Estate Planning Bits

Private annuities have advantages and disadvantages

Many people purchase annuities through their banks, financial advisors or insurance companies. These provide the annuitant with a steady stream of income, usually only for the remainder of his or her life, but sometimes the annuity does continue for a period of time or a specified number of years.

However, there is another option called a private annuity. When structured properly, this arrangement supplies the annuitant with a stable stream of (retirement) income, maintains all assets within the family, allows investments to be maintained by the person who is holding the funds, and also minimizes the tax burden for heirs.

The private annuity is normally drawn up between an older family member who wishes to remove a sizable asset from his or her estate and a younger family member who would otherwise inherit the asset at a later date and time. Under the terms of the annuity, the younger family member agrees to pay a certain sum of money for the lifetime of his or her parent, normally for the annuitant’s lifetime, in exchange for the asset transfer. These often include a family business, real estate, stocks and bonds or perhaps even bank accounts and certificates of deposit.

While an outright transfer from a parent to a child is normally construed to be a gift and subject to gift tax, an annuity normally avoids the gift tax because it is considered a sale of the property. There could be recognition of capital gains as well as ordinary income upon receipt of the funds for the younger generation, but with the maximum capital gains rate at 15% (not counting AMT) it is normally a bargain to sell the property and then allow the younger generation to have a higher basis for the property.

It is important to note that the structure of the agreement must be for fair market value, or any amount in excess of the sale amount may be construed to be a gift. In addition, the parent must be prepared to fully relinquish and release any and all control over the asset being sold. This includes voting rights in a business, trust, or stock that is the subject of the sale.

From the perspective of the heirs, a potential drawback would be that the parent could live longer than expected, resulting in more funds to be paid than anticipated, thus eliminating any benefit of estate tax savings. In addition, if the funds are invested and do not produce as much income or growth as anticipated, then the obligor of the annuity must still make the monthly or yearly payments in order to maintain the qualification of the private annuity.

The elder in the transaction should be cautious of a private annuity, since it is not secured by any assets. One should not enter into an arrangement with any other person unless there are sufficient funds otherwise available so that the elder is not dependent upon the income to be received from the private annuity. After all, the child may not invest the sums properly, or he may die, become disabled or divorced, etc., in which case the assets may then be available to the child’s creditors.

While a private annuity is a wonderful option for certain situations, any individual who is interested in establishing this type of arrangement should consider all other options available before entering into it.

By: Hyman G. Darling, Esquire

Using 1031 (Like-Kind) Exchanges to escape taxes

Under a section of the Internal Revenue Code which has been around for years, it is permitted to defer capital gains tax on the sale of property which is held for investment or productive use in a trade or business. This is known as a Section 1031 Exchange. The most common of these types of exchanges one is where property is sold, (the “relinquished property,”) and the proceeds are used to purchase some other property called “replacement property.”

There are certain timeframes that must be met in order to allow this transaction to be completed properly. In addition, the seller of the property is not entitled to retain and hold the proceeds, rather there is a person or entity called a “qualified intermediary” who is charged with the responsibility of holding net proceeds of this sale to be used to purchase the new property.

It must be noted that a 1031 Exchange not only facilitates deferral of the capital gains tax, but also its appreciation recapture and state sales taxes. All of these taxes together could equal 50% of the net gain, which is now available as a deposit on the newly acquired property, rather than being spent on taxes.

There are certain steps that must be taken in order to permit this transaction to occur:

The first is that prior to the sale of the relinquished property, the seller must complete documentation to allow the funds to be held by the intermediary. At the closing, the funds are transferred to him or her until the new property is purchased.

The second step is that the seller must identify the property to be purchased (replacement property) within forty-five days following the sale of the relinquished property. He or she may even identify more than one as potential replacement property, and it should be noted there are additional alternate rules for this.

The third step is that the seller must obtain a replacement property within one hundred eighty (180) days following the sale of the relinquished property. At the closing, the proceeds must be conveyed directly to the qualified intermediary, and the seller receives the deed to the replacement property. In addition, the replacement property cannot have been previously owned by the seller.

If the preceding requirements aren’t met, then the benefit of the exchange will not be available.

A 1031 exchange is also commonly referred to as a “like-kind exchange.” This basically means that the properties sold and acquired must be similar. In most cases, when the property is real estate, the seller must be able to identify and exchange one parcel of real estate for another. For example, a shopping center may be exchanged for raw land or an office building.

However, in personal property, the rules are much more restrictive. For example, a car is not a like-kind for a truck.

In addition, there must be common ownership, which means that the selling party must also be the party purchasing the replacement property, or may be what is construed to be a disregarded entity with respect to the selling person. An example of a disregarded entity is an entity such as an LLC or a trust, where a sole tax-payer holds 100% of the beneficial interest in the entity. If a partnership is involved, the same parties must be owners of the sale and the new purchase.

In addition, the purchase price of the newly acquired property must be greater or equal to the value of the property being sold. If this is not the case, then a tax will be due on the difference.

As with all transactions, especially those that are tax favored, there must be strict compliance with all technical rules or the benefits will be lost. When considering a 1031 exchange, it is important to obtain all of the necessary information prior to the property even being listed for sale, so that there will be no potential loss of tax benefits. In this type of transaction, it is important to have qualified legal counsel, qualified tax assistance and also qualified real estate advice prior to entering into any transaction.

