Private annuity trust
A private annuity trust (PAT) enables the value of highly appreciated assets, such as real estate, collectables or an investment portfolio, to be realized without selling and incurring substantial taxes from their sale.
Using a PAT instead will defer the associated capital gains tax, provide a stream of income, and effectively remove the asset from the owner's estate, thus reducing or eliminating estate taxes. With these advantages, a PAT provides an alternative to other methods of deferring capital gains taxes, such as the charitable remainder trust (CRT), installment sale, or tax-deferred 1031 exchange.
A properly structured PAT involves first transferring the asset to the PAT trustee in return for an annuity, based on the owner's life expectancy or perhaps the joint lives of the owner and his or her spouse. A separate annuity can be provided to each spouse in some cases. The lifetime annuity payments are then made with the investment earnings from asset or, alternately, the asset is sold and the proceeds are reinvested by the trustee to fund the payments. Payments are usually made annually, or sometimes monthly or quarterly, to the annuitants -- the owner (and the spouse if a joint annuity).
Neither the transfer of the asset to the trust nor its later sale is subject to income taxes if, as is usually the case, the annuity payment is established at a level that gives the annuity a present value equal to the value of the asset sold. However, each annuity payment when received will be partially taxable on the share of capital gains, depreciation recapture and ordinary income included in the payment. The portion representing recovery of original tax basis is not taxable.
To preserve the benefits of a PAT, the trustee must be independent, the annuity cannot be secured in any way, and the annuitants cannot have any control over the trust or its investments. Informal suggestions and advice, however, are not prohibited.
The primary benefit of a PAT is that it allows the full appreciated value of the asset to be invested and to earn income before capital gains and recapture taxes are paid. If the trust's earnings are greater than the annuity amounts paid, the excess value will accrue or can be paid out to the ultimate beneficiaries, usually the owner's heirs who will also receive any remaining investments in the trust after the annuitants have died. If annuitants die before living out their life expectancies, the trust might be required to pay a portion of the deferred capital gains taxes.
The investment of the pre-tax proceeds potentially gives private annuity trusts the ability to generate substantially more money over the long run than a direct and taxed sale. However, partially offsetting this advantage are the compressed income tax brackets for trusts that cause the investment earnings reach the maximum income tax bracket when income exceeeds $9,000-$10,000 annually. Also the trust is not allowed to deduct the amount of imputed interest built into the annuity payments that is makes. Sometimes the PAT will invest in a deferred annuity in an effort to minimize trust income taxes, but at the expense of sizable commissions and fees.
Thus, potential benefits from a private annuity trust include lifetime income, deferral of capital gains and depreciation recapture, investment flexibility and diversification, enhancement of retirement income, and tax-free inheritance of the remaining trust funds by the designated beneficiaries. These benefits in many cases will enable a PAT to provide superior results as compared to a charitable remainder trust (CRT), installment sale, or tax-deferred 1031 exchange.
External links
- Private Annuity Trusts by Noll & Company - a trusted PAT advisor.
- NAFEP National Association of Financial & Estate Planning.
- The Tax Forum The Tax Forum - Objective source for private annuity trust information.
- Quantum Advisors - a trusted, full-service PAT firm.
- Annuities Institute National independent planning firm for unbiased advice.