Law Office of John P. Bradbury

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1 Law Office of John P. Bradbury / (212) jbradbury@nyrelaw.com Tax & Estate Planning with Real Estate Assets This seminar will review: Current tax regimes and the goals of estate planning 3. Discussion of real estate special attributes for estate planning Tax & Estate Planning with Real Estate Assets This seminar will review: 4. Techniques especially suited to estate planning with real estate a) Qualified Personal Residence Trust (QPRT) b) Grantor Retained Annuity Trust ( GRATs ) c) Low Interest Loans / Installment Sales d) Self-Cancelling Notes / Private Annuities POINTS Points are deductible if % of amount borrowed not a flat fee Loan on principal residence secured by property Must be paid with funds other than lender HUD-1 lines 801 and 802 POINTS REFI Points Generally not deductible on year paid but ratably over term of loan If property is sold, unamortized points are deductible in year of sale CLOSING COSTS Add to basis of property not deductible in year of purchase transaction 1

2 RENTED HOME (Vacation or Temporary Rental) Two Limitations - Deducting costs (maintenance, repair, depreciation, insurance and utilities) TEST # ONE - Personal Use Test Taxpayer ( T ) uses home for less than the greater of (i) 15 days per year or (ii) 10% of the number of days the residence is rented at Fair Market Value ( FMV ) RENTED HOME (Vacation or Temporary Rental) Two Limitations - Deducting costs (maintenance, repair, depreciation, insurance and utilities) TEST # TWO - Passive Loss Limitation (Section 280 A) investors can only deduct losses from rental activities to the extent of their income from rental activity. RENTED HOME (Vacation or Temporary Rental) Passive Loss Limitation (Section 280 A) AGI < $100,000 not subject to 280A and can offset ordinary/non-passive income up to $25,000. AGI > $100,000 the $25,000 permissible deduction is reduced by 50% of the excess and completely phased out at $150,000 HOME OFFICE Two considerations in determining Home Office Deduction Relative importance of activity performed at each business location Time spent at each location HOME OFFICE Requires no other fixed location for administration or management of business Does not preclude meeting with customers, client or patients at a fixed location away from home Examples Writer / Jewelry Maker / Designer - yes Teacher / Plumber / Anesthesiologist - no HOME OFFICE Calculation of Home Office Deduction Gross income derived from business Deduct share of mortgage interest and real estate taxes on a proportionate basis T deducts non-home related expenses of running business (business phone and office supplies) 2

3 HOME OFFICE Calculation of Home Office Deduction To the extent subtotal is positive, T is entitled to deduct a proportionate share of the residential maintenance costs, such as depreciation and utilities. GAIN ON SALE OF RESIDENCE Post May 7 th 1997 Rollover provision and $125,000 exclusion no longer apply T can exclude up to $250,000 ($500,000 if T is married and files a joint return) of gain realized on the sale of a principal residence GAIN ON SALE OF RESIDENCE To be eligible T must have owned the residence and occupied it as a principal residence for periods aggregating two year or more out of the five years prior to the sale GAIN ON SALE OF RESIDENCE Change of Employment, health or other unforeseen circumstances and move is more than 50 miles T is able to benefit from a fraction of the $250,000 / $500,000 exclusion [(18 months / 24 months) x $250,000] GAIN ON SALE OF RESIDENCE ---- Example One H&W each own a home separately and used as a principal residence before marriage. Neither spouse meets the use requirement of the other spouse s residence. H s gain is $200,000 and W s gain is $300,000 H&W must realize gain of $50,000 on W s gain GAIN ON SALE OF RESIDENCE ---- Example Two Unmarried taxpayers A&B own a house as joint owners, with each owning a 50% interest. They sell the house after owning and using the home as a principal residence for two years. Gain from sale is $256,000 A & B are each eligible to exclude $128,000 3

