Intergenerational Transfers: Private Annuities
Tree Farmer Magazine: March/April 2001 - Volume 20, No. 2
Many tree farmers want to transfer ownership to the next generation before they die. This may reduce the size of your estate and provide a real incentive for the kids to get involved. Transferring legal title is simply a matter of abiding by real estate transfer law for your state. It's the tax aspects that cause heartburn.
If you don't receive payments, the present value of which equal the fair market value of the tree farm at the time of transfer, you''ve made a gift. The amount of the gift is the fair market value of the tree farm minus the fair market value of whatever you receive in return. You can receive cash or its equivalent, or any legally binding contract for which the value can be determined. This includes an annuity contract. This is contract obligating someone (obligor) to pay someone else (annuitant) a determined amount annually for as long as the annuitant lives.
The annuity contract could be a commercial contract your heir purchase with you named as the annuitant, but this would not provide the major tax benefits available to you and your heirs. It could also be a private annuity with you as the annuitant and the heir as the obligor. This is the option discussed here.
The older you are, the higher the required payments would need to be to equate the present value of the payments at a specified interest rate and the fair market value of the tree farm. The IRS "strongly suggests" that the proper way to determine the present value of an annuity is to use the valuation tables in Code Sec. 7520. The tables are based on life expectancy for someone of a given age.
Estate tax considerations
If you sell your tree farm and take an annuity contract in payment, you no longer own it. If the present value of the annuity payments equals the fair market value of the tree farm at time of sale there will be no gift tax. Any appreciation in its value after the sale will not be included in your estate. Of course the annuity payments will be included unless you have a plan to transfer these amounts with a gifting or charitable contributions program, or unless you use the payments to meet living expenses.
You would want to carefully assess the risk associated with depending on a private annuity to meet living expense needs. If you depend on the annuity payments for living expenses, donating the tree farm to a major charitable organization with the capacity to make guaranteed payments to you for life might be a better option.
Exclusion from your estate requires that the transfer be an " arm's-length" transaction. You should not retain any security interest in the Tree Farm and the amount of annuity payments should not be tied to income the obligor derives from the Tree Farm.
Since the fair market value of a given parcel of land and timber is somewhat subjective, the best possible appraisal should be obtained to reduce the likelihood of fair market value becoming an issue with the IRS when your estate is settled.
Income tax considerations
If you wanted to convert your tree farm into an annuity directly you would have to sell the farm, pay taxes on the gain and then buy a commercial annuity. By selling for a private annuity the gain is not immediately recognized. Rather it's spread over your life.
A portion of each year's payment is recovery of capital, i.e. your basis in the tree farm, and is not taxed. The balance is taxable, usually as capital gain. If you live longer than the IRS's life expectancy table assumed, payments received thereafter are fully taxable.
The obligor pays tax on income from the tree farm, but can't deduct the annuity payments since they represent the capital cost for acquiring ownership. Also, if the obligor has to make payments beyond your expected life no loss deduction is allowed.
Security issues
The annuity contract must be unsecured if you want to avoid immediate payment of tax on the gain. Your annuity income must be tied to the obligor's financial health and trustworthiness. If the obligor dies before you do, his or her estate makes the payments. The annuity payments will not reflect decreased buying power resulting from inflation. This is to your disadvantage, but helps the obligor.
Conclusion
Private annuity contracts are one of the many options available to transfer your tree farm to the next generation. Consider all the possibilities and discuss them with your attorney and the heirs involved. We'll look at other options in up-coming issues.
The following article has been reproduced here from the "Tree Farmer" magazine with the permission of the American Forest Foundation, 1111 19th Street, N.W., Suite 780, Washington, D.C. 20036. (Telephone 202.463.2462)