Private Annuity Trust (PAT)
A Private Annuity Trust provides owners of highly appreciated assets (real estate, stocks, businesses, collectables, etc.) with benefits including:
1. NO capital gains taxes upon sale of asset.
2. NO estate taxes due upon taxpayers death.
3. Create an income stream for life.
4. Eliminates the headaches of asset management.
The PAT is a sophisticated tax planning tool, and you must hire a qualified income tax specialist, Estate and Tax Attorney, Certified Public Accountant and Trustee. These people will provide the necessary resources and information to facilitate the PAT’s process.
What is a Private Annuity?
A Private Annuity is a contractual agreement of sale between two private parties.
Usually the seller (the annuitant – the parent) of an asset transfers property to a family member (the obligor – the children or heirs) in exchange for a “special payment contract” (an annuity) of substantially equal value. The obligor is then responsible for making annuity payments to the annuitant during his/her lifetime.
What is a Private Annuity Trust?
A Private Annuity Trust (PAT) is a specialized and sophisticated trust designed to give structure and convention to the private annuity contract. The trust may sell and use the proceeds to provide an income stream for the life of the annuitant(s).
Benefits of a Private Annuity Trust:
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Real estate values have increased, and with higher valuations come new and expensive tax implications. Capital gains taxes, depreciation recapture taxes, state taxes, estate taxes and loss of deductions all threaten to take a significant part of the gains.
Sellers are now routinely facing large monetary gains, resulting in substantial income tax bills.
There are many reasons investors are selling their real estate. They may want to exit from the management involved in real estate.
Some people are uncomfortable about the real estate market and don’t want to see gains disappear. Others may have a buyer for their property but cannot find a suitable property to 1031 exchange into.
HOW DO I SELL MY PROPERTY AND NOT PAY THOSE TAXES?
Investors have traditionally used a variety of methods to try to limit or defer the tax consequences. Installment sales, Self Canceling Notes, and Charitable Remainder Trusts (CRT) have been the more publicized methods in the past.
Tax professionals have increasingly turned to a strategy called Private Annuity Trusts (PATs), which are appealing because they may provide significant income and estate tax relief and other benefits including:
--- NO capital gains taxes, depreciation recapture taxes or state taxes owed upon the sale of your property.
--- NO estate tax imposed upon the taxpayer’s death.
--- The creation of an income stream for life or joint lives.
How a PAT Is Structured
A PAT is a contractual agreement between private parties. Usually the transferor (the annuitant -- the parent) transfers ownership to the transferee (the obligor-the child or other beneficiary) an asset (real estate, stock, businesses, etc.) in exchange for the unsecured promise to provide a stream of payments for life (an annuity contract). The PAT is simply a specific trust set up and designed to give structure, formality and a legal conduit to the private annuity contract.
In an investment property sale you can take full advantage of this PAT structure. For example, if your property has a cost basis of $500,000 and you plan to sell it for $4,500,000, there would be a taxable gain of $4,000,000. Instead of paying federal capital gains taxes, potential state income taxes, and other taxes of over $1,000,000 you can set up a PAT and pay no taxes at the time of sale. You, as the annuitant, would then be entitled to receive an income payment for life from the $4,500,000 based on your age and the federal rates in effect at the time. At your death, your heirs receive the $4,500,000, minus withdrawals, plus any growth, and estate tax free.
The Private Annuity Trust Alternative
With a PAT, capital gains taxes, depreciation recapture taxes, and state taxes are deferred until income is received with each annuity payment. This income stream may be deferred until age 70 ½. When the income is received, a portion will be a tax free return of the initial tax basis in the property and a portion will be ordinary income based on the deferred gain realized on the sale of the asset.
If you are 58 years old and owe $1,000,000 in combined taxes at the time of sale, you may now be able to defer that until you are age 70 ½ and then receive payments over approximately another 15 years. No interest or penalties accrue on the $1,000,000.
In 2004 and 2005, $1,500,000 of a decedent's estate is sheltered from the estate tax ($3,000,000 for a couple if titled correctly).