4 GAIN ON SALE OF RESIDENCE ---- Example Three A buys a house in 1991 and uses it as his principal residence. In 2004, A s friend B moves in with A and A sells a 50% interest in the house, with A realizing a $136,000 gain. In 2006, A sells remaining 50% interest to B and realizes a gain of $138,000. A may exclude $114,000 on second transfer to B. Surviving Spouse Penalty --- ELIMINATED on sales or exchanges by surviving spouses made after December 31, The increased exclusion amount applies to a sale or exchange of property by an unmarried individual whose spouse is deceased on the date of such sale if: Surviving Spouse Penalty ELIMINATED if: 1. The sale occurs no later than two years after the date of death of such spouse, and 2. Immediately before the date of death, either spouse met the 2 out of 5 year ownership requirement, both spouses met the 2 out of 5 year use requirement, and neither spouse was ineligible to claim the exclusion because of another sale or exchange within the prior two years that qualified for the exclusion (' 121(b)(4)). Surviving Spouse Penalty ELIMINATED Thus, for ownership and use, only one spouse must have owned the property for periods aggregating two years or more during the five year period immediately before the date of death. However, both spouses must have met the use requirement by using the property as a principal residence for periods aggregating two years or more during the five year period immediately before the date of death. Tax & Estate Planning with Real Estate Assets GAIN ON SALE OF PROPERTY SUBSTANITIALLY EXCEEDS $250,000 / $500,000 Convert to rental property and hold for a sufficient period to qualify for 1031 exchange treatment. Pre-1977 Joint Tenancies Between Husband & Wife Portion of the property passes to the surviving spouse by operation of law, it is sheltered from estate tax by the unlimited marital deduction. The surviving spouse gets a corresponding step up in basis for the one-half of the property which was included in the deceased spouse's estate. 4

5 Pre-1977 Joint Tenancies Between Husband & Wife Joint tenancies between a husband and wife created prior to January 1, 1977 enjoy special treatment for estate tax purposes. The value of the property is included in the estate of the first spouse to die based on the proportionate share of the purchase price furnished by the decedent. Pre-1977 Joint Tenancies Between Husband & Wife So if the decedent furnished all the consideration for the property, then the full value of the property will be included in the deceased spouse's estate. The income tax benefit to the surviving spouse is a full step up in basis. Pre-1977 Joint Tenancies Between Husband & Wife If you are dealing with a pre-1977 spousal joint tenancy, do not sever the joint interest without considering the consequences of receiving only a onehalf, rather than a full, step-up in basis when one spouse dies. FOREIGN SELLER & WITHOLDING TAX 1445 the purchase of a real property interest must deduct and withhold from the purchase price where the seller is a foreign person Avoid withholding requirement by obtaining seller certification (FIRPTA) Withholding is 10% and furnished to IRS within 20 days of sale FOREIGN SELLER & WITHOLDING TAX No withholding requirements when Value of residence transferred is less than $300,000 Required for a $5,000 dirt farm A Withholding Certificate is provided by IRS EXTENSION OF 121 BENEFIT TO HEIR OR ESTATE The $250,000 exclusion will be available to the heir or estate of such decedent or to a qualified revocable trust left by such decedent. Two year residency period of decedent applies to heir A qualified revocable trust may be treated as having been owned by the decedent by virtue of the power to revoke. 5

6 THREE TAXES Current Tax Regimes Taxes imposed on the transfer of wealth by transferor Estate Tax Gift Tax Generation Skipping Tax THREE TAXES Current Tax Regimes Each transfer tax has its own rate structure (with many overlaps between the estate and gift tax) and each permits certain deductions, exclusions and credits, which are not uniform. Current Tax Regimes THREE TAXES ESTATE TAXES Tax made on transfers made by decedent at death. Tax levied on value of the sum of (i) all property in which the decedent owned at time of death and (ii) property decedent transferred during life, less applicable deductions. Current Tax Regimes THREE TAXES GIFT TAXES Current Tax Regimes THREE TAXES GIFT TAXES Tax imposed on donor based on aggregate value of property transferred during lifetime Tax rate equals estate tax rate Every donor has aggregate lifetime exemption of $1,000,000 ( gift tax applicable exclusion amount ) Unlike estate tax, the gift tax applicable exclusion amount is NOT scheduled to increase Current Tax Regimes THREE TAXES GENERATION SKIPPING TAX Tax imposed (in addition to estate and gift tax) on transfers to grandchildren and other persons who are treated by statute as the functional equivalent of grandchildren ( skip persons ) (37.5 yrs older) Generation Skipping Tax Rate = Estate Tax Rate 6

