THE PRIVATE ANNUITY TRUST
A Way Out

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Those of us who own highly appreciated
assets like homes, commercial real estate,
stock portfolios, or businesses are often
reluctant to sell because of the capital gains
and depreciation recapture costs associated
with the sale.

How many times have you heard this?

?I have a commercial property I would love to sell, but capital gains taxes would kill me.?

?I?d like to move out of the landlord
business, but with the capital gains tax hit, what other choice do I have??

?Sure it would be nice to sell when I can
lock in my appreciation, but after the
government takes their share and makes me repay depreciation, is it really worth it??

Sound familiar?

Fortunately there is a way out?a smart and
financially sound way to address these
issues. For many of these tax scenarios, the
answer may lie in the Private Annuity Trust
(PAT).

The PAT is an IRS-accepted program
(Section 72 of the IRC) that allows a seller
to defer capital gains tax at the time of the
sale. There is no maximum on the size of the

transaction. The PAT can be used on any
kind of sale that generates a capital gains
liability including the sale of a primary
residence, rental properties, vacation homes,
commercial properties, hotels, retail
developments, strip malls and even raw land
to name a few.

A Closer Look at Capital Gains Taxes

As you well know, capital gains taxes can
run from 15 to 25 percent (depending on the
state). Then, if there is depreciation recapture on the sale, the federal rate of 25% can make this expense even higher than the capital gains tax.

Even on a primary residence, with the growth of equity accumulated over the years
there may be a hefty tax surprise when the
property is sold (even after considering the
$250,000 exemption per individual).

This still isn?t the end of the story.

The capital gains amount must also be added
to the sellers adjusted gross income (AGI).
This means that capital gains or profits may
raise the ?floor? above which one can take a
number of itemized deductions, resulting in
a large decrease or total loss of these
deductions.

This combined impact often makes the
effective, but hidden capital gains rate much
larger than federal and state income tax
rates.

Then to make matters worse the capital
gains and depreciation recapture taxes must
be paid within ninety days of the sale of the
asset.
A Private Annuity Trust Scenario

Now you can see why the Private Annuity
Trust becomes such a valuable strategy for
sellers faced with this dilemma.

In the following example, the process starts
when a property owner (annuitant) transfers
ownership of their property into a PAT (a
dedicated family trust).

In our example the asset is worth
$1,000,000. The annuitant has selected one
of their heirs to be trustee. (In all PAT
contracts, the transfer isn?t a gift, but a
special type of sale.)

Next, the trust ?pays? the annuitant for the
property. The payment isn?t in cash, but
with a special payment contract between the
trust and the annuitant called a ?private life
annuity.?

A private annuity is similar to an installment
sale. However, 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 life. Since the property in
our example is worth $1,000,000, the face
value of the annuity contract is also
$1,000,000.
The annuity payments may begin
immediately or may be deferred for months
or even years. Deferral is strictly an option.

It is important to understand that payment of
the capital gains tax is handled like an ?easy
installment plan.? You only pay capital
gains on the taxable amount of the
incremental income you receive each year
from the trust. There is no interest or penalty
on these deferred payments of tax. This is
like receiving a tax-free loan from the IRS.

On top of that the tax payments will be
made with depreciated dollars due to
inflation, while the investment money in the
trust will grow at a rate greater than
inflation.

Now, let us examine some numbers and
compare the PAT transaction to a normal
taxed sale.

In our example, the property is valued at
$1,000,000. The annuitant?s basis is
$200,000, leaving a profit of $800,000. We
are estimating a combined federal and state
capital gains tax rate of 20% that yields
$160,000 of taxes. This leaves a net cash
amount of $840,000 in the normal sale
compared to $1,000,000 in the annuity
deferral sale.

We are assuming the money invested in both
cases earns a conservative 6% before
income taxes for the next 20 years (the
property owner is 45 and chooses to start
receiving payments at 65). Under the normal
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 a $1,056,380 advantage to the
annuitant due to the larger amount of net
cash that was initially invested.

Recap:

Depreciation Recapture

We have primarily focused on capital gains
tax. However, depreciation recapture taxes
are also deferred with a PAT.