Any amount over this is subject to the estate tax (otherwise known as the "death tax"). This tax can quickly reach up to 50% of your taxable estate. Because a PAT removes this asset from your estate, there is no estate tax or probate costs.
Assume your net worth is $10,000,000, you are married and have a marital deduction bypass living trust. If you both passed away in 2004, anything over $3,000,000 might be taxed up to 50%. Your estate (your children and your beneficiaries) might owe up to $3,500,000 in estate taxes!! This tax can be avoided on the assets in a PAT.
Another advantage of the PAT is the income feature. The PAT is funded with the proceeds from the sale of your property. The trust issues a private annuity contract that is required to pay out an income for life based on interest rates and actuarial tables published by the government. As the annuitant, you will receive the federally determined amount for the rest of your life. This income can start immediately or it may be deferred. It should begin though by age 70 ½.
Each payment can consist of three components; a capital gains portion, a regular income portion, and a tax free return of principal portion. Because you will be taxed on this income, many people try and defer the income for as long as possible. At the death of the annuitants, the trust must revisit its basis and may be required to pay the remaining capital gains tax if the annuitants died earlier than their life expectancy. This has a similar effect of paying back the remaining capital gains tax that the seller would have paid at the time of sale years …sometimes even decades… before.
The Competing Alternatives
A PAT has become increasingly popular because it has advantages over other competing strategies. If a seller was selling their 2nd home--- a beach house for instance --- they could consider options such as an installment sale or a CRT.
There are pros and cons with each alternative. In a PAT the biggest drawback is that the trust is irrevocable and generally only the income payments can be taken out. In an installment sale there are different risks. What if the buyer defaults on his contract? You might have to take back a neglected property and sell it in a depressed market, possibly turning a profit into a loss. The depreciation recapture tax is also due up front in an installment sale. That’s money out of your pocket right away. And if you were to pass away before the installments were completed then the value of the remaining portion is included back into your estate for the dreaded estate tax.
A CRT is another planning strategy used to defer capital gains and income taxes on the sale of an appreciated asset. However, unless you have a significant charitable intent, the PAT often provides more benefit to the family because in a CRT the assets eventually will be left to charity as opposed to your heirs.
It is important for you to use professionals who are familiar and well versed in the language of private annuity trusts. When set up, funded, and executed properly, a Private Annuity Trust can be a versatile and valuable tool for your estate and tax planning needs.
SELLING YOUR HOME WITHOUT PAYING TAXES
Real estate values have soared. With the higher valuations come new and expensive tax implications. Capital gains taxes, depreciation recapture taxes, state taxes, estate taxes and loss of deductions all threaten to take up to 75% of your gains.
In the past, if you sold your primary residence, the $500,000 married couples exemption would have sheltered some or all of your gain from taxes.
HOW DO YOU SELL YOUR HOME AND NOT PAY the TAXES?
Investors have traditionally used a variety of methods to try to limit or defer the tax consequences. Installment sales, Self Canceling Notes, and Charitable Remainder Trusts (CRT) have been the more publicized methods in the past. Since the 1980’s though, tax professionals are increasingly turning to a little known strategy called Private Annuity Trusts (PATs).
PATs are appealing because they may provide significant income and estate tax relief and other benefits including:
--- NO capital gains taxes, depreciation recapture taxes or state taxes owed upon the sale of your home.
--- NO estate tax imposed upon the taxpayer’s death.
--- The creation of an income stream for life or joint lives.
How A Private Annuity Trust Is Structured
A PAT is a contractual agreement between private parties. Usually the transferor (the annuitant--the parent) transfers ownership to the transferee (the obligor-the child or other beneficiary) an asset (real estate, stock, businesses, etc.) in exchange for the unsecured promise to provide a stream of payments for life (an annuity contract). The PAT is simply a specific trust set up and designed to give structure, formality and a legal conduit to the private annuity contract.
In a primary home sale you can take full advantage of this PAT structure. For example, if your home had a cost basis of $500,000 and you sold it for $3,000,000, you would have a taxable gain of $2,000,000 (after the $500,000 joint exemption). Instead of paying federal capital gains taxes, potential state income taxes, and other taxes of nearly $500,000 you can set up a PAT and pay no taxes at the time of sale. You could take out $1,000,000 tax free (basis plus exemption) and then as the annuitant, receive an income for life from the $2,000,000 gain based on your ages and the federal rates in effect at the time. At your death, your heirs receive the $2,000,000 minus withdrawals plus any growth estate tax free.