7 Current Tax Regimes THREE TAXES GENERATION SKIPPING TAX Every donor has aggregate lifetime exemption from GST of $2,000,000 ( GST exemption amount ) 2011 Exemption $5,000,000 Rate 35% Current Tax Regimes NYS Estate Tax Exemption is $1,000,000. NYS Estate Tax Rates: 1.6% for $100,000 over exclusion 4.0% for $500,000 over exclusion 6.4% for $1,000,000 over exclusion 9.6% for $3,000,000 over exclusion 11.2% for $5,000,000 over exclusion 16.0% for $10,000,000 over exclusion Estate Tax /Gift Tax / Rate 2002 $1 million $1 million 50% 2003 $1 million $1 million 49% 2004 $1.5 million $1 million 48% 2005 $1.5 million $1 million 47% 2006 $2 million $1 million 46% 2007 $2 million $1 million 45% 2008 $2 million $1 million 45% 2009 $3.5 million $1 million 45% 2010 Repealed $1 million 35% 2011 $5 million $1 million 35% 2012 $5 million $5 million 35% 2013 $1 million $5 million 50% Foreign Purchasers Lifetime gift and estate exclusions do not apply. Do not permit single foreign purchaser ownership Single Member LLC Term Life Insurance Foreign Purchasers Foreign Investor Passive Activity Income (Rentals) File taxes in first year of rental activity NOT first year of rental income. Failure to file will result in levy of 30% tax on gross income without regard to offsetting expenses. Foreign Purchasers How many days may a foreign person stay in the US without having an obligation to be a US tax filer. (i) No more than 180 days in one year and (ii) 180 rule applied to three year look back test, results in a maximum of 120 days consistently. All days spent in /3 of days in (1/3 of 120) 1/6 of days in (1/6 of 120) 180 days 7

8 Goals of Estate Planning Basic principle is simple make maximum use of the ability to make gifts that do not require payment of gift tax Making Most of Non-Taxable Transfers Low tech estate planning techniques that permit wealth transfer without triggering gift tax. a) Lifetime gift tax exclusion b) Annual exclusion gifts c) GST annual exclusion gifts Making Most of Non-Taxable Transfers Low tech estate planning techniques that permit wealth transfer without triggering gift tax. a) Lifetime gift tax exclusion Every taxpayer can give an aggregate of $1,000,000 of taxable lifetime gifts without paying gift tax. Making Most of Non-Taxable Transfers Low tech estate planning techniques that permit wealth transfer without triggering gift tax. b) Annual exclusion gifts 2503(b) allows $12,000 to be transferred each year ro an unlimited number if persons free of gift tax (gift tax annual exclusion) Annual exclusion gifts do not use any of donor s lifetime gift tax exclusion amount Making Most of Non-Taxable Transfers Low tech estate planning techniques that permit wealth transfer without triggering gift tax. c) GST annual exclusion gifts Annual exclusion gifts are also exempt from the GST without using any of the donor s GST exemption amount Gifts in trust must meet special criteria to be GST exempt Making Most of Non-Taxable Transfers Basic principle is simple make maximum use of the ability to make gifts that do not require payment of gift tax 8

9 Transfer Property With Potential Appreciation Transferring property (such as real estate) with appreciation potential reduces transfer taxes because the appreciation on the gifted property escapes transfer taxation. Transfer property that can be valued with substantial discounts. Gifts of discounted assets produce transfer tax savings because the value of the discount escapes transfer taxation. QPRT for primary residence and vacation home GRAT for income producing asset (not necessarily real estate) Real Estate What s It Worth Unlike marketable securities, real estate investments do not have readily ascertainable values. The value of a gift will generally be determined by appraisal, which involves a certain amount of subjectivity. YOU WILL DIE & YOU SHOULD HAVE A WILL QPRT QPRT In 1992, the IRS issued a lengthy and elaborate regulation which permits for Qualified Personal Residence Trust or QPRT. 9

10 A QPRT is an irrevocable trust created pursuant to Section 2702(a)(3) to hold a personal residence. Basically, a taxpayer transfers his or her personal residence to the QPRT for a term of years. For this purpose, a personal residence is defined as the principal residence of the grantor and one other residence of the grantor, or an undivided fractional interest in each. The remainder interest passes to the objects of the taxpayer's bounty, usually his/her children. If the taxpayer dies during the term of the QPRT the value of the assets in the QPRT is includible in the taxpayer's gross estate under Section If the taxpayer survives the term of the QPRT no portion of the value of the QPRT will be taxable in the taxpayer's estate if the QPRT is properly structured. A QPRT can permit the trustee to sell the residence to a third party during the term, provided the sale proceeds are either (i) reinvested in a new residence or (ii) paid back to the donor, either all at once or in the form of an annuity. DOWNSIDE: If grantor survives term and wishes to remain in property, they must either (i) grant life estate to spouse (who must consent to living with them) and/or (ii) pay fair market value rent. 10

