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PRIVATE ANNUITY TRUSTS GET NEW LEASE ON LIFE

Sure, individual retail real estate investors want to defer capital gains taxes on the properties they sell. But those who want to avoid the hassles of finding and buying the replacement properties a 1031 exchange requires could opt for an estate-planning vehicle called a private annuity trust.

These private annuity trusts, or PATs, are best-suited to investors who are finished actively trading real estate or are ready to retire, says Kevin McBarron, president of the National Association of Private Annuity Trusts. But they also work for investors who cannot find a property appropriate for a like-kind 1031 exchange or who believe an exchange property has achieved its income potential.

PATs are essentially installment plans for deferring capital gains taxes. A shopping center owner sells a property to the trust and gets paid an annuity. IRS guidelines typically require these annuity payments to start when the seller reaches 70.5 years of age. The PAT trustee can sell the property and invest in other real estate or in stocks.

The PAT system can be a money saver. Say an investor sells a $1 million property minus an initial investment and allowable expenses of $200,000 for a profit of $800,000. That sale would normally incur a 15 percent federal tax plus, possibly, a state tax of, say, 5 percent. Thus, the investor would owe about $160,000 in capital gains taxes, according to the Salt Lake City-based National Association of Financial & Estate Planning (NAFEP). Assuming the net investment cash earns 6 percent pretax over the next 20 years and that the seller begins getting annuity payments at, say, 65, he would receive $330,119 under the PAT plan, versus $277,300 a year if he paid the tax. Over the 20 years, that is a difference of $1 million.

This PAT structure, a tax shelter for such value-appreciating assets as land, art and stock, has in fact existed in one form or other for years, says Chris Wetherall, director of NAFEP. The trusts were modernized in 1955 when the IRS formalized their taxation. A series of subsequent court cases and IRS rulings solidified the guidelines, and lawyers began applying them more broadly, says McBarron.

The vehicle is gaining considerable popularity. More brokers and realtors are becoming certified estate advisers so they can offer PATs to their clients. NAFEP reports a 35 percent increase in estate planning transactions, estate adviser training and PAT services between 2002 and 2003. By late October PAT-related activity was up 90 percent against last year. Though NAFEP cannot identify how much of its business is dedicated to retail real estate, it says that between 90 and 95 percent of its current PATs are commercial-real-estate-related.

Low cap rates are creating interest in the instrument by discouraging investors from making new purchases, says McBarron. The cap rate for retail deals in California averaged 7.8 percent at the end of August, for instance, the lowest in the country, according to Real Capital Analytics, a New York City-based real estate research firm. Some investors “will not step up to the plate at these cap rates,” McBarron said.

Further, investors are asking more questions about PATs and are getting more comfortable with them as a tool for retirement and financial planning, says McBarron.

But PATs will probably not overtake 1031 exchanges, says Wetherall. Rather, it is more likely they will be used as a complement, since shopping centers held in PATs can subsequently be used in a like-kind exchange.