Private Annuities
A private annuity differs from a commercial one in two respects. First, ordinary property other than cash, normally real estate, is used to acquire the annuity and, second, the promise to make the payment is made by an individual, often a son or daughter rather than an insurance company. Payments under a private annuity are payable periodically, but they usually cease upon death of the annuitant.
A private annuity can be used if a parent wants to transfer a farm or ranch to a child in exchange for a guaranteed income for life. However, no mortgage or other security (except life insurance in the event of death) may be given to the parent to guarantee payment of the required annual amount. Some parents might consider such an arrangement a serious drawback. In addition, there may be adverse income tax consequences to the child should he sell the real property acquired by the annuity prior to the annuitant’s death. The tax basis becomes the sum of all annuity payments.
Generally, private annuities are discouraged in estate planning; however, there may be exceptions. If a child agrees to pay to the parent a fixed payment for the farm for the rest of the parent’s life and if the parent dies prematurely, the child buying the farm receives a windfall that may make the other children unhappy. On the other hand, if the parent lives longer than a normal life, the child purchasing the farm pays in excess of the property’s value. An insurance company usually is in a financially better position to fund a lifetime annuity than is an individual.
The main advantage of selling the farm for a lifetime annuity is that the farm is not included in the seller’s estate for estate taxes. The main disadvantage to the selling parent is that the buyer’s promise is unsecured and the parent is left with little financial protection if the buyer dies or becomes bankrupt. To enjoy the tax saving features of a private annuity requires that the buyer’s promise must not be secured by seller retaining rights in the property involved. Thus, it is different from a typical installment sale. Each annual payment to the parent is usually comprised of ordinary income, return of capital, and capital gain.
A situation in which the lifetime annuity might be justified is where the parent has several farms, is short of liquid assets, such as cash, is unable to take advantage of the annual gift tax exclusions and all of his children are interested in buying a farm. In this case, if a default occurs, the parent would still have land and income remaining from the other farms. Also, if all children were involved, a charge of favoritism to one child could not be made.
The parties involved in a private annuity should seriously consider all tax ramifications of private annuity transactions. Private annuities often result in liability for income and gift taxes. Check with your attorney and tax accountant for further details on private annuities.