From the December 2005 issue of Investment Advisor • Subscribe!

The Fine Print

You can defer taxes with a private annuity trust. But do so carefully

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Private annuity trusts (PATs) are creating quite a buzz in the real estate, legal, and financial planning communities. To read the marketing brochures, you'd think a PAT is a safe way to capitalize on the windfall gains experienced recently in the real estate market without paying a fortune in taxes. But putting the strategy into play can be challenging and carries risks often not fully considered by advisors and their clients.

In 2003, the IRS gave preferential tax treatment for long-term capital gains. For most taxpayers, the top federal tax on long-term capital gains is 15%. The rate can be higher for certain types of property. In addition, sellers qualify for a capital gain exemption of up to $250,000 ($500,000 if married) when selling a personal residence. But even at 15%, the increased taxable income can result in reduced allowable deductions or personal exemptions, not to mention higher state income taxes.

Traditionally, there are four ways to defer or spread out capital gains over several tax years. Installment sales are the most tried-and-true method of deferring taxes. The seller only pays taxes when he receives a payment from the buyer. Each payment consists of principal, capital gains, and interest. A private annuity is a form of installment sale done between family members to provide the older generation with income for their lifetime. A private annuity, unlike an installment sale, also allows deferral of depreciation recapture incurred by most commercial real estate.

Another technique to spread taxes over the taxpayer's lifetime is a charitable remainder trust. The taxpayer (donor) receives a portion of the trust's income over her life, and, at death, the balance of the trust is turned over to the donor's favorite charity. Most people will use an irrevocable life insurance trust in conjunction with the charitable trust. The gift to charity is replaced by life insurance payable to the family.

Finally, a 1031 exchange allows a taxpayer to trade one piece of commercial or investment real estate for another without incurring immediate taxes on the gain. Of course, for a taxpayer looking to rid himself of the responsibility of property management, the 1031 exchange is not an attractive alternative.

Recently, a new strategy for deferring taxes--the private annuity trust--is getting attention. The marketers have taken the private annuity and blended it with an irrevocable trust. The trustee and the property owner enter into a sales agreement, but instead of receiving cash, the property owner (the annuitant) is paid in installments stretched over the owner's life expectancy. The trustee then sells the highly appreciated property and reinvests the proceeds in a diversified investment portfolio. Usually, up to 10% of the property is held in reserve and 90% is invested to generate the annuity.

A portion of the trust can, and often does, purchase a commercial annuity issued by an insurance company to guarantee the trust's payments to the annuitant. When the trustee sells the asset, there is little or no income tax because the trust now has a basis equal to the present value of the annuity payments.

Neither the annuitant nor her spouse can serve as trustee of the PAT. Nor can the annuitant be a beneficiary of the trust. The trust beneficiaries are typically the annuitant's children, who may have to wait for the annuitant's death to benefit from the trust.

The annuitant may be able to defer the income payments, and thus the capital gain, until age 701/2. Like the installment sale, each payment consists of return of principal, capital gains, and interest--until the annuitant reaches his life expectancy. Beyond that time, the annuity payment will be taxed as ordinary income because the annuitant has recovered his basis and paid taxes on all of the capital gain.

While real estate is the most popular asset to sell to a PAT, most types of property with a low basis are appropriate. Property subject to a mortgage will not receive all the benefits of a PAT. The discharge of mortgage is treated as income to the seller and will be taxed in the year the property is sold to the trust.

PATs' Disadvantages & Risks

One of the primary disadvantages of the PAT is that the annuitant loses control of the trust's investments. She cannot influence how the trustee invests or manages the assets. Neither the annuitant nor the annuitant's spouse may act as trustee, and, with the frequency of divorce in this country, many parents fear putting their assets in the hands of their children.

A PAT is not flexible. If the annuitant runs into a financial emergency, he cannot receive a lump sum from the trust. Some PAT marketers infer that the annuitant has a great deal of flexibility through loans received from the trustee. This may lead to the annuitant viewing the trust as a holding tank for retirement funds. It is just this type of misunderstanding that costs estate owners millions of dollars in taxes when the courts ignore their family limited partnerships. A better alternative might be to pledge the annuity payments as collateral for a loan from a commercial bank.