How does a PAT help with an installment
sale? While an installment sale can spread
the capital gains out over a number of years,
it cannot do the same with depreciation
recapture. In either a cash or an installment
sale, the depreciation recapture is taxed
immediately.

Furthermore, installment sales have ?related
party? rules that prevent an arrangement
such as the PAT described above. The
related party rule will only permit an
installment sale with an outsider while the
PAT allows an arrangement with a family
member.

Investments
There is substantial flexibility in making
investments with the trust?s funds. The
money may be invested in securities, real
estate, or even in a new or existing business.
The primary requirement of the trust?s
investment program is simply to produce the
necessary cash flow to be able to make the
annuity payments.

Additional Benefits

1. The Private Annuity Trust also offers the following significant benefits:

2. Whatever is left in the trust at the time of the annuitant?s death will pass to the beneficiaries completely free of estate and gift taxes.

3. This arrangement does not trigger any
   gift tax consequences no matter how
   much the property is worth.

4. The property will not need to go through probate when the annuitant dies.

5. The formal mechanics of the trust
   provide the discipline that some find
   helpful in providing for their own
   retirement.

6. The private annuity works equally well for single or married annuitants. Married couples can have the private annuity written as a joint, last to die contract.

PAT vs. Charitable Remainder Trust

In the PAT nothing needs to be given away to charity as is required with a competing strategy known as the Charitable Remainder
Trust.

The PAT allows all principal and accrued
interest to be paid to the annuitant, whereas
the Charitable Remainder Trust pays the
grantor income (interest) only. In most cases
the PAT yields more bottom line dollars
than the Charitable Remainder Trust.

As illustrated above, the Private Annuity
Trust has the ability to generate substantially
more money over the long run than a direct
and taxed sale. It is also superior to the
Charitable Remainder Trust and installment
sales in many respects.

Frequently Asked Questions

Q. How can I know the amount of my
payments?

A. Three factors are involved: 1)
Annuitant(s) age, 2) Selling price of the
property minus any fees, commissions or
mortgages that must be paid off, 3) The
length of deferral, if any, until payments
begin. The actual amount can be provided
to you through a free tax-savings
illustration.

Q. What happens if I live longer or less than
life expectancy?

A. Payments go on until you (or the
surviving spouse) die, no matter whether
that is sooner or later than life expectancy.
Life expectancy is just the number used to
calculate the size of the payments. After
your death (or the surviving spouse?s) the
annuity payments stop and the remainder of
the trust is transferred to the beneficiaries.

Q. Is this plan flexible?can annuity
payments vary over time?

A. The trust may issue more than one
annuity contract to the annuitant at the
outset. One would be immediate and the
other (or multiples) would be deferred.

Q. Can I cancel the PAT contract after a few
years and get my money out?

A. If the trustee agrees, you may terminate
the trust and get the cash out. However, you
would owe all the taxes, plus penalty and
interest, on the full amount of cash you
received.

Q. What happens if capital gains tax rates
are lowered after I set up the PAT?

A. Politicians frequently advocate lowering
capital gains rates, so this could happen. In
that case, you would get the benefit of the
lowered rate on the capital gains portion of
your annuity payments.

Q. Can the trust buy property at a later date?

A. Yes, the investments of the trust are
extremely flexible. The annuitant can even
borrow from the trust. However, the trust
must be able to make the annuity payments
scheduled in the contract.

Q. What happens if the trust goes broke
before I die?

A. With bad luck or poor investment this
could happen. In that case there would be no further tax liability. You obviously cannot
be taxed on money you do not have.

Q. When the property sells, may I keep
some of the cash from the sale?

A. Yes, in that case you would pay taxes
only on the portion of money you kept.

Q. I would like my tax advisor and attorney
to analyze the PAT plan. Can you help?

A. We will gladly provide your tax advisor
or attorney with the technical and legal
information he/she needs to evaluate the
plan. They can also review: IRS Revenue
Rulings 55-119 and 69-74; IRS?s
GCM39503 of 5/19/86; Treasury Decision
TD-8754 issued in 1998; and the Ninth
Circuit U.S. Court of Appeals decision
?LaFargue v. Commissioner, 689 F. 2d 845
(1982).?