Family Wealth Planning: Real Estate and the Private Annuity

By Stephanie Hunt

A combination of circumstances is causing an increasing interest in the private real estate annuity as a way to reduce or defer taxes on gains. On the one hand, many investors have seen the value of their real estate holdings rise substantially over the past few years, which means that a sale will result in a substantial capital gains tax even at the current 15 percent rate. On the other hand, the unwillingness of Congress to terminate estate taxes means that passing the property by inheritance could mean a significant sum will be paid upon the death of the present owner. (Currently, the exemption is $2 million after which the tax rate rises sharply to as high as 46 percent.) Finally, the IRS has been showing an increasing interest in private annuities, believing that in many cases the tax rules are not properly followed.

Annuity Benefits

Owners of real estate portfolios should consider the benefits of a private annuity with their children (or other younger family members). An annuity, while keeping property within the family, can enable the older family member to continue receiving income and at the same time exclude the real property from his estate. Put another way, an annuity permits the family to retain today's real estate values for tax purposes rather than date-of-death value, which could be much higher.

What Is an Annuity?

An annuity is a transfer of property from one party (the annuitant) to another party (the obligor) in exchange for the obligor's promise to pay a specified amount of money annually (hence the term "annuity"). A private annuity is one between the annuitant and someone not in the business of selling annuities. The period of time over which payments must be made can be the lifetime of the annuitant; the lifetime of the survivor of the annuitant and spouse; or for a term of years at least equal to the annuitant's life expectancy.

Example: A father owns an apartment house with a fair market value of $500,000. He wishes to remove the property from his taxable estate while at the same time avoiding a large capital gains tax that would be due on a straight sale. So he transfers the property to his daughter in exchange for her promise to pay her father a fixed sum each year for the rest of his life.

How Much is the Annuity?

Assume the property has an existing mortgage of $250,000, so that the current equity is $250,000. It is this sum that determines how much the daughter must pay over to her father (in the form of an annuity) over the balance of his life. The amount of each annual payment depends on the life expectancy of the annuitant and the applicable federal rate (AFR) that changes periodically and is based on current interest rates.

The IRS has tables from which the annual payment can be determined. If the father is 65, the June 2006 annuity factor is 9.7151. (See Treas. Reg. S 20.2031-7). Under this formula, the daughter must agree to pay her father $25,733 each year for the rest of his life (even if he outlives his life expectancy). The sum is a result of dividing the equity of $250,000 by 9.7151.

Advantage of Private Annuities

In the example just given, the following benefits are achieved by the parties:

• Estate exclusion. The property transferred by the annuitant is excluded from his estate since he no longer owns it and (in the language of the tax law) has received adequate and full consideration in money or money's worth. His daughter benefits from any future appreciation.
• No gift tax. No gift tax is payable by the annuitant because the transfer is structured as a sale. Nor is his unified credit against tax reduced, provided the property is accurately valued. (Any under-valuation can give rise to a gift tax or reduction of the unified credit.)
• Deferral of gains tax. If the property has appreciated in value, the annuitant need not pay capital gains tax at the time of the transfer. Instead, part of each future annuity payment will be treated as capital gain; part as a return of principal to the annuitant; and the rest as ordinary income until the annuitant has recovered his tax basis in the property. All subsequent payments will be ordinary income.
• Non-taxable gain. In the event the annuitant dies before the annuity payments equal the full value of the property, any remaining untaxed gain will escape tax.
• No initial cash. The obligor, usually a younger family member, need not pay any cash at the time the transfer is made.

A private annuity will not make sense if the annuitant's taxable estate will not exceed $2 million (the current exemption amount equivalent to the unified credit). In the case of a husband and wife, their combined non-taxable estate can reach $4 million, provided each one will have an estate at least equal to $2 million.

Will the Obligor Perform?

A disadvantage of a private annuity is that the obligor's promise to pay the annuity cannot be secured by a mortgage on the property or be funded by a specific charge against any source of cash such as the rent income from the property. So if parent and child have a falling out or the child is unable to make the payments for any reason, the parent has no recourse except a lawsuit, which may be fruitless if the child has no assets. Another risk of a private annuity is that the parent will survive the child. The child's estate then must continue to make the annuity payments out of the estate assets.

One way to reduce the risk of future unpaid amounts is a refinancing of the property by the parent before the transfer to the child. The refinancing proceeds will be tax-free to the parent if the new loan does not exceed the parent's basis in the property. After the refinancing, the amount of the annuity will be reduced because the transferred equity will be lower in amount.

Another way to reduce the risk of nonpayment if the child predeceases the parent is to have another family member take out (and be the beneficiary of) a life insurance policy on the child's life, with the understanding that any insurance proceeds will be used to make annuity payments to the father. However, the obligation of the other family member to so use the insurance cannot be legally binding, just as the annuity itself cannot be backed by security. Stephanie Hunt is a Tax Manager in BDO Seidman's New York office. She can be reached at (212) 885-7401.

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Alvin L. Arnold at (212) 885-8235.