Selling Homes High While Keeping Taxes At A Distance
Pacific Beach Real Estate, Mission Beach Real Estate, San Diego County Real Estate
Do you want to cash out of a property at today's high prices, but are hesitant to so because of the hefty capital gains tax bill? I have written quite a bit previously about the tax favored treatment that an IRC 1031 can provide via the tax deferred exchange, so you should know that you are able to defer both state and federal capital gains taxes when you enter into a "like-kind" exchange. But, possibly you are tired of dealing with "tenants & toilets" and want to get out of the rental/investment business altogether and move on into retirement. Alternatively, you are not quite ready for retirement but want to take some portion of the sale proceeds in cash and also create a personal income stream for later retirement. Let´s say that in either case, you need to find a way to defer the dreaded capital gains taxes but just don´t want to buy any more property! And, I am willing to bet that to date, no one has told you of a way to make this happen. Right? Well, class is in session.
As a quick refresher, let´s first understand the probable implications of a real estate sale (non principal residence) without a deferral of taxes:
- Capital Gains Taxes: 15% federal and 9.4% state = 24.4% total
- Depreciation recapture: 25%
- Alternative Minimum Tax (if applicable)
OK, one such strategy is an installment sale wherein the owner sells the property on a long-term payment plan. The buyer pays the cost of the property in regular installments with interest which allows the seller to stretch out capital gains taxes, typically over a five year period, in order to avoid a huge upfront tax bill.
A lesser-known strategy (and the subject of this article) is using a Private Annuity Trust wherein owners are also able to defer capital-gains taxes by collecting proceeds over time. This is not to be confused with an annuity issued by an insurance company. Rather, it is a trust in which the property owner transfers ownership to a trust before completing a sale to a buyer. The trust then closes escrow with the buyer and subsequently pays the owner for the property, not in cash, but with a special payment contract called a private annuity which stipulates that payments from the sale go to the owner for the rest of his or her life3;essentially in installments.
In a normal sale, the seller would immediately pay capital gains tax on the full value of the property. However, because with a private annuity, payments will be made in installments over the seller's life, the seller is only taxed on payments when they are received instead of all upfront. Payment amounts are determined by IRS life-expectancy tables.
Let´s use John and Betty Jones as an example of how this might work. John and Betty own a rental property and they wish to cash-out. But, they also correctly know that if they sell the property without some sort of deferral, they would incur significant taxes. Assume the following:
- Market Value of the property = $1,000,000
- Original Cost basis = $300,000
- Adjusted basis (after depreciation) = $200,000
- John & Betty´s Age = 60
Now, without a plan to defer taxes, John and Betty would have a depreciation recapture of $100,000 and a long term capital gain of $700,000. As a result, the federal and state capital gain tax liability would be approximately $185,000, leaving only $815,000 to be invested. However, John and Betty are informed that a Private Annuity Trust would benefit them by keeping the $185,000 working for them rather than being paid in taxes and working for the IRS. Once John and Betty understand the trust and see the tax savings, they decide to establish the trust.
Let´s walk thru the steps. First, an attorney familiar with private annuities drafts the trust and also applies for a tax ID#. Once the property is transferred into the trust (prior to the sale), the property can close escrow and the full $1,000,000 sale proceeds are deposited into the trust. Next, the IRS' mortality tables (tables that estimate life expectancies) are consulted and an annuity calculation on John and Betty´s lives is conducted. In this case, with their current age of 60, the joint life span is estimated to be 29.7 years. So, they are allowed to defer the capital gains tax from the sale of the $1,000,000 property over those years and they will also receive annual income from the trust which is the annuity payment. An interest rate that varies month depending on the Treasury rate (recently 5.4%) is factored in which yields an annual payment of $73,175. Of this amount:
- $6,263 is a return of principal and will be tax free
- $25,051 is treated as a capital gain yielding a tax of $5,760 per year
- $41,861 is treated as ordinary income and is taxed per the individual´s marginal tax bracket (assuming 30%) = $12,558 tax per year
This can be a bit complex so let´s think of it this way:
- First, the annuity holder has a cost basis in his or her property. A proportionate share of that basis is returned to the holder each year in the form of an annual payment. That share is tax free to the annuity holder.
- Another part of each year's payment will be a proportionate share of the capital gains realized from the sale. That portion will be taxed at capital gains rates. So, if the annuity holder has a 15 year life expectancy, he or she will receive 1/15th of his or her basis and 1/15th of the capital gains each year.