11 DOWNSIDE: QPRT has no estate tax value if grantor does not survive term. The way GST works with QPRTs, provides a strong incentive for the property to pass only to the donor s living children, and, if a child of the donor dies during the QPRT term, provide for that deceased child s issue with other gifts or bequests outside the QPRT. DOWNSIDE not so bad: Estate tax consequences of donor s death or death of donor s direct issue can be ameliorated by life insurance. With insurance program in place with a QPRT, strategy changes from can not lose to must win estate planning strategy. DOWNSIDE not so bad: Donor can also tier QPRT terms, Example: 1/3 of property with term of 2 years 1/3 of property with term of 4 years 1/3 of property with term of 6 years THE OLDER THE DONOR THE BETTER Time Value of Money Retained Contingent Reversion Valuation Discount for 60 year old donor; 15 year QPRT: Property Value = $1,000,000 Discount from Retained Income Interest (15 yrs) = Discount for retained contingent reversion = Valuation Discount for 80 year old donor; six-year QPRT: Property Value = $1,000,000 Discount from Retained Income Interest (six yrs) = Discount for retained contingent reversion = Valuation Discount for 60 year old donor; 15 year QPRT: Property Value = $1,000,000 TOTAL Discount = Net Gift Value = $294,880 Valuation Discount for 80 year old donor; six-year QPRT: Property Value = $1,000,000 TOTAL DISCOUNT = Net Gift Value = $296,510 11

12 Jeanette is a widow in her mid-60s with four adult children. Having seen her parents' estates devastated by estate taxes, she is determined to avoid that result for her own children. She meets regularly with members of her estate planning team (lawyer, accountant, and financial planner/ investment advisor) to discuss estate tax-reduction strategies. One result of these discussions is that, in 2004, Jeanette gives her residence, a condominium worth $1 million, to a qualified personal residence trust, or QPRT. The trust provides that Jeanette may continue to live in the condo rent-free for the 15-year term of the trust. During that term, Jeanette will be sole trustee of the trust, and continue to pay all expenses of the condo (such as property taxes and condo association fees), so for the next 15 years her living arrangements will not change. If Jeanette decides to sell the condo, the sale proceeds will belong to the trust. In that case, the trust can either reinvest the proceeds in another residence for Jeanette to live in, or pay Jeanette a cash annuity for the balance of the 15-year term. At the end of the 15 years, if Jeanette is still living then, things will change. At that point, her four children become the "beneficial owners" of the trust. 12

13 Jeanette will continue as trustee, and she will still have the option to live in the trust-owned residence, but she will have to start paying rent to the trust just as any other tenant would. The rent will flow through to her children as trust beneficiaries. Because Jeanette has made a gift to her QPRT, she must file a gift tax return for Even though the condominium she gave away is worth $1 million, the value of her gift, for gift tax purposes, is only about $300,000. There is no gift tax payable because her gift is less than her lifetime gift tax exemption amount. (If she had already used up her exemption on other gifts, she would have to pay about $125,000 in gift taxes.) While Jeanette is setting up her QPRT, her same-age friend Marla, who owns an identical condo unit down the hall, and is just as wealthy and estate tax-averse as Jeanette, is doing no estate planning. Because the federal government is flirting with repealing the estate tax, Marla is going to "wait and see"-maybe the estate tax will go away (now maybe not so much) Flash forward 25 years, when Jeanette and Marla die. It turns out the estate tax never was repealed. Jeanette continued to live in her trust-owned condominium for the rest of her life, paying rent to the trust for her occupancy for the last 10 years. 13

