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:: Beyond Private Annuities
The private annuity was
just stripped of it's most alluring
benefit—capital-gains tax deferral. Long
favored by the wealthy because it
allowed them to avoid huge capital-gains
taxes on appreciated real estate (or any
other appreciated asset, for that
matter), the private annuity will no
longer enjoy the tax-deferral benefit,
the IRS recently announced. Private
annuities can still be used for other
purposes, but beware: The IRS is
watching, and may decide to audit.
Private annuities
involve the sale of an asset—usually
real estate, but any asset other than
cash qualifies—in exchange for a promise
of future annuity payments.
Traditionally, the IRS has seen these
exchanges as a wash with no taxable
gain. A typical scenario would involve
wealthy parents entering into one of
these arrangements with children. The
income tax is then spread out over the
lifetime of the annuity payments, and
when the parents die, the remainder of
the sum goes to the
beneficiaries—usually the kids.
Particularly troublesome to the IRS was
the fact that under the old rules the
children could take Mom and Dad’s
property, sell it to a third party and
still avoid income tax on the gains.
According to estate
planners, real estate investors can
enjoy similar tax benefits in a 1031
exchange, but, because you’re exchanging
one property for another, you don’t
actually get the money. (Plus, a cooling
real estate market has also dampened the
use of the 1031.) The private annuity
grew in popularity because taxpayers
could reap the same tax-deferral
benefits but get paid cash over time
from the annuity.
The “proposals are
designed to combat the problem of some
taxpayers who have been inappropriately
avoiding or deferring gain on the
exchange of highly appreciated property
for the issuance of annuity contracts,”
writes the IRS in the regulation
proposal. To read the IRS document,
click here.
“The IRS decided it was
too good of a deal,” says Mike Delgass,
an advisor with Sontag Advisory, an
independent RIA in Westport, Conn. As a
result, any exchanges made after Oct. 18
(with some less attractive exceptions
allowed until April 17, 2007) are now
taxed immediately on the gain generated
by the parents’ sale to the children.
But private annuities
can still be of some use. While the IRS
may have stripped them of their
income-tax benefits, private annuities
can still offer estate-planning
advantages. Delgass offers the example
of a father who purchases a piece of
property and soon after is diagnosed
with cancer. The building, which Dad
paid $5 million for, the full-value, is
new enough that capital gains are not a
worry. But estate taxes are. If Dad dies
with the building in his estate, his
heirs will owe $2.5 million on it. The
building can be transferred out of the
estate using a private annuity.
But, says Delgass, “As
long as Dad lives for at least 18 months
after the exchange is made, the property
is protected from that whopper of a
transfer tax. “It’s information
arbitrage,” says Delgass. “We know
something—in this case that Dad has
cancer—that the IRS does not,” he says.
In short, cases where assets are new and
haven’t appreciated much, or where the
capital gains are minimal because of the
underlying tax structure—say, in a
family business structured as an
S corporation—private
annuities are still solid
estate-planning tools.
Others say they now
should be avoided altogether. Alvin
Brown, a tax attorney and principal of
Alvin Brown & Associates in Fairfax,
Va., says the language used by the IRS
in its
update
about private annuities is “very strong”
and anyone considering using one may
want to think again. He should know:
Brown spent 30 years at the IRS and was
a supervisory manager in the Washington
office, signing off on IRS tax
regulations and interpretations. “Even
if you’re using them for estate-planning
purposes, that’s a judgment call on the
part of the IRS examiner,” he says. Not
only that, “Service computers will be
looking for ‘private annuity’ in
filings,” he says “and, if it comes up,
you’ll be inviting an audit.” (Brown,
who says he’s tired of the IRS beating
up taxpayers, runs a nonprofit forum for
citizens to upload and share their
experiences with the IRS, called
www.irsforum.org,
in the hopes of creating more
transparency with IRS actions.)
Depending on the
desired savings—income taxes, estate
taxes or both—there are other options
besides private annuities. “Two options
to avoid capital gains are
charitable
remainder trusts and
installment sales
for a note,” says Andrew Katzenstein, a
law partner with Katten Muchin Rosenman
in Los Angeles. (Katzenstein tackles the
private annuity topic in the December
issue of
Trusts and
Estates, the sister
publication of Registered Rep.
magazine.) With the charitable remainder
trust, parents get an annuity for life
but when they die the remainder of the
asset goes to charity, not the kids as
with the private annuity. “And the most
you can keep is 90 percent of the
property. You have to give at least 10
percent to charity,” says Katzenstein.
There are also
grantor trusts,
which offer estate-tax savings, as well
as
self-canceling
installment notes, which
Katzenstein says “look a lot like
private annuities,” have “a million
advantages” and will likely become the
most sought after replacements for those
who would have used private annuities.
Whichever route you
choose for your clients, these estate
planners and others warn interested
parties to tread carefully. Says Brown:
“Good tax planning should be a
conservative endeavor, not an aggressive
one.”
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