The Private Annuity Trust
by Christian Ramsey

Tax Planning Opportunities for Owners of Appreciated Property

Many owners of ranches, farms, vineyards, land, and homes and estates on acreage are suddenly finding that their properties are worth more than ever due to the recent boom in real estate values. Even though most regard higher value as good news, there are a few issues to consider that may not immediately be apparent, such as the tax consequences for selling a highly appreciated property, or the estate taxes that heirs may have to pay if the property owner were to die.
Capital gains tax and estate tax are now the shadowy visitors lurking around the corner for property owners, waiting to take their cut. The question is, “How can one keep from paying a large tax bill?” and one of the best answers is called a Private Annuity Trust (PAT).
Private Annuities and Private Annuity Trusts have actually been around since the 1950s and were originally created as an alternative to an installment sale when selling a business. The main difference between an installment sale and a Private Annuity Trust (PAT) lies in the fact that a PAT will collect the entire sales price of a highly appreciated asset and then pay the grantor of the trust according to a written agreement called a “Private Annuity.” Therefore there is little risk of forfeiture as opposed to an installment sale situation. With either of these arrangements, capital gains tax is due as the seller receives a payment. But that is not the only difference, nor is it the most important difference, which is that PATs will avoid depreciation recapture costs. Private Annuity Trusts also have considerable benefits for estate planning concerns.
The avoidance of depreciation recapture costs is incredibly important because many owners of ranches or large parcels of land have inherited the property from previous generations, with assets that are fully depreciated. Each time the property passes to a new generation the government takes some cookies from the cookie jar. Of course each time a property is sold, the government also takes its cut. Knowing how to keep your tax bill as small as possible is becoming of greater importance.
A Private Annuity Trust, or PAT, works like this: a seller sells the property to their PAT for a lifetime income contract (called a private annuity) and then immediately sells again to the buyer. Since the sale to the PAT was an arms-length transaction, it establishes a new basis in the property. When the PAT sells to a buyer, there is no tax due because the basis has been stepped up and it is a wash sale. The cash value sits in the PAT until the owner decides to draw the lifetime income payment stream. As income is received, it is taxed in a fashion similar to an installment sale would, partly a return of basis and partly capital gains. Assets held in a PAT can be invested in a virtually limitless fashion, but with prudent investing, it is possible for the PAT to out-grow its distribution payments and create a legacy to the seller’s beneficiaries.
Since a PAT is a non-grantor irrevocable trust, the assets in the trust are held outside of the seller’s estate which is of considerable benefit for estate or death tax concerns, for protection from judgments or liens, for Medicaid planning and more. Loans can be made against the assets in the PAT which make it a fantastic tool to continue real estate investing in a tax advantaged fashion with many of the same liability benefits as real estate investing through a LLC but with ongoing tax advantages. When the Owner of a PAT dies, then assets are passed directly to their beneficiaries, not only at a stepped up basis but also completely avoiding probate. The more acreage you own, or the greater the size of your estate then the greater the benefit of this tax advantaged strategy.
When should one consider a PAT? The answer is if you plan on selling a property and your capital gains bill will be greater than $30,000 or so then it makes sense to investigate further. Alternatively, if your estate is worth more than four million dollars and you would like to plan on avoiding as much estate taxes or court costs as possible, then this strategy would also be of interest. The costs to establish a Private Annuity Trust generally start in the range of a few thousand dollars and depend on the amount of capital gains tax being deferred and the complexity of the trust. PATs, once established, can be used many times. Each time a new asset is transferred into the trust, there is only a small amendment fee to add a new private annuity contract inside the trust. It is one of the most flexible strategies available.
People who own ranches or larger land parcels that they wish to pass on to their heirs can benefit from the use of the Private Annuity Trust in a number of ways. One example involves an elderly couple who own a 180-acre ranch in California. With the skyrocketing values of property in California, the couple was forced to consider ways that they could preserve their ranch for their children at their death, and still be able to pay the costly California estate tax that would occur when they both passed. Such estate taxes often force the sale of property upon the demise of the owners. Both husband and wife were over the age of 70 and that caused life insurance to be more expensive than they could afford. This couple used a Private Annuity Trust to help keep the majority of their ranch for their children. The couple sold 40 acres of their 180 acre ranch to a Private Annuity Trust, which created the following benefits: it provided a lump sum of money so that there would be funds sufficient for their children to pay projected estate taxes. Additionally, it provided the couple with an income stream from the PAT. This is just one example of how this real estate exit strategy could be of benefit.

Christian Ramsey, Advanced Wealth Management
Advanced Wealth Management

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