Overcome the Burden of Capital Gains Tax With a Gift from Uncle Sam By James L. Flanagan CEA, CEP

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1 Overcome the Burden of Capital Gains Tax With a Gift from Uncle Sam By James L. Flanagan CEA, CEP Anyone who has ever sold or been party to the sale of any highly-appreciated real estate, knows what a burden the capital gains tax can be. The long-term capital gains tax rate is 20%. When you factor back in the depreciation recapture tax, you can add an additional 5%. Some states have their own capital gains tax adding another 3%. The total can be as high as 28% in capital gains taxes. This burden has stopped many a property owner from selling their highly appreciated real estate. However, there is a simple method, without using a 1031 exchange for selling highly-appreciated real estate. The process uses a Private Annuity Trust. First, I d like to illustrate why the only methodology available to defer capital gains taxes, the 1031 exchange, is often impractical and too cumbersome to be a viable solution for most sellers. There are a number of issues that you need to be aware of regarding 1031 exchanges. The old property and the new property must be either bare land or rental property. If the property passes this test, you can exchange this real estate for any other type of real estate, as long as it is property that has been and will be held for productive use in the investor s trade or business. The next issue with the 1031 exchange is the time frame. From the day you close on the property, you have 45 days to identify the properties that you wish to

2 consider purchasing in your exchange; and then you must close on one or all of those properties within 180 days. There are some serious time constraints that are put on this process for it to work properly. Another issue is that of how title to the property must be held. Title on the property must remain exactly the same. You cannot touch any of the funds from the sale. All proceeds must be reinvested in a property of equal or greater value. But that is not all. There are IRS identification rules. The three property rule states that you may identify three properties of any value; or you may identify any number of properties, as long as the total market value does not exceed 200% of the sale price of the property you are exchanging. If you identify more property than is permitted in the previous two rules, you must acquire 95% of what was originally identified. Still another issue is that you must use a qualified intermediary. A qualified intermediary is used to sell your property, hold your funds, purchase the replacement property and then they transfer title back to you. You must transfer all of your rights on title and interest, to the qualified intermediary. The intermediary cannot be your lawyer, your CPA, your bank or a family member. No license is required to be a qualified intermediary. For these reasons, you must exercise extreme caution when choosing a qualified intermediary. If each and every one of these conditions are not met, the exchange will not qualify under the internal revenue code. Not only is this process complicated and cumbersome, in some markets, it is impossible.

3 The final issue with a 1031 exchange is that it does not hold any promise for the individual that does not want to buy a new piece of real estate. Unfortunately, there are times when our clients are no longer interested in owning property. In order for a client to use a 1031 exchange they must continue to own and manage real estate. Clearly, there comes a time in our client s lives when they may want to exit the real estate marketplace. We need to be able to provide them with an acceptable exit strategy. The aforementioned issues make it difficult to meet all of the criteria to establish a proper 1031 exchange. I believe the superior method for the sale of highlyappreciated real estate is through the use of a private annuity trust. The National Association of Financial and Estate Planning (NAFEP) has created an IRS compliant document that allows for the sale of highly-appreciated real estate, without the rules and procedures of the 1031 process. Not only does it defer capital gains taxes upon the sale, but it also allows them to delay all recognition of gains, usually as late as their age 70 _. The trust can invest the proceeds from the original sale in additional real estate or any other type of investment as the trustee deems prudent. There are no restrictions on trust investments. No time restrictions or value restrictions apply to the Private Annuity Trust. The owner may even take some of the proceeds from the sale (subject to tax) and still defer the gain on the balance. The process is simple and easy to explain to your clients, costs very little to implement, and can in many

4 cases, help solve other, more complex problems for your client regarding estate tax issues. Here is how it works. The property owner (seller) places the appreciated asset into a trust, rather than directly selling it to the buyer. The trust belongs to and is controlled by the seller s family. Its beneficiaries are the heirs or children of the property seller. The trust purchases the asset from the seller. Instead of a cash purchase, the trust pays the seller with an annuity contract. The annuity contract is a private arrangement issued by the trust itself and is not a commercial annuity from an insurance company. The annuity makes the seller an annuitant and that is how we will refer to the seller after this. The annuity contract is a promise to make payments to the annuitant for the balance of the annuitant s life. The payments can be made to either a single person or in a joint last-to-die arrangement to a married couple. Often the first payment on the annuity is deferred, maybe for many years down the road, such as when the annuitant has reached retirement age. But the annuitant has the option of beginning the annuity payments right away. Usually the annuitant has located a real buyer for the assets and has negotiated a fair market price for it. If not, that may be done by the trustee after the asset goes into the trust. In any case, the sale is not completed until the asset has been placed in the trust. When the transactions are complete, the asset has been sold twice. First, from the annuitant to the trust, and paid for by an annuity, and second from the trust to the real buyer in either a cash or installment sale.

5 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 or her life. Payments can also be made on joint life expectancy. The private annuity process results in an exchange of the annuitant s property for lifetime income, with that income being based on the full value of the property. The annuitant will receive all of the principal and all the accrued interest under actuarial assumptions. In other words, the annuitant is given full and adequate consideration for the property. Therefore, the property transfer to trust is not a gift and not subject to gift taxation. Likewise, when the annuitant dies, there are no estate taxes, because the property was sold and the annuity expires, null and void, at that point. The private annuity arrangement is a type of insurance policy for the annuitant s gift and estate tax planning. As long as the annuitant is alive, he will continue to receive his payments to help with his living expenses, but the balance of the annuity property is out of your client s estate immediately when he dies. A trust may issue more than one annuity contract, which is to say that if a client had multiple properties, they would only need one trust but they would be able to sell multiple properties within the same trust. This makes this an extremely cost-effective approach and gives tremendous flexibility from an income and taxation standpoint.

6 There has been a lot of discussion recently about lowering the capital gains tax rate. In this case, if capital gains taxes are lowered or eliminated completely, and the annuitant has sold property in trust, when they begin receiving payments, they receive them at the new tax rate. If the tax is eliminated, your client will completely avoid the tax from that point forward. Most private annuity transactions cost between $2,000 and $4,000 to be fully implemented, including all attorney s fees. The higher end of this price range is reached with unusual and complex situations, usually involving complex real estate deals, sub S corporations or other business assets. The private annuity does not eliminate the taxes, but defers them for a long period, often for decades, with no penalty or interest for doing so. It only takes a matter of days to implement this process completely. A trust is not established normally until a buyer for a property has been located, and the true market value of the property has been identified. The Private Annuity Trust strategy represents an excellent option for your clients. In simple terms, it addresses the needs of those who want to purchase additional real estate, as well as the needs of those trying to exit the real estate marketplace. For additional information on this unique sales strategy, you may contact the author at (630)

7 Comparison With A Taxed Sale Taxed Sale Annuity Deferral Selling Price 250, ,000 Basis 50,000 50,000 Profit 200, ,000 C. G. Taxes 50,000* Deferred Net Investment Cash 200, ,000 Deferral Period 20 Yr. 20 Yr. Annuitant Present Age Annual Payout 95, ,782 Est. Life Payout 1,900,500 2,375, ,140 Advantage * Assuming 20% Federal and 5% State tax rates