On Your Way to Easy Street

Use a private annuity trust to boost your income and save on taxes, too.

By Mary Beth Franklin, Senior Editor

From Kiplinger's Personal Finance magazine, September 2005

Facing retirement, George and Karen Howard wanted to generate income by selling George's boyhood home, in California's San Joaquin Valley, which they had been renting out. But the couple faced a big stumbling block: a tax bill of nearly $110,000 on the appreciated property, based on the 15% federal tax rate on long-term capital gains plus an additional 9.3% levied by California.

Then the Howards, who live in Dos Palos, Cal., learned about a strategy that let them boost their income and stretch the tax bill over their lifetime. They set up a private annuity trust for the benefit of their two grown children, then sold the house and surrounding 17 acres to the trust for about $500,000. The trust, in turn, sold the property to a third party.

Rather than receive a lump sum from the sale, the Howards will get about $2,800 a month from the trust for the rest of their lives. The trust's assets can be invested in stocks, bonds, mutual funds or other real estate.

That payment, which is based on the property's sale price, the couple's joint life expectancy and the assumed interest rate determined by the IRS, is nearly triple the amount the Howards were receiving in rent. Although they can't receive more than $2,800 a month, they can borrow from the trust. "It will allow us both to retire on easy street," says George, 67, a retired farmer and part-time rural mail carrier. Karen, 62, is a full-time mail carrier who plans to retire at the end of this year.

And instead of paying nearly $110,000 in capital-gains taxes up front, they will pay about $4,200 a year over 25 years (their joint life expectancy). The portion of their monthly income that represents their cost basis in the property is tax-free, and the balance is taxed as ordinary income.

A waiting game

Although the Howards decided to take annuity payments immediately, younger investors who use this strategy, such as Michael Stahl, often prefer to wait, deferring payments -- and taxes -- until they're closer to retirement.

Michael, 42, and his wife, Jennifer, 40, plan to create a private annuity trust for the benefit of their 6-year-old daughter, Kristina, when they sell their home near San Diego. Because the Stahls have lived in the house for less than a year, they don't qualify for the usual tax exemption of $250,000 per individual, or $500,000 per couple, on the sale of the house. Their expected gain of $465,000 would be taxed as ordinary income, and the combined federal and state tax bite of 44% would consume more than $200,000 of their profit.

Michael and Jennifer plan to delay the start of their annuity -- and their need to start paying the tax bill -- for as long as possible, although payments must begin by the time Michael turns 70½. "Anything that can help me minimize my taxes is great," says Michael, a professional real estate investor.

A private annuity trust "is like an interest-free loan from Uncle Sam," says David Reyes, a certified estate adviser with Reyes Consulting, in San Diego. Whatever is left in the trust after the second owner dies passes to the beneficiaries free of estate taxes and without going through probate.

Tap your gains

The California land rush has made private annuity trusts popular there for several years. Now the trusts are spreading to other parts of the country, says Tom Ambrose, of Ambrose Financial, a wealth advisory firm in Chadds Ford, Pa. (www.mypatplan.com/tambrose). The trusts allow sellers to capture their real estate gains and diversify into other investments without having to pay the tax bill all at once.

Anyone who wishes to sell highly appreciated assets, such as stocks and art, is concerned about the immediate income-tax liability and doesn't need a lump-sum payment should consider a private annuity trust, says Reyes. A trust can also be appropriate for people concerned about estate taxes.

Such trusts are generally not suitable for younger people who need more income than an annuity would allow, or for homeowners selling a primary residence who qualify for the tax exemption on capital gains. To get an idea of your potential tax savings, request a free illustration at Reyes's Web site, www.privateannuitytrust.net/davidreyes. Set-up fees range from $5,000 to $10,000.

-- Research: Elizabeth Kountze

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