Tax issues

A PAT Answer

Private annuity trusts offer another approach to tax deferral.

Editor's note: The November/December 2006 issue of Commercial Investment Real Estate contains the article "A PAT Answer," which discusses private annuity trusts as a tax-deferral strategy. After the magazine was printed, the U.S. Treasury Department issued proposed regulation 141901-05 that reverses theInternal Revenue Serviceposition on private annuities. The proposed regulation would require capital gain taxes resulting from the sale of an appreciated asset to be recognized in the current tax year, rather than deferring them over the life of the annuitant. This effectively eliminates the benefit of capital gains deferral in aprivateannuitytrust. Anyprivateannuitytrust that has not been established and funded by October 18, 2006, will not be able to defer their capital gains upon the sale of the appreciatedtrust asset. Existingprivateannuitytrusts that have been in place prior to October 18, 2006, will not be subject to this proposed regulation.

C apital gains taxes are an issue that all investors face. Upon the sale of highly appreciated commercial real estate assets, investors must decide whether to pay the capital gains taxes that are due or use one of the various available methods to defer the taxes.

Many commercial real estate experts believe that property prices are at an all-time high. To take advantage of the current market conditions, some investors want to forgo tax-deferral strategies and simply cash out while prices are optimal. Other investors want the ability and flexibility to hold off buying additional property via 1031 exchanges until the market reaches equilibrium. Still others want to sell portions of their real estate at today's prices to reduce exposure or diversify their investments. While many investors may think 1031 exchanges are their only option for deferring tax gains, there are other alternatives in the market. Specifically, creating a private annuity trust may be precisely the right tax-deferral structure to utilize.

PATs, which can be both alternatives and complements to 1031 exchanges, allow sellers to defer capital gains taxes at the time of sale. They can be used with any kind of highly appreciated asset such as land, apartment buildings, industrial or storage facilities, hotels, existing businesses, and stocks. PATs also provide a solution to defer the gains on a primary or secondary residence - two assets where 1031 exchanges fall short. Understanding this simple tax-deferral strategy and being able to communicate it effectively to new prospects and existing clients is the first step to creating a valuable source of new commercial real estate business.

What Are PATs?

PATs are a simple strategy with sophisticated applications - a tax-savings technique that can defer capital gains taxes for years and minimize estate taxes.

Included under Internal Revenue Code Section 72, PATs allow property owners to sell appreciated assets to irrevocable trusts in exchange for a stream of payments over their lifetime. The trust then sells the asset to the intended buyer. Since the asset is transferred to the PAT at fair market value, the trust does not recognize a gain at the time of sale. Instead, gain is recognized as the property owner, or grantor, receives payments over its lifetime, and capital gains and recapture taxes are paid as the income is received. Capital gains tax burdens are not eliminated; rather they are deferred long term - often for decades - with no penalty or interest. PATs also transfer an asset out of the grantor's taxable estate, eliminating any estate tax that may exist upon the grantor's death. In addition, since PAT transactions are a sale from the seller to the trust, no gift taxes are incurred from utilizing this strategy.

The asset should be placed into the trust prior to escrow opening to take advantage of the capital gains tax deferral. The trust must have as its trustee a party other than the property owner - an adult child or relative is the usual choice. Its beneficiaries typically are the children or grandchildren of the property seller. In some cases, a non-related third party such as a trusted family friend or adviser may be needed for trustee or co-trustee services.

The trust buys the asset by paying the grantor (seller) with an annuity contract. The annuity contract is a private arrangement issued by the trust itself and is not to be confused with a commercial annuity from an insurance company. The annuity contract is a promise to make payments to the grantor for the balance of the grantor's life. The payments may be made to either a single person or in a joint last-to-die arrangement with a married couple. Often the first payment on the annuity is deferred, possibly for many years, such as when the grantor has reached retirement age. But the grantor has the choice of starting the annuity payments at any time, even immediately.

When the grantor begins to receive annuity payments, some of each payment is subject to a fraction of the original capital gains taxable amount. The taxable amount is spread out in equal payments over the balance of the grantor's actuary life expectancy. For example, if the grantor has a life expectancy of 20 remaining years at the point the annuity payments begin, the grantor will pay 1/20th of the capital gains and recapture tax each year. Neither penalty nor interest must be paid on any deferred taxes.