14 Both women's condominiums appreciated about four percent per year and are now worth $2.6 million each. Marla's condominium is included in her estate for estate tax purposes, and adds about $1.2 million to her children's estate tax bill. Jeanette's condo, though, is out of her estate; her children inherit it without paying any estate tax. Jeanette's children's transfer tax "cost" of inheriting Jeanette's condo is that Jeanette used up $300,000 of her lifetime gift and estate tax exemption to make her gift to the QPRT way back in That much exemption is worth about $144,000 in estate taxes, so that amount, plus the several thousand dollars of professional fees required to create the QPRT, is all Jeanette's children paid to inherit this asset. The QPRT saved over $1 million of estate taxes for Jeanette's children. That's not even counting the $100,000 a year in rent Jeanette paid to her children for the 10 years that she lived after the end of her 15-year QPRT term. 14

15 The children had to pay income tax on that $1 million of rental income, but their income tax rate is about 10 points lower than the estate tax rate they would have had to pay if they had inherited this money from Jeanette rather than receiving it as rent. So, the rental arrangement saved another $100,000 of taxes-without even considering the appreciation that the children earned by investing the rent payments they received from Jeanette. That appreciation would have been part of Jeanette's taxable estate had she not paid rent to her children. The QPRT Jeanette created in 2004 does have some quirks. If Jeanette had died before the end of the 15-year term, the trust's assets would have "reverted" to her estate; in effect the trust would have been cancelled in that case, and not produced any estate tax savings. The QPRT Jeanette created in 2004 does have some quirks. Another quirk is that if any of Jeanette's children had died prior to the QPRT term's end, that child's issue would not have received a share of the QPRT; the trust would pass only to Jeanette's living children. The QPRT Jeanette created in 2004 does have some quirks. These odd provisions were required (under our complicated tax law system) to preserve the taxsaving objective of the trust. Jeanette blunted their effect by buying some term life insurance: on her own life (to provide the children with a cash payout if they did not receive anything from the trust because she didn't survive the QPRT term), and on her children's lives (so that if a child did die prematurely, and lost his or her share of the QPRT, the child's heirs would receive insurance cash instead). 15

16 QPRT - Who Should Get One? QPRTs - Who Should Get One? FOR NOW A widow, widower, divorced person or single individual who is over age 50 and in good health, with total assets worth $5 million or more, including a residence worth $500,000 or more, who wants to save estate taxes for his or her children. The key ingredients are wealth, health, a valuable residence, and the goal of saving taxes for offspring. QPRT - Who Should Get One? FOR NOW A married couple in their 50 s (or older) with total assets worth $10 million or more, including one or more residences, who want to save estate taxes for his or her children. Again, the key ingredients are wealth, health, a valuable residence, and the goal of saving taxes for offspring. QPRT - Who Should Get One? FOR NOW Many clients who adopt QPRTs do not fit these exact profiles, but he previous descriptions would be the most common tyoes of QPRT donors FOR NOW Beware of transferring a residence which is encumbered by a mortgage. As with any gift of encumbered property, if the donor remains liable on the mortgage and continues to pay the note, he or she is making an additional gift with each principal payment. You should still be able to transfer encumbered property to a QPRT by providing, either in the QPRT instrument or in a separate agreement between the grantor and trustees, that the grantor will remain primarily liable for the debt and that the trustees can look to the grantor for restitution if the mortgagee forecloses or attempts to foreclose on the mortgage. 16

17 Since the QPRT transaction is a gift, the basis of the residence in the hands of the ultimate donee will be the donor's basis. This means that the donee will recognize a capital gain on the subsequent sale of the residence. This income tax consequence is usually mitigated by the greater transfer tax savings. Grantor Retained Annuity Trust or GRATs Similar estate tax strategy to QPRT but work with investments (real estate or other) other than primary residence or vacation home. Ideal investments to fund a GRAT should either anticipate considerable appreciation or generate substantial income. Grantor Retained Annuity Trust GRAT permitted by 2702 Offers opportunity to make transfer with reduced or no gift tax Should be funded with assets that either (i) generate substantial income or (ii) are expected to appreciate substantially in value Grantor Retained Annuity Trust An irrevocable trust that last for a fixed terms of years and pays the person who created it (the Grantor ) an annuity that is fixed or increases up to 20% per year. The annuity must be paid, even if trust assets have not produced income or appreciation. If necessary, the annuity will be paid by returning trust principal to Grantor. At the end of term of years, the property remaining in trust passes to the people that were specified when trust was created (or remains in trust for them). Grantor Retained Annuity Trust Basic Methodology When a GRAT is created, Grantor makes a gift equal to the value of the property contributed to the GRAT less the present value of the annuity Grantor will receive. Annuity is valued using a discount rate specified by IRS each month ("Section 7520 rate") Annuity created in Nov would have been valued using a discount rate of 5.0% (today = 5.6%). Therefore, if GRAT assets produced a total rate of return of more than 5.0% per year, "extra" growth will pass to remaindermen free of gift tax. Grantor Retained Annuity Trust Mortality Risk If Grantor were to die during the term of GRAT, transaction would effectively be undone, but there would, in almost all circumstances, be no adverse transfer tax consequences to the Grantor's estate. GRAT would be included in the Grantor's estate, but estate would receive credit for any gift tax paid when the GRAT was created (or the estate would recover any portion of the Grantor's gift tax applicable exclusion amount used to shelter the gift). 17

