Private Annuity Trusts: Questions and Answers

By Ray A. Smith
The Wall Street Journal

A recent Building Value column discussed creative ways investors could defer capital-gains tax bills from the sale of their properties. Numerous readers wrote in asking for more information about one such strategy: private annuity trusts.

Under this plan, the owner of commercial or residential property transfers ownership to a trustee prior to the sale of the property. The trust pays the seller with a special payment contract called a private annuity that stipulates that payments from the sale of the property go to the owner for the rest of his or her life. The trustee then sells the property to the buyer, getting cash for the property and holding it in a trust. The trustee also can invest the money held in trust.

Since the private annuity contract calls for payments to be made in installments over the seller’s life, the seller is only taxed on payments when they are received, rather than upfront. The amount of payments is determined by Internal Revenue Service life-expectancy tables.

Here are some of the specific things readers inquired about, along with the responses of financial planners. The accompanying chart explains how the payments to the annuity holder are taxed.

How Long Can I Defer Payment? Annuity holders can defer payments for years after the sale but they must begin by age 70½. Once payments begin, the annuity holder will receive payments for as long as he or she lives.

Who Can be a Trustee? The seller — or private annuity holder — can’t be the trustee or have any direct control over the trust. The trustee may be any adult, including an adult child, who is not claimed as a dependent. Even the annuity holder’s accountant, attorney, financial adviser, family friend or relative outside of the immediate family can be a trustee, according to the National Association of Financial and Estate Planning. What’s more, you can have one trustee or two co-trustees.

How Much Do I Get? The annuity holder’s income is fixed, meaning that he or she receives a fixed payment amount determined by the private annuity’s face value, the annuity holder’s age and the Internal Revenue Service’s stipulated interest rate. The holder can’t receive more than his or her fixed payments, regardless of what the trust earns through investments made with the proceeds. Whatever extra the trust earns on investments has to be held for the trust beneficiaries or paid to them. Scott A. Leonard, a certified financial planner in Redondo Beach, Calif., says that since it’s assumed some of the proceeds will be invested, part of the payments from the annuity will be taxed as income.

What About Other Taxes? Sellers using the private annuity also can defer taxes known as depreciation recapture, in which the IRS recaptures depreciation the owner had previously received deductions for. For example, if depreciation recapture on the sale of a $500,000 house comes out to $100,000, and life expectancy of the annuity holder is 25 years, that would amount to $4,000 a year in depreciation recapture taxes, according to Mr. Leonard.

What Properties Count? Some readers wondered whether a rented-out single-family home could be sold with the owner using a private annuity. The answer is yes. Annuities can be used for a rental property and a primary residence.

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