Another disadvantage is that the annuitant does not have a secured interest in the trust assets, and there is a possibility that the annuity payments can bankrupt the trust. Remember that a PAT is basically an installment sale. The amount of the payment is based partly on the seller's age (or the joint age of the seller and spouse), the value of the asset at the time of the sale, and an IRS-specified interest rate. The annuitant can expect to recover the asset's purchase price by the time he reaches full life expectancy.

This results in much larger payments than the newly diversified portfolio can earn. If the annuitant lives past normal life expectancy, the trust is obligated to continue the payments. In the best case, the trust investments will earn more than the IRS interest rate and create a reserve. In the worst case, the trust will run out of money. For this reason, commercial annuities provide a safety net for the trustee. Unfortunately, the price of commercial annuities is based on historically low interest rate assumptions and provide limited opportunities to benefit the remaining beneficiaries.

An issue often glossed over is that the trust is responsible for the taxes on interest, dividends, and capital gains earned by the trust assets. The trust does not get a corresponding tax deduction when it pays out the annuity payments. This effectively ends up as double taxation--at the trust level and in the hands of the annuitant.

There is some uncertainty about how potential depreciation recapture may be treated. Normally, the owner of rental or commercial real estate will depreciate the property every year to reduce income taxes. The depreciation is recaptured at a 25% tax rate when the property is sold. There is some debate among tax professionals as to whether the recapture is taxed when the trust sells the property or is deferred under the annuity rules.

PATs are sold as a panacea for capital gains taxes and often assume that capital gain rates will remain at today's levels. If tax rates increase in the future--or revert in 2008 to ordinary income tax rates--the annuity payments from the trust will be subject to the higher rates. In the end, the increased taxes may not be offset by the tax deferral of the PAT arrangement.

Finally, it is hard to find an attorney independent of the PAT marketing organizations to write the legal documents or give a legal opinion on the technique. Some marketers only provide specimen documents to graduates of their own educational programs or in exchange for a share in the commissions of an annuity product. Moreover, the legal opinion letters provided by PAT marketers can only be relied upon by the organizations themselves. If the client cannot find independent legal counsel familiar with PATs, he should consider applying for a Private Letter Ruling applicable to his situation.

Only clients who are willing to accept the risk of a negative tax outcome should undertake the PAT. While the strategy relies on tried-and-true income and estate tax techniques (cited as legal authority by PAT marketers are Revenue Rulings 55-119, 80-80, and 69-74; GCM39503 (5/19/86); TD-8754 (1998); and LaFargue v. Commissioner, 689 F. 2d 845 (1982), the IRS can challenge the PAT on the basis that the trust has no real purpose other than to avoid income taxes. Considering that a client can spend from $5,000 to $10,000 to set up a PAT--and thousands more in annual management fees--an adverse IRS decision on the income tax benefits of the PAT could generate additional taxes and legal fees.

We only have to look back at reverse split dollar as an example. Reverse split dollar was marketed as a way for business owners to shift corporate income to the stockholder without taxation. The IRS ignored this twist of the traditional split-dollar plan for decades before issuing Notice 2002-59. While reverse split dollar may have its place in executive benefits planning, the IRS is clearly not favorably disposed toward this method of minimizing taxation.

Legal commentators also warn that the IRS could challenge the PAT as a "step transaction," which occurs when a taxpayer tries to disguise a normally taxable transaction by inserting an intermediate step. In other words, a seller cannot exchange a piece of real estate for a portfolio of stocks, bonds, or annuities without recognizing capital gains on the real estate. Creating a trust solely to transact the sale and avoid capital gains taxes will not necessarily be accepted as valid. The IRS has attempted with some success to attack other intermediaries, like family limited partnerships, when they served no purpose other than to minimize taxes.

The PAT is one of several strategies to consider when the time comes to liquidate a highly appreciated asset to generate a stream of income. The PAT strategy should only be undertaken by someone who understands its risks and who is willing to pay the additional cost of independent legal advice to determine if it is appropriate.

Tere D'Amato, CLU, ChFC, and CFP, is director of advanced planning, wealth management, for Commonwealth Financial Network in Waltham, Massachusetts. D'Amato earned her MSFS with an emphasis on estate planning through the American College in 2003. She can be reached at tdamato@commonwealth.com.

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