- The last part of the payment is ordinary income and is taxed at ordinary income tax rates. The reason the annuity holder receives ordinary income is that the private annuity always earns interest on the unpaid balance and is paid out each year on top of the basis and capital gains portions.
So, let´s go back to our example. Rather than paying taxes amounting to $185,000 today, John and Betty will instead pay approximately $5,760 each year in combined federal & state capital gains tax. They also will owe ordinary income tax of $12,558 on the $41,861 annuity payment portion. Therefore, John and Betty will pay a total annual tax of approximately $18,318 on $73,175 of income per year, leaving them $54,857 of "tax free" annual income. This income is guaranteed over the remainder of their lifetime and the payments will continue for as long as either John or Betty is alive. If they live their actuarial life expectancies, they will receive $2,173,297 of income from the sale of a $1,000,000 property. If they pass away early, the payments will stop and any capital gains not previously paid will be pro-rated and have to be paid that year.
So, here is what John and Betty have accomplished. First, they have deferred any capital gains and depreciation recapture taxes (for which the owner previously received deductions for) due on the sale of the sale of their property without having to purchase another in a like-kind exchange (IRC 1031 Tax Deferred Exchange), leaving the sale proceeds to be reinvested. Second, John and Betty will now be provided income for the rest of their lives. Third, they have eliminated any estate taxes on the property transferred into the trust.
A couple of additional issues:
- Annuity holders can defer payments for years after the sale and no capital gains taxes will be due during that time. However, they must begin by age 70. If you have other sources of income and don't need the payments from the property sale right away, then you may want to choose deferral. Once payments begin, the annuity holder will receive payments for as long as he or she lives.
- Who can be a trustee? The seller (the private annuity holder) can't be the trustee or have any direct control over the trust. The trustee may be any adult, including an adult child, who is not claimed as a dependent. The annuity holder's accountant, attorney, financial adviser, family friend or relative outside of the immediate family can be a trustee. However, the trustee could make bad investment decisions or commit fraud, jeopardizing the seller's payments. Therefore, you should ensure that the trustee is a responsible person who will make smart investments with the proceeds from the sale and won't squander the gains.
- How much do you get? The annuity holder's payment is a fixed amount determined by the private annuity's face value, the annuity holder's age and the IRS's stipulated interest rate. The holder can't receive more than his or her fixed payments, regardless of what the trust earns through investments made with the proceeds. Whatever extra the trust earns on investments has to be held for the trust beneficiaries or paid to them. Since the seller doesn't get the entire purchase price right away, one needs to be comfortable deferring income and have other sources of assets or income.
- You should not make the annuity the only or a major source of your overall income or net worth. You cannot pull a lump sum of money out of the annuity so you want to have other means of coming up with cash in a crunch.
- There is some flexibility in the payment stream. The trust can lend money to the annuity holder or issue more than one annuity to the holder from the start. The annuity holder can also borrow from a bank and pledge the annuity payment stream to receive a loan.
- The entire value of any asset transferred into a Private Annuity Trust is removed from the taxable estate of the annuity holder. Thus, when the annuitant/holder dies, the payments to him or her cease and the annuity becomes null and void, leaving nothing in the estate. Any assets which have been transferred into the Private Annuity Trust will be exempt from any inheritance or estate taxes and any asset remaining in the trust when the annuitants pass away will go to their heirs as defined in the trust, completely free of estate and gift taxes.
- A Private Annuity Trust affords asset protection from lawsuits. Note: A judgment creditor may be able to access the income stream.
- Income is set for life without adjustment for inflation and the trust is irrevocable.
- There are set-up and annual fees, however, the trust pays these and the trust also files annual tax returns prepared by the trustee.
- If you've studied Charitable Remainder Trusts, you may see some similarities. The major difference is that the Private Annuity provides a higher annual pay-out. Additionally, anything left in the trust when the original annuitant passes away goes directly to the beneficiaries of the annuity which are more than likely going to be family members instead of a charity. On the other hand, the annuitant doesn't receive a deduction on their tax return since nothing is being donated to a charity, as in a CRT. Also, the annuitant doesn't receive the lump-sum money (after tax of course) to do with as they please.
- This can be done with any appreciated asset such as stocks, businesses or even artwork!
In summary, if you want: to sell property and defer taxes; an exit strategy that does not involve a 1031 exchange; guaranteed income; a way to protect assets from creditors; and, to transfer assets at time of death to your beneficiaries both estate and gift tax free, then a Private Annuity Trust may be an option for you.