Now comes the actual sale. The IDGT gives an installment note to the client for the property's appraised value, adjusted for any appropriate discounts. There is no capital gains tax on the sale, Keebler says, because the trust is the grantor's alter ego for income tax purposes and transactions with oneself are not taxed. Likewise, although the trust must pay the grantor interest on the note at the applicable federal rate (AFR), there is no tax on the interest income.
Suppose a defective trust sale was completed in October, when the AFR for notes maturing between three and nine years was approximately 3.6%. Further imagine the trust property earning 200 basis points more than that, or 5.6%, in the first year. The trust has to pay 3.6% interest to the grantor, so her estate grows by that amount, minus the trust taxes she pays. Meanwhile, the 200 basis point excess return remains in the IDGT, where it bypasses transfer tax. So does any appreciation in the trust assets.
Selling assets to an IDGT for a private annuity, rather than an installment note, helps clients get assets out of their gross estate immediately, says Gerald Townsend, president of Townsend Asset Management in Raleigh, N.C. The client must have a life expectancy of at least one year and can't be terminally ill. Yet, if she does not survive the life expectancy shown in IRS tables, this type of transaction can lop off a big chunk of an estate. It's best to use income-producing property intended to be held long term.
Here's how it works: After priming the IDGT with cash and having the property appraised, the client sells it to the IDGT, which issues the private annuity-an unsecured promise to pay the client a fixed amount regularly, typically for life. (That's why income-producing property is recommended. Its cash flow makes it easier for the trust to pay the annuity.) In order to avoid gift tax consequences, the value of the transferred property must equal the present value of the payment stream.
The annuity payments obviously flow back into the grantor's estate, but consider the case of a 90-year-old nursing-home resident that Townsend is currently working on. He has recommended that the elderly man transfer $500,000 of real estate to a defective trust in exchange for a private annuity. Based on a five-year life expectancy, 4.4% Section 7520 interest rate and other factors, the client's annual nontaxable payment from the trust would be about $132,000. Therefore, if he dies after receiving two annual checks, the transaction will have sliced his estate by roughly $236,000-$500,000 property transferred out, minus $264,000 received from the annuity. The estate is further lowered by any taxes paid on the trust income.
The major downside, ghoulish as it may seem, is that the client could live a long time. All those annuity payments would fatten the estate, which would then have to be trimmed again via other strategies. "A private annuity is like taking a pill to lose five pounds right now and worrying about improving your diet later," Townsend says.
It's also important to note that the trust beneficiaries inherit the grantor's basis in the property. There is no step-up. In effect, then, the strategy saves the grantor estate tax but costs inheritors capital gains tax. But the latter is much cheaper and isn't triggered until the asset is sold-if it's sold. Townsend says, "Because the asset in this case is real estate, the heirs should be able to do a Section 1031 like-kind exchange. So potentially you've got some extremely long-term deferral on the income tax side."
While the certainty rendered by Rev. Rul. 2004-64 obviously makes the present a good time for transactions such as these, low interest rates do, too. For current IRS money rates, go to www.irs.gov/taxpros/lists/0,,id=98042,00.html.
When the Annual Exclusion Just Isn't Enough
Suppose your clients want to give their recently married daughter $80,000 for the down payment on a home-without gift tax consequence. One individual can give another $11,000 gift tax-free per year under the so-called annual exclusion. So married clients can transfer $44,000 to another couple each year.
The $36,000 gap?