for reducing ordinary income tax exposure. 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.
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