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How to Shield Large Capital Gains

Last update on: Nov 06 2017

Successful investors and business owners always face a tax planning dilemma.

If they sell their highly appreciated assets, they owe capital gains taxes. Even at today’s low top federal rate of 15%, the tax can amount to a sizeable chunk of money. People do not like their net worth to decline by that amount with one transaction.

The capital gains tax can be avoided by holding the assets until they are inherited. Under current law, heirs can increase the tax basis to its current fair market value. They can sell immediately and avoid any capital gains taxes.

Unfortunately, the assets also will be included in the owner’s estate. If the estate is large enough, federal estate taxes can total up to 45% of the assets’ value. There also might be state death taxes. Even if estate taxes are not an issue, holding the assets is not desirable if the owner wants cash, a more diversified portfolio, or believes now is the optimum time to sell.

Tax planners offer a strategy to resolve this dilemma, the private annuity trust. While the trust can be useful, it is being oversold by some planners in search of quick fees, and some versions now are on the IRS’s radar screen as suspicious tax strategies.

The private annuity trust has been a mainstay of tax and estate planning for highly appreciated assets for many years. When structured within established bounds it can be valuable for the right taxpayers.

In a private annuity trust, the owner of appreciated property first creates an irrevocable trust. Usually, the owner (or the owner and spouse) is the beneficiary of the trust for life, and the owner’s children or other loved ones are contingent beneficiaries.

The owner then “sells” the appreciated property to the trust in exchange for an annuity for life. The IRS issues tables that are used to set the annuity rate. Factors that determine the annual annuity payment include current interest rates, age of the seller, and the value of the property. The annuity payments can begin immediately or in the future. The later the payments begin, the higher the annual payment. There is no tax due when the asset is transferred to the trust, since all the owner has received is a right to future annuity payments.

The trustee then sells the property and invests the proceeds in a diversified portfolio that should be able to meet the annuity payments. The trust usually owes no taxes on the sale of the asset.

As annuity payments are received, they are split in three parts for tax purposes. Part of the payment is a return of the basis in the original property; that part is tax free. Part of the payment is capital gains on the sale of the property and is taxed at the capital gains rate. The third part is ordinary income. IRS regulations explain how to apportion each payment. If the owner exceeds life expectancy, the full sale price of the property will be recovered in annuity payments. All of each subsequent payment will be fully taxed as ordinary income.

After the owner dies, the remaining amount in the trust is paid to his children or other beneficiaries under whatever terms were set in the trust agreement. (The trust is not essential to the plan. An owner can sell the asset directly to his children in exchange for a private annuity. But many owners prefer the additional safety of using a trust.)

The private annuity trust takes the asset out of the owner’s estate, allows deferral of taxes over the rest of the owner’s life, and can provide assets for the heirs. Proper selection of the trustee also ensures that the sale proceeds are well-invested.

But the private annuity trust is not for every property owner.

An irrevocable trust is required to get the tax and estate planning benefits. The owner cannot get the property back, borrow against it, or receive additional payments beyond the annual annuity no matter how much the cash is needed. In addition, the owner cannot exercise control directly or indirectly over the trust. Independent control of the trust is required to receive the tax benefits. Also, the trust only defers taxes.

It does not eliminate them. Another disadvantage is that using the annuity can convert future capital gains into higher-taxed ordinary income. That occurs because the proceeds from a sale of the asset could have been invested to earn long-term capital gains. But under the trust strategy, when cash is received as an annuity payment it is taxed as ordinary income. Using the trust also imposes another layer of taxes, because the trust has to pay income taxes on investment income it earns but does not distribute.

Of course there are fees. Because of the high cost of creating the trust, you probably need capital gains of at least $200,000 to justify the cost. There also will be annual fees for the trustee. The trust money must be invested and accounted for, and the trust must file its own tax returns in addition to submitting information returns to beneficiaries. These might be included in the trustee’s fee or might be billed separately.

The IRS also is questioning some of the private annuity trust strategies.

A few promoters are setting up trusts that allow the property owner essentially to retain control over the property and the sale proceeds after the trust is created. In those cases, the IRS will challenge all the tax benefits and say that the original owner essentially sold the property to a third party himself and still controls the proceeds. The trust simply will be ignored and the transactions all taxed as though the owner retained the property and sale proceeds.

The IRS also is raising questions about cases in which the owner effectively negotiates the sale of the property first, and then transfers the property to the trust. If there is a contract before the property is transferred to the trust, the IRS is likely to say the owner has to pay capital gains taxes on the sale. It isn’t clear at what point the IRS will ignore the trust if there were negotiations but not a written contract or binding agreement. But the closer the owner gets to nailing down a deal before turning things over to a trustee, the more likely the IRS is to challenge it.

A private annuity most often is used by owners of appreciated real estate, especially since the recent boom. But the strategy can be used to shelter gains in almost any assets: art, collectibles, small businesses, and securities.

Before entering a private annuity trust, be sure you know the disadvantages such as loss of control, irrevocability, and the long-term taxes. Also consider alternative strategies. These strategies include charitable remainder trusts, installment sales, and tax deferred exchanges of investment real estate or business property. Don’t forget the boring option of selling the property, paying today’s low capital gains taxes, and having full control of the after-tax proceeds.



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