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Question: My client set up a Private Annuity Trust (PAT) to defer taxes on the sale of appreciated real estate. The trustee bought a deferred annuity to help make payouts, but the annuity isn’t generating enough income. What are the consequences of cashing out the annuity?
Answer: Wikipedia has an entry that describes how pre-2007 private annuity trusts (PATs) were used to defer income taxes on the sale of a capital asset:
To respond to the question, we’ll make the following guesses regarding the arrangement:
- The grantor sold an appreciated capital asset to the PAT prior to October 2006, in exchange for regular annuity payments.
- The trustee of the trust sold the asset to a third party, getting a lump sum in return.
- The trustee of the trust used the lump sum to buy the deferred annuity that is the subject of the question.
- The trustee of the trust is taking regular distributions from the deferred annuity to meet the payment obligations to the grantor.
- The distributions that can be taken from the deferred annuity are insufficient to meet the payment obligations established under the PAT.
Any taxable gain in the annuity not previously recognized by the trust in annuity would be taxable—probably to the trust itself (depending on how the trust is written).
Assuming the trustee honors its obligation to make regular payments to the grantor, the grantor would continue to be taxed under normal pre-2007 PAT rules as payments are received.
PATs are highly technical and fact-specific. In all situations of this type, we recommend getting the client’s accountant involved in the discussion for real answers that will apply in the client’s situation.
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