By: Hyman G. Darling, Esquire

Tax law changes may impact you

In May, President Bush signed into law The Tax Increase Prevention and Reconciliation Act (The Act). This provides good news for investors with taxable capital gains and dividend income, and it also provides bad news by expanding the reach of the “kiddie tax” on unearned income from assets owned by a child.

In 2003, the legislation was passed that reduced the tax rate on capital gains and dividends to 15% for middle and upper income taxpayers. That legislation was scheduled to revert to the former, higher rates at the end of 2008, but The Act extends the favorable, 15% rate until the end of 2010. Of course, the favorable rate is only applicable to assets held for more than one year. Those assets held for less than one year are still taxed as ordinary income, as well as dividends distributed by some real estate investment trusts and certain tax-exempt organizations.

Current law prevents converting traditional IRAs to Roth IRAs if the your adjusted gross income is more than $100,000, but beginning in 2010, the Act eliminates this income cap. You may want to consider converting your traditional IRA to a Roth IRA because Roth IRAs offer tax-free qualified withdrawals. As always though, please discuss your particular situation with a tax professional before converting your IRA.

There is bad news though for parents who pass income-producing assets to their children. Previously, the Act applied to children up to age 14. The Act extends the existing tax rules to children up to age 18. Specifically, the first $850.00 of unearned income from assets owned by a child is free from federal taxes. The next $850.00 is taxed at the child’s rate. Any unearned income above those amounts is taxed at your rate, as the parent.

Consult a tax professional if you have additional questions about how these changes may affect you and if you are able to take advantage of these them.

By: Brett A. Kaufman, Esquire

Distributing your property among your children when you die

When considering the preparation of a Will, one of the decisions your must make is the distribution of your tangible personal property. These items typically include jewelry, collectibles, art and other mementos that you’ve collected during your lifetime. Sometimes you’ll leave an item of material value to a person or charity, and other times, an item of sentimental value may be left for a personal reason to friend or family member in order to preserve a memory.

Too often, the question arises in families as to the distribution of the tangible personal property. It is normally desired that your family distribute the property in a friendly and harmonious manner, but this frequently is not the case. Therefore, you may either leave a separate memorandum with your Will that itemizes the specific property left to certain individuals, or you may include this language within you Will itself. In the alternative, you may simply put small stickers on the bottom of item, with a letter, and have a separate attachment listing all of the items and individuals to receive the property.

In addition, some people have videotaped their house, and not only specified on the video who should receive each specific item, but also provided details on how the property was acquired so that there will be a perpetual history of that item. A complete record of detailed descriptions of your items and the individuals to whom they should be left, should cause less confusion, anxiety or problems within your family relative to the distribution of your assets.

In the event that the creator of a Will is incapacitated and permanently institutionalized outside of the home, then perhaps the agent under the Durable Power of Attorney will have the authority to make these distributions during the lifetime of the donor in lieu of waiting until the estate is probated.

In any event, it is always preferable to have as much detail as possible to eliminate the necessity of probate and facilitate your estate’s administration. When probate is necessary, and there is a problem relative to the distribution, it may help to insert language within your Will that directs options to occur in the event that the tangible personal property is unable to be distributed in concert with your family.

One option is to force each legatee to purchase from the estate each item they wish to have. But this can cause a bidding war. Another option is to allow individuals to select an item of property from the house by rotating selections, possibly starting with the oldest to youngest child. There could also be a system of “drawing straws,” which again allows individuals to select items rather than force a sale. Another alternative is to merely state that your children must agree on the equitable distribution of the tangible property upon their your death, and if they are not harmonious in the distribution, then you will “come back to haunt them.” ;)

By: Hyman G. Darling

How the Marital Deduction may be a disadvantage

One of the benefits of being married is a legal principal called “The Marital Deduction.” In essence, this means that with a few exceptions, any assets passing to a spouse are exempt for both income tax and estate tax consequences. Therefore, if a wife dies and leaves all of her funds, without limitation, to her husband, there will not be any estate taxes due at that time. However, if the threshold for filing a tax return is met, then it will be necessary to file an estate tax return merely to establish that the Marital Deduction is being utilized to eliminate taxes. The deduction applies whether or not the assets are joint, payable by contracts such as insurance, names the spouse as the beneficiary of a retirement plan or even if the assets are in the decedent’s name alone and the assets pass by Will to the surviving spouse. In all of the aforementioned cases, the Marital Deduction applies so that no tax will be due.

However, it is at the second death that Uncle Sam taxes all of the assets, and the utilization of the Marital Deduction in the first estate will prove to be a detriment. This is because the exception that the first decedent had for estate tax purposes, currently two million dollars at the Federal level, is lost. The exception is not used for assets passing to a surviving spouse, as these assets automatically qualify for the marital deduction, since all assets passing outright to a spouse must take advantage of the deduction. If the exception had been used, then the first two million dollars of assets in the surviving spouse’s estate would not have been included, and the surviving spouse would also have her two million dollar exemption, thus providing a total of four million dollars in assets to pass to the next generation.

If a client does not have assets totaling two million dollars, which may include all stocks, bonds, cash, life insurance, real estate and other assets, it may not be necessary to worry about the Marital Deduction and loss of the credit, since the estate will not exceed the threshold for estate tax purposes. However, it is wise to be mindful that any assets in excess of the two million dollar threshold will be taxed at the rate of 46%, and this tax will be imposed on all assets after exemptions and deductions. Since many of the assets in an estate have already been income taxed when they were earned, at death they are going to be estate taxed, which will only further reduce the amount of money that may pass to children and grandchildren.

By: Hyman G. Darling, Esquire