A 1031 Alternative: Defer Capital Gains Without Rolling Into Another Property

Those of us who own highly appreciated assets like homes, commercial real estate, stock portfolios, or businesses, are often reluctant to sell that asset because of the capital gains tax and depreciation recapture costs associated with the sale. How many times have you heard client’s complain about their inability to get out from an asset because of high taxes? We hear it all the time. As a result, clients will often do nothing as opposed to take a large tax hit (15% plus 4-9% state rates for capital gains and 25% depreciation recapture rates), or they might look for another property where they can do a 1031 exchange, also known as a like kind exchange. A 1031 exchange allows us to defer capital gains and depreciation recapture by rolling the proceeds of our original property sale into another property that must be identified with 45 days of the closing on the original (sale) property, and closed upon with 180 days of the closing on the original (sale) property.

The problem for many is that they want to sell, but don’t want to roll into another property. This can be for a variety of reasons. The inability to find a compelling purchase (top of the market, poor CAPX rates), or simply wanting to get out of that particular market. Fortunately, there is a smart and legal way to address these significant tax liability issues, without having to roll into another property. The vehicle that allows one to accomplish the deferral of capital gains tax and depreciation recapture tax is a Private Annuity Trust. Of course, the value proposition of deferring taxes is the ability to earn money on tax dollars that would have been paid to the government, but are now deferred. The private annuity trust is part of the Internal Revenue Code, IRC Section 72, and has been used as an estate planning vehicle since the 1950’s. Furthermore, US Appeals Court decisions as well as IRS revenue rulings and opinion letters ensure sound legal footing for this unique planning vehicle.

The process starts with a property owner, (referred to further as the annuitant), transferring ownership of the property to a dedicated family trust (The Private Annuity Trust). The owners of the trust are the heirs of the annuitant, probably his children. Next, the trust “pays” the annuitant for the property. The payment isn’t in cash, but with a special payment contract called a “private annuity”. It is strictly a private arrangement between the trust and the annuitant that acts something like an installment sale. Instead of specifying an exact number of payments as in an installment sale, the private annuity promises to make payments to the annuitant for the rest of his/their life. The form of payment is a lifetime income stream (annuity), which can be based on joint lives. The annuitant(s) is not taxed on the sale since he/they have not yet received any cash for the sale, only a contractual right to receive income for life. Annuitant(s) can also choose to defer their income from the trust because they have other income and don’t need the payments right away. Of course, annuity payments may begin immediately. There is no interest or penalty owed on these deferred payments of the tax.

Once the annuitant(s) begin receiving their payments, they owe a portion of the taxes they would have paid upfront. This effectively acts as paying the taxes in an easy installment plan. The amount of the payment and hence the tax owed is based upon the actuarial life of the annuitant(s). The seller / annuitant will earn much more money than he would if he / she sold the property and paid the tax up-front. This is due to the deferral and the spreading of the tax payments over the seller’s life. Each payment is comprised of three components: Return of Basis (no tax), Capital Gains/Depreciation Recapture, and Ordinary Income (interest earned on the proceeds). Let us now examine some numbers and compare the annuity transaction to a straight taxed sale.

We start with the $1,000,000 property value. The annuitant’s basis is $200,000, leaving a profit of $800,000. We are estimating combined federal and state capital gains taxes at $160,000, which is 20% of the profit. This leaves net cash of $840,000 in the direct sale vs. $1,000,000 in the annuity deferral sale. We are assuming the investment cash earns a conservative 6% before income taxes for the next 20 years. The property owner is 45 and chooses to start the annuity payments at age 65. Under the direct and taxed sale, the property owner receives annual payments of $277,300 vs. $330,119 under the annuity plan. This yields an estimated life payout of $5,546,000 under the taxed plan vs. $6,602,380 with the annuity strategy. That is an advantage of $1,056,380 more dollars too the annuitant! This advantage is due to the larger amount of net cash that was initially available to invest for the annuitant. Although this example had a deferral, the tax savings are just as dramatic with immediate receipt of income from the trust.

The advantage of using a Private Annuity Trust over an installment sale (no deferral of depreciation recapture, related party limitations, creditworthiness, closely held business exclusions) and the charitable remainder trust (money not left to beneficiaries, interest only payments) are too numerous to examine in this article. Suffice to say, it is a far superior planning tool than these other vehicles. Some additional, and significant benefits of using the private annuity trust include the assets in the trust passing outside your estate, so your beneficiaries receive the assets Estate Tax Free! (both Federal and State) These assets also avoid lengthy and costly probate. Many of the illustrations I run in my own practice result in excess of 4 times the money passing to the beneficiaries as compared with the straight tax sale with the sale proceeds remaining in the estate of the seller. While it is true that between now and 2010 estate taxes are being fazed out, the law sunsets in 2011 and will revert back to the 1 million dollar exclusion of the gross estate. According to the Wall Street Journal and my own arguments, the likelihood of estate taxes going away permanently are slim.

Additionally, the assets are protected from lawsuits and creditors of the annuitant(s) and the beneficiaries. Furthermore, the annuitant does not have to put the entire proceeds into the trust, they can put in just a portion, paying a pro rata share of the taxes. The annuitant also has the option of borrowing from the trust, thereby allowing them to use the assets to continue to participate in the real estate market if they are so inclined. Distributions to beneficiaries may also be structured in such a way that the entire lump sum is not given all at once, but rather dispensed over time. As you can see, the Private Annuity Trust is a flexible and powerful planning tool that allows you to earn money on deferred taxes and offers a number of outstanding estate planning features. If you would like to find out more or have an illustration done for one of your clients, please don’t hesitate to contact Brian P. McCarren.

Brian P. McCarren is a professional money manager for Janney Montgomery Scott LLC. He is a designated Certified Financial Planner and Attorney whose practice focuses on wealth creation and preservation through the use of innovative investments and estate planning vehicles. Mr. McCarren utilizes a comprehensive set of tools and strategies to put together a complete financial plan. An avid reader and student of the world economy, Mr. McCarren uses a wide array of resources to find the best investments and instruments to maximize risk adjusted returns in the most tax efficient manner. Mr. McCarren works closely with and utilizes attorneys and accountants to ensure that plans and planning strategies are implemented in the most efficient manner. Mr. McCarren and his partner manage over $200 million in assets.