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Capital Gains Deferral/Avoidance: The Private Annuity Trust

By Roccy M. DeFrancesco, JD, CWPP™, CAPP™ - Email Editor

Date : Feb 14, 2006

The Private Annuity Trust

The number one issue concerning/upsetting wealthy clients today is paying taxes. Clients in some states pay 45%+ income tax, and everyone pays 15% or more in capital gains tax.

This article will describe how you can defer and possibly avoid capital gains tax on appreciated stock (private or public) OR real estate through a Private Annuity Trust (PAT).

Let's look at an example to see if a PAT will work for you. For this exercise Dr. Smith will be our candidate for the PAT. Dr. Smith is 40 years old and invested heavily in real estate by buying property in California and Florida several years ago. Dr. Smith thinks the real estate boom is about to bust and would like to sell his property and avoid or defer the capital gains tax. Dr. Smith could use a 1031 exchange to roll the proceeds and gains to a new investment property, but again, he is interested in getting out of real estate and into a different, more secure investment.

Assume Dr. Smith's property is now worth $2,000,000 and that he paid $200,000 for the property (his “basis”). Assume Dr. Smith's federal capital gains tax rate is 15%, and assume that there is a 5% state capital gains tax rate. This would mean that he would have to pay 20% tax on the $1,800,000 gain. If Dr. Smith does nothing, he will have to pay $360,000 in capital gains taxes when he sells the property.

The Use of a PAT

If Dr. Smith uses a PAT, he can defer and potentially avoid capital gains tax on the sale of the real estate.

How does the PAT work? 1) Dr. Smith makes a for-value transfer to the PAT before a sale of property is complete. 2) The PAT will issue back to Dr. Smith a “private” annuity. The annuity is considered “private” because an insurance company is not involved in the process. This transfer is not a gift since Dr. Smith transfers the property for value received (the annuity stream). The payment of the annuity will be for the life of the client and can be immediate or deferred for a period of months/years

The PAT sells the property. The Trust now owns the property and needs to sell it to be able to fund its repayment obligation to Dr. Smith. This buyer is typically lined up prior to setting up the PAT. The Trust does not pay a gain on the sale because the property transferred was worth $2,000,000, which was also the sale price.

The key to this transaction is that Dr. Smith does not have to pay capital gains tax on the sale of the property when sold by the PAT. Dr. Smith will pay taxes when he receives each annuity payment from the PAT (similar to an installment sale). Most clients will pick a lengthy deferral period before receiving the annuity stream of income. In doing so, the client effectively is allowed to use the government's money (the amount that would have been paid in capital gains) to grow and benefit the client through an increased annuity stream of income.

A client can defer the annuity payment stream until the age of 70 ½. Let's look at the numbers, assuming Dr. Smith implements the PAT at age 40, starts his annuity stream at age 61, and has it pay for twenty years.

Explaining the above chart:

The above chart makes certain assumptions and works with certain tax facts. The above example assumes that, if Dr. Smith does not use the PAT, he will take his money home after paying the capital gains taxes and invest it in mutual funds earning 6% but netting less because of typical dividend and/or capital gains taxes (assumed 20% for this example). I also used a money management fee of 1% annually.

The annuity payment that comes from the PAT is going to have two taxes levied on it. I assumed tax free growth inside the PAT (which will come from using an indexed annuity or tax free bonds) of 6% annually.

The annual annuity stream (which is $559,225 pre-tax) is taxed as follows:

-The $200,000 basis comes back tax free in the amount of $10,000 per payment.

-The $1.8 million dollar capital gain is divided up equally over 20 years and is taxed at 20% on $90,000 annually leaving $72,000.

-The growth on all the money invested in the PAT minus the basis and amount allocated for the capital gains treatment is taxed as ordinary income ($559,225-$10,000- $90,000 = $459,225 which is treated as ordinary income. $459,225 x .6 = $275,535). From the actual annuity payment of $559,225, Dr. Smith keeps $357,535 ($72,000 + $10,000 + $275,535 = $357,535). With the PAT as illustrated, Dr. Smith ends up $2.230 million ahead during the time frame illustrated.

What Happens If the Client Dies?

If Dr. Smith dies after the payment term and if there is still money in the PAT, those assets will pass to the heir's capital gains and estate tax free. This can happen if the investments in the Trust generate higher returns than are needed to pay out the annuity stream for the stated period.

What happens if Dr. Smith dies before his expected date of death? The answer is that it depends on whom you speak with. Some marketing entities are telling advisors that all of the assets in the Trust will pass to the beneficiary's capital gains and estate tax free no matter when the client dies. More conservative consultants tell clients that there is a potential that the IRS could recast the PAT as an installment note with a balloon payment due when the client dies. If this happens, the beneficiaries will have to pay capital gains tax on the remaining payments and estate tax on the assets remaining in the PAT.

I added this to the article to make readers aware of this potential problem and to make sure you receive full disclosure instead of a pure marketing pitch that is being given by most entities marketing this concept.

Conclusion

If you are looking to sell real estate or stock and would like to defer and possibly avoid the capital gain in an effort to maximize retirement income, you should learn about the PAT.

A Private Annuity Trust education module is available for clients and advisors. NOTICE - SEE IRS REGULATIONS FOR NEW PRIVATE ANNUITY TRUST RULES.

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