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.