Private Annuity

Private Annuity

A private annuity, also called a private annuity trust or PAT, is a contract made between two parties in which valuable assets like real estate or investments can incur a transfer of ownership without incurring capital gains taxes. While the rules governing a private annuity contract have been changed to address a perceived loophole in the capital gains tax provision, any private annuity that was contracted prior to October 2006 was grandfathered in and remains protected.

Private Annuity Rules

A private annuity was designed specifically for the purpose of deferring taxes on highly valuable collections or property by removing them from the individual’s ownership, allowing them to be used to provide income and avoid the typically high taxes involved in the sale of highly appreciated assets. Other similar arrangements can be made through the use of a charitable remainder trust, an installment sale, or a 1031 exchange.

The key to the private annuity is its ability to defer taxes on the appreciated value of the asset. The first step to setting up a private annuity is to transfer ownership of the property to the annuity. The transfer of the asset is not taxable. The private annuity then uses the value of the asset to perpetuate an income stream for the annuity contract holder. A private annuity contract is not issued by an insurance company. Instead of having to pay taxes on the entire appreciated value of the asset, the private annuity beneficiary only has to pay taxes on the actual payments made from the annuity each year, which diminishes the tax burden.

Private Annuity Formula

The private annuity contract uses a formula to determine the payment amount and is based on the Internal Revenue Service life expectancy tables. There are different life expectancy rates for individuals and for joint owners of an asset. The payment is calculated by using the age of the asset owner and the value of the asset. The interest rate is based on an IRS rate called the Applicable Federal Rate. Payments are typically made monthly, but can also be made in quarterly installments or annual payments.

One of the most crucial rules governing private annuities is the installment of an independent trustee. The annuitants are not allowed to control the trust or make any decisions regarding the investment of the funds in the trust. The main benefit of a private annuity is the capability it provides individuals to fully realize the appreciated value of an asset prior to having to pay taxes on that increased value.

To preserve the benefits of a private annuity trust, the trustee must be independent, the annuity cannot be secured in any way, and the annuitants cannot have any control over the trust or its investments. Informal suggestions and advice, however, are not prohibited. Another advantage to a private annuity is the trust’s ability to continue making payments to additional beneficiaries if the trust continues to gain value after the owners die. Because of the October 2006 ruling that prevents private annuities from being used as workarounds for capital gains taxes, many insurance companies have developed options which closely mimic private annuity contacts but are called something different, such as structured sales options.
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