Clients often ask how they can divest themselves of a highly appreciated asset and yet defer the payment of the income tax on the sale. If the appreciated asset is real estate, perhaps a like-kind exchange would provide the desired benefit. But if the asset is stock, a deferred exchange is not permitted. However, one may use the technique of the sale of the asset to a trust to defer the payment of the taxes through the use of a private annuity. And, while interest rates have crept up over the past year, they are still relatively low, making private annuities attractive.
An annuity is a contract between two parties whereby one party B, the annuitant, transfers property to the other in return for a promise to make periodic payments to the annuitant for a fixed period of time. In a commercial context, the arrangement is generally between an annuitant and insurance company. However, a private annuity is between two individuals or, in the estate planning context, an individual and a trust.
If one sells assets to a trust, whether real estate, stock, or other investments, the trust and the grantor may enter into a private annuity arrangement whereby the annuitant will receive annuity payments. The payments required to be made from the trust to the annuitant are based on the value of the assets sold to trust and the interest rate at the time of the sale.
If the property is sold after the annuitant has sold it to the trust, the gains are not taxable to the trust and are not immediately taxable to the annuitant; the gains are required to be recognized only when the annuitant receives the annuity payments. Thus, when the annuitant begins to receive the payments, part of the payment will be taxable as ordinary income and part will be capital gains. Finally, to the extent the assets appreciate in the trust before they are distributed to the beneficiaries, the grantor will have avoided estate taxes on the appreciation of the assets after the sale.
When the annuitant sells assets (such as real estate or a business interest) to a trust, the IRS determines the value of the sale by reference to interest rates at the time of the sale. The lower the IRS interest rate at the time of the conveyance, the lower the required annuity payment to the grantor each year. If the fair market value of the property sold is equal to the present value of the annuity payments, the sale is not treated as a taxable gift.
By creating the private annuity trust during a period of low interest rates, the annuitant can reduce the payments required to be made from the trust, thereby leaving more cash in the trust to be paid to the beneficiaries. Consider the following examples: Mr. Johnson, age 70, sells stock worth $1,000,000 to his child in July 2005. If, under the terms of his private annuity, his child agrees to pay him an annual annuity payment of $107,851 for his lifetime, the sale is not a taxable gift. If Mr. Smith (also age 70) had made the same sale in September 2001, the required annual annuity payment would have been $116,010. The difference in the two required annuity payment amounts results solely from the difference in interest rates at the time of the sales (4.8% for the 2005 gift and 5.8% for the 2001 gift).
If you have any questions regarding the use of a private annuity in your estate plan, please do not hesitate to telephone us.