Mrs. Lewis inherited a stock portfolio from her uncle when he died in the 1970s. Over the years, the handful of stocks had appreciated from about $200,000 to over $2.5 million. Despite her advisors' advice - and her own instincts - she could not bring herself to diversify her holdings because of the looming capital gains taxes that she would have to pay. She felt as though the success of her portfolio and reaching her financial goals were out of her control.
Like many others with highly appreciated assets, Mrs. Lewis, who was now 65 years old, had "investment paralysis." She knew that greater diversification and the ability to invest in more income producing assets would provide less volatile returns as well as a more secure income source. But the idea of paying 20% of her gains back in taxes irked her.
Mrs. Lewis began exploring some options with her advisors and was intrigued by the idea of entering a "Private Annuity" arrangement with her two daughters. The Private Annuity strategy is designed to allow for immediate diversification of highly appreciated assets, while spreading the payment of capital gains tax over her life expectancy. She and her daughters signed a private annuity agreement, whereby she sold half of the appreciated stocks to each daughter in return for a lifetime annuity from each of them.
Mrs. Lewis' daughters are now each obligated to pay her $8,500 per month for the rest of their mother's life. The capital gains taxes are paid over the remainder of her life as the annuity amount is paid each year1. As a further tax advantage, if the annuity is properly structured, no matter when she dies, the assets sold in return for the annuity can be passed to her daughters free of gift or estate tax. As soon as she sold the stocks to her daughters, they could begin diversifying the highly appreciated stocks without incurring an immediate capital gains tax and investing in a diversified portfolio, since the daughters have a step-up in basis.
A few months later, Mrs. Lewis revealed that she had purchased a painting for $2,500 in the 1960s. When she heard that the artist's work had become very popular, she decided to have it appraised. She was very surprised to hear that the piece could now fetch over $500,000 at auction! Mrs. Lewis' daughters did not share her admiration for the work and the market for the artist's work had never been hotter, so she decided that now was the time to sell it. But again she was concerned about the huge capital gains tax liabilities, so she sold it to one of her daughters in return for another lifetime annuity. Her daughter sold the painting for $600,000 without incurring immediate capital gains tax.
Using the Private Annuity strategy, Mrs. Lewis and her family were able to diversify some highly appreciated assets and transfer them to the next generation gift tax free, while deferring the payment of capital gains taxes and providing a steady income stream for Mrs. Lewis.
1Note that a portion of each payment will be ordinary income and taxed as such.
This article is for informational purposes only and is not intended as an offer or solicitation for the sale of any financial product or service or as a determination that any investment strategy is suitable for a specific investor. Investors should seek financial advice regarding the suitability of any investment strategy based on their objectives, financial situations, and particular needs. This article is not designed or intended to provide financial, tax, legal, accounting, or other professional advice since such advice always requires consideration of individual circumstances. If professional advice is needed, the services of a professional advisor should be sought.