Life can be so ironic and cruel. Imagine if you built your entire business on one narrow part of the tax law, and then the tax law changed because you became too successful marketing it. That’s exactly what happened to private annuity trusts.
Do you have clients who want to sell highly appreciated assets and “avoid” the current capital gains taxes and depreciation recapture? Would they like to have money they otherwise would have paid to the IRS or state in taxes in an account that grows and can provide a lifetime income stream? Do they also want a plan that removes highly appreciated assets from their estates for estate tax purposes?
For many clients with highly appreciated assets, the answer is yes. Until recently, one vehicle clients could have used to accomplish the above goals was the private annuity trust. Functioning like an immediate annuity, the vehicle can provide a guaranteed income stream for life through the sale of property transferred by the client to the PAT.
But the IRS issued on October 17, 2006, proposed regulations–IR-2006-161–that would for all intents and purposes “kill” the use of PATs to defer capital gains taxes on the sale of an appreciated asset by applying the same rule to exchanges for both private annuities and commercial annuities. And if you can’t use PATs for this purpose, there is little reason to use them.
What other solutions are available? There are 2 you should consider: (1) the charitable remainder trust and (2) the Intentionally Defective Grantor trust.
Charitable remainder trusts
By gifting a highly appreciated asset to a CRT, a client can enjoy a current income tax deduction and a reduction in capital gains taxes over time (neither of which was a benefit of a PAT). Like a PAT, a CRT provides a lifetime income stream and removes the asset from the client’s estate.
By using some of the CRT’s lifetime income stream to fund a life insurance policy owned by an irrevocable life insurance trust (also called a “wealth replacement trust), the client can also leave a lasting legacy for children. The same objective can also be achieved with a charitable gift annuity.
The CRT in action
Assume that Dr. Smith, age 60, has an estate valued at $5 million and that he owns a rental property worth $500,000 and has a basis of $100,000. Assume also that Dr. Smith still works as a surgeon, making $400,000 a year.
(1) Dr. Smith gifts the property to a charity in exchange for a CRT.