By Laurel A. Kent in conjunction with Tom Annick

Are you hanging on to some low-basis, highly appreciated assets that you would gladly sell if you could somehow avoid losing much of the value to taxes? One solution might be an estate planning arrangement known as a charitable remainder trust (CRT). This type of trust may provide you with income tax deductions and other tax breaks, while enabling you to convert an appreciated asset -- such as stocks, bonds or real estate -- into an income stream for life.

With a CRT, you transfer assets into the trust and take a charitable income tax deduction, although not for the entire amount of the gift. The trust, in turn, may sell the assets and invests the proceeds into high income-producing investments. The trustee pays the donor a certain amount each year for a stated period -- usually for the donor's lifetime -- and then turns over the principal (also known as the "remainder" interest) to the charity name by the donor in the trust agreement. Because Health Volunteers Overseas is registered with the IRS as a 501(c)(3) corporation, the donor could choose HVO to receive the gift.

When the CRT sells the asset, it pays no immediate tax on the gain, so all the proceeds can be reinvested to produce income. If you had sold the asset outright instead of giving it to the CRT, you would have paid the IRS capital gains taxes on your profit, in addition to any capital gains tax imposed by your state. In setting up a CRT, you may name yourself as trustee, which enables you to manage the investment of the funds in the trust. Alternatively, by using a professional trustee such as a bank or the nonprofit organization itself, you could help ensure that the arrangement complies with the complex legal rules which must be followed to retain the tax benefits.

Suppose a 65-year old physician owns $100,000 worth of Pfizer stock that he bought some years before for $20,000. He wants to unload the low-yielding shares and invest the proceeds in higher yielding bonds or stocks. so he transfers the stock into a CRT instead, and elects to receive $7,000 annual income for the rest of his life, after which the principal will go to his favorite cause -- Health Volunteers Overseas. The trust sells the shares and invests the proceeds to return 7%, paying no capital gains tax on the $80,000 gain. The yearly income stream the trust pays out will generally be considered distributions of ordinary income, on which the physician will pay tax.

He also gets an income tax deduction in the year the transfer is made. Since the stock won't pass to the charity for several years, however, the deduction will be less than the stock's current market value. The deduction will be equal to the present value of the remainder interest given to HVO at his death.

Calculation of the deduction is based on four main factors: the fair market value of the asset, the life expectancy of the income beneficiary (the person receiving the yearly payout), the discount rate, and the payout rate chosen by the income beneficiary. In this example, using an 8% discount rate, the physician's deduction would be approximately $43,000, subject to certain limitations.

Whether you choose to make a gift of an asset directly to a charity or though a CRT, the value of the asset, together with any future appreciation, will be removed from your taxable estate -- which may reduce your estate tax liability at your death. With a CRT, you can shrink your taxable estate by the amount ultimately retained by the charity. Of course, since the charity is the ultimate beneficiary of the trust assets, you will want to make sure that you have otherwise adequately provided for your family.

One way to replace assets donated to charities is by purchasing life insurance for the benefit of your heirs. Funds to purchase the insurance policy may be available through increased income resulting from the tax deduction for the donated asset and the cash flow produced by the investment of the trust proceeds. By holding the insurance policy in an irrevocable trust and making it the owner of the policy, the death benefit may be kept out of your estate, thereby reducing your estate tax bill.

There are two kinds of charitable remainder trusts to choose from; both are irrevocable, meaning they can't be canceled once the trust document is executed. The "annuity trust" throws off a steady income flow at a fixed amount each year -- $5,000 or some higher amount annually, for instance. These types of CRT's tend to be more popular with people in their seventies or older who want the security of a guaranteed pay out in their old age and who don't want to take the risk that a market dip could erode the trust principle a few years down the road.

Unlike the annuity trust, the charitable remainder "unitrust" pays out a fixed percentage of the net fair maket value of the trust assets as it may vary from year to year. Unitrusts pay a variable return -- annual distributions fluctuate with the fortunes of the invested fund. While annuity trust are appraised just once, unitrusts must be revalued each year, which can drive up administrative expenses. But unitrusts also permit additional contributions of property under certain conditions, which can increase your income. Younger investors tend to prefer a unitrust over an annuity trust because its flexibility can provide a hedge against inflation over the long term.

A new law limits the yearly annuity and unitrust payments from a CRT and mandates a minimum percentage value for the charity's remainder interest. Regardless of which type of CRT is used, the annual amounts received by the donor are generally subject to income tax, either as ordinary income or as capital gain.

Properly drafted, a charitable remainder trust may be successfully used to achieve numerous tax and financial planning objectives. Consult with a professional adviser to determine whether charitable giving should be a part of your financial planning strategy.

Laurel A. Kent, First Vice President, Legg Mason Wood Walker in McLean, Virginia, provides investment advice to individuals and not-for-profit organizations. She may be reached at (800) 233-8134. Tom Annick, CFP, CLU, Sagemark Consulting in McLean, Virginia, provides estate and financial planning for individuals. He may be reached at (703) 821-1685.

Anyone interested in making a planned gift to HVO or any of its divisions should contact Nancy Kelly at (202) 296-0928 at the number above.