The Private Annuity Trust Alternative
With a PAT, capital gains taxes, depreciation recapture taxes, and state taxes are deferred until income is received with each annuity payment. This income stream may be deferred until age 70 ½. When the income is received, a portion will be a tax free return of the initial tax basis in the property and a portion will be ordinary income based on the deferred gain realized on the sale of the asset.
If you are 58 years old and owe $500,000 in combined taxes at the time of sale, you may now be able to defer that until you are age 70 ½ and then receive payments over approximately another 15 years. No interest or penalties accrue on the $500,000.
In 2004 and 2005, $1,500,000 of a decedent's estate is sheltered from the estate tax ($3,000,000 for a couple if titled correctly). Any amount over this is subject to estate taxes (otherwise known as the "death tax"). This tax can quickly reach up to 50% of your taxable estate. The PAT removes this asset from your estate, and there is no estate tax or probate costs.
Assume your net worth is $10,000,000, you are married and have a marital deduction bypass living trust. If you both passed away in 2004, anything over $3,000,000 might be taxed up to 50%. Your estate (your children and your beneficiaries) might owe up to $3,500,000 in estate taxes. This income tax can be avoided on the assets in a PAT.
There are many other advantages of PATS but the last one we will speak of here is the income feature.
The PAT is funded with the proceeds from the sale of your home. The trust issues a private annuity contract that is required to pay out an income for life based on interest rates and actuarial tables published by the government. As the annuitant, you will receive the federally determined amount for the rest of your life. This income can start immediately or it may be deferred. It should begin though by age 70 ½.
Each payment can consist of three components; a capital gains portion, a regular income portion, and a tax free return of principal portion. Because you will be taxed on this income, many people try and defer the income for as long as possible. At the death of the annuitants, the trust must revisit its basis and may be required to pay the remaining capital gains tax if the annuitants died earlier than their life expectancy. This has a similar effect of paying back the remaining capital gains tax that the seller would have paid at the time of sale years before.
The Competing Alternatives
A PAT has advantages over other competing strategies. If a seller was selling their 2nd home--- a beach house for instance---they could consider options such as an installment sale or a CRT.
There are pros and cons with each alternative. In a PAT the biggest drawback is that the trust is irrevocable and generally only the income payments can be taken out. In an installment sale there are different risks. What if the buyer defaults on his contract? You might have to take back a neglected property and sell it in a depressed market, possibly turning a profit into a loss. The depreciation recapture tax is also due up front in an installment sale. That’s money out of your pocket right away. And if you were to pass away before the installments were completed then the value of the remaining portion is included back into your estate for the dreaded estate tax.
A CRT is another planning strategy used to defer capital gains and income taxes on the sale of an appreciated asset. However, unless you have a significant charitable intent, the PAT often provides more benefit to the family because in a CRT the assets eventually will be left to charity as opposed to your heirs.
It is important for you to use income tax professionals who are familiar and well versed in the language of private annuity trusts.
When set up, funded, and executed properly, a Private Annuity Trust can be a versatile and valuable tool for your estate and tax planning needs.
Attribution
Information here has been summarized from that provided by the National Association for Private Annuity Trusts: 888-877-PATS (7287) and www.NAPAT.org.
Disclaimer
You must consult with an income tax professional or attorney prior to making decisions about the use of a Private Annuity Trust. The information contained here is for that and not intended to replace competent legal, tax, or financial planning advice. The applicable tax codes apply to and relate to federal tax law only. Information here may be specific to the State of
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Disclaimer: The information contained herein is not the providing of legal services or services of an accountant. If a person wants or needs such professional services, he or she must contact and retain counsel or a certified public accountant. There are risks associated with the acquisition and ownership of real estate.
Harrison & Christi Long
"Explore Real Estate" Team
Coldwell Banker
949-854-7747