18 Grantor Retained Annuity Trust Income Tax Consequences During GRAT term, Grantor will be treated as the owner of the trust assets for income tax purposes and will be taxable on all income of the GRAT. Because the payment of income taxes does not constitute an additional gift by the Grantor, the economic value of the gift to the remaindermen is increased. Grantor Retained Annuity Trust Example Basic GRAT Donor, a 60 year old male, funds a GRAT with appreciated closely held business stock worth $1 million in November 2005 when the Section 7520 rate is 5.0%. Under GRAT instrument, Donor retains a 5% annuity - $50,000 per year -for a term of 10 years at which time assets of the GRAT are distributed to his children. Grantor Retained Annuity Trust Example Basic GRAT Value of Donor's taxable gift is $640,165. Low Interest Loans In a low interest environment (like today) a loan is a simple but useful tool. The favorable interest rate allows the borrower to increase his/her wealth if borrower s return on investment is greater than the interest charges by lender. Low Interest Loans To avoid imputed interest and gift tax consequences, the loan should bear interest at the applicable federal rate under Section 1274(d). Loans made in November 2005 with terms of greater than three and less than nine years are required to bear interest of 4.19%, compounded semi-annually. Low Interest Loans A parent may make a low-interest rate loan to a child in order to enable a child to invest in real estate with no or less institutional financing. Lender may periodically forgive the interest payments or a portion of the outstanding principal, but caution should be used to avoid impairing the status of the transaction as a loan. 18

19 Low Interest Loans In the context of an intra-family loan, forgiveness of a loan will be deemed a gift. If all interest and principal payments are forgiven, the Service can be expected to argue that the transaction was intended to be a gift from the outset. Installment Sales Basic Structure Allow a taxpayer to freeze the value of the assets sold for transfer tax purposes, while avoiding the application of Chapter 14. Basic transaction is simple: A tax payer sells an asset to members of his family or to a trust for the benefit of members of his family for fair market value. The purchase price is paid with a small cash down payment and the balance evidenced by a promissory note. Installment Sales Transfer Tax Consequences Seller's estate will now contain a fixed-value asset-the purchase price-instead of the sold asset, which was expected to appreciate in the future. There is no taxable gift, provided that the purchase price represents fair market value, and the note bears interest at least equal to the applicable federal rate under Section Installment Sales Transfer Tax Consequences If the Service determines that the value of the asset is greater than the purchase price, the difference in value will be deemed a gift. Similarly, if the interest on the note is too low, it will be treated as a low interest rate loan. Interest will be imputed for income tax purposes, and the seller will have made a gift based on the amount of forgone interest. Installment Sales Transfer Tax Consequences Transaction is not subject to Chapter or 2702 Allows for sale on 25 year interest only loan. Installment Sales Income Tax Consequences Seller realizes gain or loss for income tax purposes. The buyer's basis in the asset is the purchase price. There is no step up in basis for future appreciation up to the time of the seller's death. 19

