When to Buy a Private Annuity

Written by Hersh Stern Updated Friday, June 29, 2018

Often, creating estate-planning strategies is delayed because people are relying on income generated by their property to survive. However, it is possible to plan your estate while keeping your current income intact.

A private annuity (PA) is a tool by which you can get property out of your estate and into the hands of your children prior to your death. If it's set up properly, it will avoid estate and gift taxes and continue generating income to you for the rest of your years.

Structuring your annuity

The structure is very simple. Ownership of your property is transferred to your children (or other beneficiaries), who promise to make payments to you for the rest of your life.

When the annuity is done right, the property is not included in your estate; your children are considered its owners. Each payment you receive is part tax-free return of your basis in the property, part capital gain, and part interest. Your children get a basis in the property equal to the annuity payments made to you. When the value of the annuity is equal to the value of the property, your children can sell the property right away without incurring capital gains taxes and use the entire sale proceeds to reinvest.

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The PA is especially attractive when you have property with a low basis. Capital gains are recognized over many years instead of all in one year. Similarly, if the property was subject to depreciation recapture, that recapture is spread out over years as payments are received. For these reasons, PAs are frequently used for business interests, real estate, securities, cash, and any other property with the potential for large capital gains.

When establishing your annuity payments, you have to determine the fair market value of the property. IRS annuity tables from Code Section 7520 are then used to determine the actual payment amounts.

The tables are designed so that if you live to your life expectancy, you'll receive full value and interest from your property. If you do not live to your life expectancy, the beneficiary comes out ahead because payments end at your death. If you outlive the expectancy (as most of us hope), you'll receive more than the value of the property plus interest.

Under the watchful eye

The PA is scrutinized closely for errors by the IRS. They too are aware of its many benefits. Don't let this deter you from using a private annuity; just be sure to take the following steps:

Valuation

When determining the fair market value of the property being transferred, be sure to get an appraisal from a qualified professional.

Security

The PA must be unsecured. If you have any doubts about the ability or willingness of your children to make the payments indefinitely, a PA is not for you.

Payment Amount

The IRS tables must be used to determine the annuity payments.

Life Expectancy

Your life expectancy determines the amount of annuity payments. The older you are, the higher the payments will be.

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The IRS says the tables cannot be used if someone has a terminal illness or otherwise is not likely to live for more than one year from the date of the annuity. The IRS has even tried to say that the tables can't be used when someone is not in good health but not terminally ill. So far, the IRS has not succeeded in these cases (McLendon Est., CA-5, 91-1 USRC p60,220, reversing T.C. Memo 1993-459.)Life Insurance. Buy life insurance on your children to be sure payments will continue if one or more of your children predeceases you. The PA contract cannot contain references to the insurance.

Make the right choice

The PA is a good choice for some people. But if you're concerned about receiving all of the future payments and want some security, you should explore other options such as a commercial single premium immediate annuity (SPIA) sold by an insurance company.

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