The Treasury Department and Internal Revenue Service are expected this week to adopt a rule change that effectively kills the use of private annuity trusts to postpone taxes on the sale of appreciated property.
Advisors therefore should consider alternative strategies -- including installment sales, charitable gift annuities, and self-canceling installment notes.
If the Treasury/IRS proposal is adopted as anticipated on Feb. 16, private annuity trusts will be subject to the same tax treatment as commercial annuities. This new treatment would be retroactive to Oct. 18, 2006, the date of the federal announcement of the proposed rule change (transactions implemented before then would be grandfathered.).
A lot of taxpayers could be affected. Use of the private annuity trust as a way to defer capital gains taxes grew dramatically during the recent real estate boom -- even though many advisors were uncomfortable with the strategy. The approach had an individual transfer an appreciated asset (such as real estate or a closely held business) to a trust (whose beneficiaries were family members) in return for a lifetime of fixed annuity payments that, based on the person's life expectancy, cumulatively amounted to the asset's fair market value (FMV).
The idea was that the original owner would get to pay taxes on his gain over time as he received the annuity payments. But the profit would be enjoyed almost immediately, as the trust would quickly sell the property to a third party and because the trust had purchased the property at FMV, it would not be liable for capital gains taxes.
The IRS didn't much like the maneuver and, with the proposed rule, knocks it out of the box.
So how might today's seller lawfully mitigate or defer taxes on appreciated property?
David Handler, partner in the Chicago office of Kirkland & Ellis LLP and a member of the Trusts & Estates advisory board, points to the installment sale as one possibility: An individual can engage in an installment sale of a property to a family member or other individual. By taking a portion of gain into income each year, the installment sale method defers taxes to later years. The buyer can resell the property -- but still is obligated to pay back the seller. Meanwhile, the buyer's property tax basis is the market value of the property when it's sold.
The drawbacks to this strategy are (1) a seller does not get the sale proceeds immediately and cannot reinvest the money, and (2) the seller gives up control of the asset. So, if a parent sells a profitable rental property to a family member, for example, that person must have the skill to manage the property. If he can't manage the property and fails to make the installment payments, there could be problems.
Rather than private annuity trusts, Seth Pearson, financial planner and president of Pearson Financial Services in Dennis, Mass., says that he likes charitable remainder trusts (CRTs) to provide income to retirees, as well as their children and grandchildren.
Take a property valued at $1 million, says Pearson. Half the property is put in a CRT for the parents; the other half is gifted in a trust for the children, with the parents name as trustees. The property is sold inside the CRT, so no capital gains taxes are owed.
The parents get an immediate $50,000 income tax deduction for the gift to charity, based on a complex formula. They withdraw an equal amount from their individual retirement account (IRA) and convert it to a Roth IRA, naming their grandchildren as beneficiaries. That $50,000 is left to grow in value tax-free for their grandchildren's lifetime.
The parents' trust, which pays them periodic income, continues for 20 years or the parents' lifetime, whichever is longer. When the parents die, the proceeds from the sale of the property revert to the charity. But the $500,000 share in the children's trust continues to grow in value.
The downside may be the asset goes to the charity when the parents die. However, the parents' trust says that if they die, the children must get income from it for at least 20 years. Plus, the children's own trust is paying them income for life.
For rapidly appreciating property, Charles Rubin, a Boca Raton, Fla.-based tax attorney, finds a sale to a defective grantor trust attractive. Unlike many structured sales arrangements, this involves no commercial annuity. This is similar to an installment sale, says Rubin, except that no taxes are paid on the gain on the sale of a property.
How it works: the owner of a property sets up a trust for family members so that everything the trust owns is treated for income tax purposes as being owned by the person who created it. "If I sell the property to the trust for tax purposes, I'm really selling it to myself," Rubin says. "That doesn't create a tax event. The trust is still effective for estate and gift tax purposes. When I die, I don't own the property any more. Any increase in the value of the property after I sell it escapes taxation from my estate."
Drawbacks: a defective trust could make it hard to sell a property because the trust buying the property gets the same basis in the property as the seller had. This means that if the property appreciates dramatically, a buyer could be saddled with significant capital gains taxes when he eventually sells the property. Also, the buyer trust pays for the property over time with a promissory note. For the IRS to respect this transaction, the buying trust should have other assets -- typically equal to at least 10 percent of what it was buying, Rubin says.
Handler agrees this type of trust is a viable alternative to a private annuity. He also suggests people look at the tax consequences of establishing a grantor trust, particularly when property values are on the rise.
"In some case it might be better to sell the property and pay the capital gains taxes," Handler notes.
Alan Lavine is co-author with his wife, Gail Liberman, of Quick Steps to Financial Stability (Que/Penquin Group).
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