TRUSTS OF THE THIRD PARTY KIND

An obscure tax case, Burnet v. Logan, in 1931, laid the foundation for a solution for today’s real estate owners seeking a way to cash out of real estate while minimizing the tax bite. The Supreme Court analyzed a sale of stock by a Mrs. Logan to a corporation in exchange for a promise of annual payments based upon the production of an iron ore mine. The court found this did not constitute a sale.

From this ruling came a transfer technique known as a private annuity in which a person (“annuitant”) transfers property to another person (the “obligor”) in exchange for the obligor’s unsecured promise to make periodic payments to the annuitant for the remainder of the annuitant’s life.

As practiced today, the owner of an appreciated piece of property sets up an irrevocable trust, with an independent third party trustee. The owner then sells the property to the trust at fair market value in exchange for a life annuity, obligating the trust to pay an amount annually based upon: the value of the property transferred into trust; the actuarial age and life expectancy of the annuitant; and an applicable interest rate determined by the IRS.

The trustee, once the property has transferred, is free to sell the property and reinvest the proceeds in an investment account controlled by the trustee. Up to this point there is no taxable event; neither the transfer of the property into the trust nor the subsequent sale by the trustee is subject to ordinary income tax, capital gains tax or tax resulting from recapture or depreciation.

However, the annual fixed payment to the annuitant is subject to tax under annuity taxation rules. A portion of the payment is tax free return of basis; a portion is capital gains based upon the total capital gains realized by the sale; and a portion is taxed as interest.

Payments continue for the life of the annuitant, or annuitants if set up as a joint annuity with a spouse. Any residual remaining is then payable to remainder beneficiaries, subject to income and capital gains tax. Since there has been no taxable transfer from an estate or gift made, the entire transaction is free of gift and estate taxes.

For the transaction to pass tax muster, the trust has to be set up and the property transferred before any attempt to sell the property. By the strictest standards, the property should not be listed for sale or be in escrow prior to transfer.

The trustee must be truly independent. Annuitants cannot be the trustee nor have direct control of any kind over the trust. The trustee may be any person who is independent of the annuitants. The annuitants’ accountant, attorney, financial advisor, adult trust beneficiary, family friend or a relative who is not in the immediate family are all possible choices.

Properties being used to fund these trusts include a personal residence, vacation home, business, appreciated stock or a piece of commercial property. Once in trust, the annuitant no longer has the right to use or enjoy the property.

If the property in trust is sold and the proceeds are reinvested, regardless of the investment results, the annuitant is entitled to a fixed payment, established at the time payments begin. If the trust runs out of money, it has no further obligation to the annuitant. If the annuitant lives beyond life expectancy, payments continue as long as the trust has funds.

Care must be exercised when setting up the trust, selecting the trustee, managing the trust, and accounting for the taxes. If not, the IRS could unwind the transaction and assess taxes along with penalties. Therefore, if contemplating such a transaction, please consult with knowledgeable tax and legal advisors.