20 A self-canceling installment note ("SCIN") is an installment note that is automatically extinguished at the death of the seller. Therefore, if the note remains unpaid at the seller's death, the unpaid balance of the note is not included in the seller's gross estate. This is the primary advantage of the SCIN over a straight installment sale. The consideration paid in a SCIN transaction must be greater than the consideration paid in a straight installment sale of the same asset. Either the purchase price or the interest rate must be adjusted to include a premium to compensate the seller for the risk that the note will not be paid in full before the seller's death. The parties should give consideration to the respective income tax consequences of either form of premium. Without such a premium, the transaction may be recast as a gift with a retained life estate (at least to the extent of the excess of value received), leading to all or part of the value of the asset being included in the seller's estate. Term of the SCIN should not exceed the seller's actuarial life expectancy to avoid the risk that the Service may recast the transaction as a private annuity. Since the risk premium is based on the seller's actuarial life expectancy, it is advisable to use a SCIN for a seller whose actuarial life expectancy greatly exceeds his actual life expectancy. A longer life expectancy reduces the risk that a seller will die before the end of the installment obligation and therefore requires a smaller premium. The SCIN is ideal for a seller in poor health, not likely to outlive his life expectancy but who is not terminally ill. If the seller outlives the installment payment period, the self-canceling feature has no meaning. The seller will have received more consideration than she would have in a straight installment sale. If the seller dies before all of the installments come due, the self-canceling provision of the note relieves the buyer of the obligation to continue payments. 20

21 The parties must respect the form of the transaction in order to avoid estate tax inclusion. Secured Note or Unsecured Note Timely Appraisals Used Did Buyer (Child) Lack Funds to Repay the Note. Advantages If seller dies during term of the note, the unpaid balance of the note is not included in his gross estate Immediately freezes the value of the asset sold for gift and estate tax purposes and transfers future appreciation on the asset to buyer Seller receives an income-producing asset (a note) Advantages May limit the amount of income generated by the asset sold (provided the installment income is structured to be less than the income produced by the asset sold) Ability to use installment sale method of reporting income Advantages Buyer takes a basis in asset equal to purchase price, as opposed to the donor's basis in the case of gift. This is so even if seller dies before note is completely repaid Buyer gets an interest deduction for income tax purposes Provides opportunity for seller to forgive all or a portion of each installment obligation. Disadvantages Immediate recognition of income on sale and additional interest income If buyer is related to seller and buyer transfers the asset within two years of the sale, seller must immediately recognize deferred portion of gain Disadvantages Seller will be taxed on gain and interest income as if cash were received if seller forgives note. Such cancellation of indebtedness by the seller is treated as a disposition of the installment obligation which triggers income recognition 21

22 Disadvantages Increased sales price of asset to account for SCIN premium (either in purchase price or interest rate). SCIN may be recast as a large gift if form of transaction is not respected or if value of asset sold is deemed greater than the selling price. Private Annuities A private annuity is an arrangement whereby one family member (seller/annuitant) sells property to another family member (buyer/obligor) in exchange for the buyer's promise to make periodic payments to the seller for the rest of the seller's life. Private Annuities At the seller's death, neither the asset transferred nor the annuity received will be included in the seller/annuitant's gross estate. This is because the annuitant is converting the asset sold into a life estate with no other retained right. Private Annuities For income tax purposes, the annuitant recognizes income and a return of basis with each payment received. That is, a portion of each payment is capital (return of basis and capital gain) and another portion of each payment is an annuity taxable as ordinary income. Private Annuities As with the SCIN, a private annuity arrangement should be considered for a seller whose actuarial life expectancy greatly exceeds his actual life expectancy, but who is not terminally ill. Private Annuities Just like the SCIN, the annuitant may forgive some of the annuity obligations. This may be recommended to the extent of the annuitant's gift tax annual exclusion. 22

23 Private Annuities - Advantages At annuitant's death, there is no estate tax inclusion for the property transferred or the value of the annuity Immediately freezes the value of the asset sold for gift and estate tax purposes and transfers future appreciation on the asset to buyer Private Annuities - Advantages Provides the annuitant with a source of income for life Permits annuitant to spread out the gain on the sale of the asset over the annuitant's life expectancy Private Annuities - Advantages A portion of the deferred gain on sale will not be recognized if the annuitant dies before his life expectancy. Buyer takes a basis in asset equal to purchase price, as opposed to the donor's basis in the case of gift. Private Annuities - Disadvantages The annuity obligation must be unsecured. If the obligation is secured, the entire gain on the sale of the asset must be recognized. If income from property sold is equal to the value of the annuity paid, there may be estate tax inclusion under Section Private Annuities - Disadvantages If the annuitant outlives his life expectancy the annuity payments must continue. If annuitant dies prematurely, obligor's income tax basis is reduced to value of payments actually made. The interest component of the obligor's payments is not deductible by the obligor. Law Office of John P. Bradbury New York Real Estate Lawyers / (212)