PAT: Deferring Capital Gains and Depreciation Recapture
By Brian P. McGarren
Those of us who own highly appreciated assets like homes, commercial real estate, stock portfolios or businesses, are often reluctant to sell that asset because of the capital gains tax and depreciation recapture costs associated with the sale.
How many times have you heard these comments?
- “I am going to get killed with capital gains taxes when I sell my property.”
- “Because of capital gains taxes, we are not going to sell our property.”
- “After all, if I own a commercial building that is generating cash flow and I don’t need a lump sum of money immediately, why would I just hand it over to the government? Why not let my kids take over so they can have an income after I pass?”
Sound too familiar? Well welcome to reality.
These are questions we hear daily that plague the minds of American taxpayers.
We hear it all the time. Luckily there is a “way out.”
There is a smart, functional and more importantly, legal way to address these issues. The answer may lay with a powerful estate planning tool called the Estate Annuity Trust.
If you own real estate with large amounts of equity and are not selling your property because of capital gains taxes or can’t find qualified, property exchanges, then you may want to consider a Private Annuity Trust (PAT).
The private annuity is an IRS accepted method, found under (Section 72 of the IRC), which allows the seller of the property to defer capital gains taxes at the time of sale.
Actually, this estate planning tool has been around since the early 1960’s and has been used for deferring capital gains taxes associated with a sale of highly appreciated assets like business and stock portfolios as well as real estate.
There is no maximum to the size of the transaction and the PAT can be used on any kind of real estate transaction such as your primary residence, rental properties, vacation homes, commercial properties, hotels, land, industrial complexes, retail developments, shopping strip malls and raw land, to name a few.
What are Capital Gains Taxes?
Capital gains are a tax on the profit we make when we sell assets. Any long-term assets sold at a profit is subject to a capital gains tax of some rate. The rate for the gain on the sale of an asset owned for one year or longer will be 15 percent for federal taxes. Most states charge 5 percent to 10 percent on top of that, making the total tax run as high as 25 percent. In Massachusetts, the state rate is 5 percent for a total of 20 percent. If there is a depreciation recapture in the asset sale, that is taxed at 25 percent federal rate, making the tax on recapture higher that the capital gains tax!
Even on your primary residence, with the growth of equity you have accumulated over the years and factoring in your tax exemption of $250,000.00 each for husband and wife, you may still have to pay a hefty tax surprise when you exit your property.
That isn’t the end of the story for the total tax effect though. Capital gains must be added to the taxpayer’s adjusted gross income. This means that capital gains or profits will raise the “floor” above which one can take a number of itemized deductions.
This often results in a large decrease or total loss of those deductions. This makes the effective, but hidden capital gains rate much larger than the stated federal and state rates.
This is where the Private Annuity Trust comes in. The process starts with a property owner, (referred to further as the annuitant), transferring ownership of the property to a dedicated family trust (The Private Annuity Trust).
In our example, we will assume the asset is worth $1 million. The transfer isn’t a gift, but a special type of sale. The owners of the trust are the heirs of the annuitant, probably his children.
Next the trust “pays” the annuitant for the property. The payment isn’t in cash, but with a special payment contract called a “private annuity.” It is strictly a private arrangement between the trust and the annuitant. The form of payment is a life annuity.
A private annuity is something like an installment sale. 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 million, the face value of the annuity contract is also $1 million.
The annuity payments may begin immediately or they may be deferred for some period of months or years. The trust then sells the property. There are zero taxes to the trust on the sale since the trust “purchased” the property in the form of a private annuity contract of $1 million and then sold it for cash at $1 million.
The annuitant is not taxed on the sale since he has not yet received any cash for the sale. Often annuitants will choose deferral because they have other income and don’t need the payments right away. Of course, annuity payments may begin immediately.
Deferral is strictly an option. It is important to understand that payment of the capital gains tax to the IRS is done with an “easy installment plan.”
There is no interest or penalty on these deferred payments of the tax.
On top of that the tax payments will be made with depreciated dollars. The tax dollars will be worth far less than they are today due to inflation. Yet the investment money in the trust will grow at greater rate than that of inflation.
In our example, the $1 million accrues interest to the annuitant. (The interest rate is dictated by the IRS under Section 7520 of the Tax Code.) So the annuitant had the entire untaxed value of the sale, $1 million, growing and earning interest for him.
The seller/annuitant will earn much more money that he would if he/she sold the property and paid the tax up-front.
This is due to the deferral and the spreading of the tax payments over an additional period. (Over the rest of the seller’s life.) Let us now examine some numbers and compare the annuity transaction to a straight taxed sale.
We start with the $1 million property value. The annuitant’s basis is $200,000 leaving a profit of $800,000. We are estimating combined federal and state capital gains taxes at $160,000, which is 20 percent of the profit. This leaves net cash of $840,000 in the direct sale year, $1 million in the annuity deferral sale.
We are assuming the investment cash earns a conservative 6 percent before income taxes for the next 20 years. The property owner is 45 and chooses to start the annuity payments at age 65. Under the direct and taxed sale, the property owner received annual payments of $277,300 vs. $330,119 under the annuity plan. This yields an estimated like payout of approximately $5.5 million under the taxed plan vs. approximately $6.6 million with the annuity strategy.
This is an advantage of just over $1 million to the annuitant.
This advantage is due to the larger amount of net cash that was initially available to invest for the annuitant.
While we have primarily focused on the capital gains tax, depreciation recapture taxes are also deferred with a private annuity. But in either a cash sale or an installment sale, the depreciation recapture is taxed immediately. While an installment sale can spread the capital gains out over a number of years, it cannot do the same with depreciation recapture.
Furthermore, installment sales have “related party” rules that prevent an arrangement such as the private annuity trust described above. The related party rule only permits an installment sale with an outsider and the Private Annuity can make an installment sale with a family member.
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 cash flow necessary for the private annuity payments to the annuitant.
There are significant benefits for the property which the annuitant transfers to the trust:
- 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.
- This arrangement does not trigger any gift tax consequences no matter how much the property is worth.
- The property will not need to go through probate when the annuitant dies.
The deferral of capital gains taxes can produce a dramatic increase of cash in your
pocket. But that is far in away not the only benefit.
- Everything from the sale proceeds and all trust earnings either goes to the annuitant or to the heirs. When the annuitant dies everything left in the trust will go to his heirs.
- The trust can make a cash sale. It is not forced to make an installment sale to the outside buyer in order to spread out the capital gains tax. This is an advantage because you never know whether the outside buyer will make all the payments on an installment sale.
- The private annuity is the equivalent of receiving a tax free loan from Uncle Sam.
- The formal mechanics of the trust provide the discipline that some find helpful by providing for their own retirement.
- 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. An income stream for life.
- You can borrow from the trust and take money out prior to closing (but must pay the pro rata tax) or at closing in the form of an annuity payment.
Nothing is given away to charity as happens with the competing strategy known as a charitable remainder trust.
The Private Annuity allows all principal and accrued interest to be paid to the property seller, whereas the charitable remainder trust pays income (interest) only. In most cases the Private Annuity yields more bottom line dollars to the property seller that the charitable remainder trust does.
As illustrated above, the Private Annuity Trust has the ability to generate substantially more money over the long run that a direct and taxed sale. It is may be superior to the charitable remainder trust, installment sale, and 1031 property exchanges in many respects.