Private Annuity: Lifetime Payments From Family, and Why the Deferral Is in Doubt

How a private annuity works, in plain English

The seller transfers property to a family member or a trust. In return the buyer promises to pay the seller a fixed annual amount for the rest of the seller's life. The buyer is a private person, not a company that issues annuities, and the promise is normally unsecured, because security was thought to make the gain taxable at once. When the seller dies, the payments stop and nothing is owed.

The amount is set so the present value of the lifetime payments, using the IRS actuarial tables under Section 7520, equals the property's value. If the payments are worth less than the property, the difference is a gift.

The income tax: old rule vs the 2006 proposed regulations

Old rule. In Rev. Rul. 69-74 a father exchanged a capital asset for his son's unsecured promise of a life annuity. The ruling let the father spread the gain over his life expectancy, with each payment split under Section 72 into a nontaxable recovery of basis, capital gain and ordinary annuity income. That ratable reporting is what made private annuities a deferral tool.

Proposed rule. On October 18, 2006 Treasury proposed regulations under Sections 1001 and 72 (REG-141901-05). If an annuity contract is received for property, the amount realized is the contract's Section 7520 value and the entire gain is recognized at the time of the exchange, regardless of accounting method, whether the annuity is secured or not. Rev. Rul. 69-74 would become obsolete. The proposal would apply to exchanges after October 18, 2006, delayed to April 18, 2007 for unsecured annuities issued by an individual where the property is not soon resold.

As of our last check the rules remain proposed: never finalized and never withdrawn. Proposed regulations are not binding, but they state the IRS view, so planning for deferral means planning for a dispute.

The estate tax side

Because payments end at death, nothing from the annuity remains in the seller's estate, and the property is out of the estate if the exchange is a bona fide sale for adequate and full consideration. If payments are tied to the income of the transferred property, or the seller keeps control, the IRS can argue Section 2036 pulls the property back in.

In Estate of Kite v. Commissioner, T.C. Memo. 2013-43, a mother transferred partnership interests to her children for unsecured 10-year deferred private annuities, valued with the IRS tables, and died about three years later before any payment was due. The Tax Court held the annuity transaction was a bona fide sale for adequate consideration, relying on her independent wealth and a physician's opinion that she was not terminally ill. The same opinion found a taxable gift on a related termination of marital trusts, a reminder that the steps around an annuity get tested too.

Who it fits, and who it does not

• Fits: a seller with an estate above the 2026 $15,000,000 exclusion, health below the tables but not terminal, and a buyer with the means to pay for life.
• Fits poorly now: a seller whose main goal is income tax deferral, because the proposed regulations would tax the gain up front.
• Does not fit: a seller who may die within a year. Treas. Reg. 1.7520-3(b)(3) bars the standard tables when death within one year is at least 50% likely.
• Does not fit: a seller who needs security. The payments depend on one family member's ability and willingness to pay, for life.

Worked example (qualitative)

Assumptions: a parent exchanges appreciated land with low basis for a child's unsecured promise to pay a fixed amount every year for life, valued with the IRS tables.

• Under Rev. Rul. 69-74: each payment is split into basis recovery, capital gain and ordinary income, and gain is spread over the parent's life expectancy.
• Under the 2006 proposal: the parent reports all the gain in the year of the exchange, measured by the annuity's table value. Later payments are taxed under Section 72 with that value as the investment in the contract.
• Early death: payments stop. The child keeps the land, with basis based on what the child paid rather than a step-up at the parent's death.
• Long life: the child may pay far more than the land's value, and payments to the parent rebuild the estate.

IRS stance and audit risk

Private annuities are not listed transactions or transactions of interest, but they are high-scrutiny. The IRS challenges the valuation (health, tables), argues gift tax on any shortfall, uses Section 2036 when payments track the property's income, and, for income tax, points to the proposed regulations. Expect questions about whether the buyer can realistically pay. Keep an independent appraisal, a contemporaneous physician's letter, and a payment record.

Costs and fees

Expect estate-planning attorney fees, a qualified appraisal, actuarial calculations, gift tax returns where needed, and annual tax reporting for both sides. The buyer cannot deduct the payments as interest. The economic risk runs both ways: the seller depends on an unsecured family promise, and the buyer bears longevity risk.

How it compares with a Section 453 installment sale

An installment sale has a fixed price, a set term, a secured note and settled deferral under Section 453. A private annuity has an uncertain total, no security, and deferral the IRS has proposed to end, with an estate tax benefit if the seller dies early. A self-cancelling installment note aims at the same estate result while staying under the installment rules. Note: a private annuity is a promise from a family member, not an insurance product; this page analyzes it neutrally and does not offer it.

Hans studies the tax side of these choices. The $5,000 Big Sale Tax Analysis models the income tax under the old and proposed rules side by side with the other paths.

Frequently asked questions