IRS Kills PAT Planning
In October 2006, the IRS issued proposed regulations that will prevent a popular tax planning opportunity dealing with the sale of real property called a private annuity trust (“PAT”).The proposed regulations will generally be effective for exchanges of property for an annuity contract after October 18, 2006. The regulations would not apply to amounts received after October 18, 2006 under annuity contracts that were received in exchange for property before that date. For a limited class of transactions, the effective date will be for exchanges of property for an annuity contract after April 18, 2007.
What Is a PAT. Typically, your real estate broker or financial advisor told you that there is a new way to sell your real property and still be able to have income tax deferral in an all cash transaction (not an installment sale) while also avoiding the depreciation recapture at a 25% tax rate. He or she referred to this type of planning as a PAT.
In a private annuity transaction, the seller transfers property to a buyer similar to an installment sale. Rather than receiving a fixed purchase price under a sale, the seller receives in exchange for the property the buyer's legally binding promise to provide a stream of annual payments of a stated dollar amount to be paid lifetime until his or her death. For estate planning purposes, the hope is that the transferor will die before his or her life expectancy has been reached. If this occurs, the balance of the annuity payments do not have to be paid and the property is not included in his or her estate!
What the New Regulations Do. The proposed regulations provide a single set of rules that leave the transferor and transferee in the same position before tax as if the transferor had sold the property for cash and used the proceeds to purchase an annuity contract.
The effect of these proposed regs (which do not distinguish between private annuities and annuities issued by commercial insurance companies) is to treat the seller-annuitant as having realized an amount equal to the fair market value of the contract determined under Code Section 7520 (this provides the actuarial tables which must be used to compute the present value of an annuity).
So if a private annuity promise or a commercial annuity contract is received by the seller in exchange for property (other than cash), the entire amount of the seller's gain or loss (if any) must be recognized at the time of the exchange!
No matter what method of account your client uses, he or she will no longer be allowed to defer recognition of gain! The same rules apply whether the exchange produces a gain or loss. The proposed regulations apply to exchanges of property for an annuity contract, regardless of whether the property is exchanged for a newly issued annuity contract or whether the property is exchanged for an already existing annuity contract.
Tax Planning Options. There are still two possible options when you want to sell your property, but still want to receive some tax benefits. One option that is the most often used is a charitable remainder unitrust (“CRUT”). Another option is called a self canceling installment note (“SCIN”). I will not discuss a SCIN in this article because they are very seldom used.
What is a CRUT? A CRUT is similar to a private annuity because the payments are based upon the IRS valuation tables described above. One main difference from an annuity is that upon the death of the transferor the remaining principal is not distributed to the family but rather to a charitable organization. It is because of this distribution to the charity that the transferor can receive an income tax deduction on the transfer, rather than having to pay any income taxes on the transfer.
I have also had experience dealing with CRUTs. In one situation, my client was selling his business and had to pay substantial income taxes because of capital gains and ordinary income related to his covenant not to compete with the buyer. A portion of his stock was transferred to a charity in exchange for the unitrust payment for his life plus receiving an income tax deduction to offset his income taxes.
What was sad in this case was that the buyer of his business could not make the payments on the note portion of the transaction. The buyer had to secure the assets of the business with a bank loan as part of the transaction and ultimately the bank foreclosed on the assets of the business. The only long-term benefit that my client received from this transaction was the continuing unitrust payments from the charity.
From this experience I learned that diversity in receiving an income stream helps reduce your risk in a sale transaction of any nature. Although initially the unitrust payment maybe not as large compared to other payments, if the CRUT was properly invested you at least can receive all of it over your lifetime.
Last month, I established a FLIP-CRUT for one of my client who was selling his 50% interest in the apartment building he owned with his other 50% partner. He wanted to have an income stream for both himself and his wife for their lifetime. He knew he had to transfer the property to the charity, before the sale of the property. He also wanted to sell the property himself, in order to save the selling expenses, which the trustee would have charged if it did the sale rather than him. Lastly, just in case the property didn’t sell as quickly has he thought he wanted the income from the property until he was able to finally sell it. The FLIP-CRUT was what we used to accomplish his goals. He was the initial trustee and under the document was to receive the net income until the property had sold and at that time had to resign as trustee.
After the sale, he and his wife in the next calendar year would start receiving the annual unitrust payments for the balance of their life (flip portion of CRUT). The trustee would invest the principal received from the sale at 8% and my client would receive a 7% unitrust payment on the principal. The annual unitrust payment to my client and his wife was projected to increase year each thereafter. In the example below, both Mary and John receives a 6% payout based upon an annual growth of principal of 7%.
Conclusion. Although the PAT is presently not a viable tax planning option for the sale of property, this does not mean that there are not other options available. Planning before a sale occurs generally leads to a better result than without it.