Utilizing a PAT allows the trust to use the entire cash proceeds, including the unpaid taxes, to invest in any worthwhile investment. The unpaid and deferred taxes remain in the trust to work alongside the rest of the sale proceeds to produce a much larger amount of income. Under this strategy there are many options in the types of investments the trust can make.

The trust is extremely flexible and versatile for most investors. For example, a PAT can be used to exchange down into a smaller 1031 property or it can be used in cases where one partner wants to cash out and other partners want to do an exchange. PATs also can be used to sell multiple properties whereby each sale would generate its own separate private annuity contract within the original trust.

A Simple Example

Suppose a couple sold an investment property in California for $10 million with an original basis of $4 million, for a total profit of $6 million. Under conventional terms, they would have to pay a total of $1,458,000 in both California state taxes (at a 9.3 percent rate) and federal taxes (at a 15 percent rate) on the sale and invest the remaining balance of $8,542,000. From those funds, they could withdraw money as necessary for retirement needs, leaving the balance to their heirs.

With a PAT, the entire $10 million in sale proceeds can be invested through the trust, and the couple can receive their annual annuity payment, on which they pay only a portion of their original tax sum. Additionally, at the time of the last spouse's death, the remaining monies in the trust pass to the beneficiaries free of estate and gift taxes. The net effect is that the annuity structure, under most conditions, results in a higher dollar amount left over for the heirs while still providing an income stream for the life of the grantors.

Downsizing 1031 Replacement Property

When sellers want a lower-priced replacement property for income, business, or even personal purposes, a 1031 exchange and a private annuity trust can be combined to defer all of the capital gains taxes.

The process requires the seller to divide the property into two ownership interests via a common and simple title process and then transfer the desired percentage of the property to the PAT prior to escrow opening. The seller's remaining interest and the PAT's interest are then sold to a third-party buyer. The interest still belonging to the taxpayer is sold or transferred as part of a regular 1031 exchange. At settlement, the proceeds through escrow are split, with part going to the PAT tax deferred and the balance to the 1031 exchange accommodator.

If some cash is desired at time of sale, the seller could divide the property into three parts and cash out one part, while implementing the PAT and 1031 exchange with the other two parts, or any combination thereof. The seller would be responsible for any taxes owed on the cash received, but taxes would be deferred on the portions sold via the PAT and the 1031 exchange.

When 1031 Exchanges Fail

In the current market, many sellers of highly appreciated real estate have entered into 1031 exchanges only to have the 45-day identification deadline expire before finding a suitable replacement property. When up against the clock, investors may be forced to pay the capital gains taxes or identify and purchase an undesirable property they never otherwise would have considered.

In these cases, the PAT can be used as a 1031 exchange safety net to defer taxes should the exchange fail. For example, prior to escrow opening, the investor establishes a PAT. The property sells and 100 percent of the cash proceeds from the sale go to escrow and pass to the 1031 exchange accommodator as usual. The exchange accommodator then proceeds to identify and exchange the property within 180 days. If the exchange is completed successfully, the PAT has a mechanism to simply uncouple the property from the trust. The original trust then can be used later for another property the owner wishes to sell.

If the 45-day exchange deadline expires without the investor identifying a replacement property or the 180-day deadline expires without closing on the replacement property, the proceeds fall back into the PAT and no capital gains taxes are due at that time. Once established, the same PAT may be used repeatedly for every future 1031 exchange.

A seller cannot wait until time is out on the 1031 exchange and then decide to implement a PAT to avoid capital gains. The PAT should be set up prior to the opening of escrow.

Commercial real estate professionals should be aware that PATs are not a one-size-fits-all approach. A PAT is an irrevocable, non-grantor trust, and there are some potential risks and disadvantages for investors. Specifically, the proceeds from the property sale are in the trust and no longer are in a grantor's personal estate; the proceeds are not immediately accessible by the grantor. The grantor often is limited to the receipt of its lifetime private annuity income stream. There is no guarantee that investment performance in the trust will be adequate to assure that the PAT payments will last for the investor's life expectancy. The trust also is managed and administered by the trustee and not the grantor. Additionally, there is some potential for legislative risk with a change in the capital gains tax rate or through future tax law. Consulting with both legal and accounting professionals is strongly recommended before investors move forward with this type of trust.

Michael E. McCready, John Cole, and Michael Gorak

Michael E. McCready, John Cole, and Michael Gorak are advisers with McCready & Associates, a financial and estate planning firm in Beverly Hills, Calif. Contact them at (866) 752-6444 or


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