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A private annuity is a transaction in which you transfer property, typically a business or appreciated real estate, to a buyer in exchange for their unsecured promise to make periodic payments to you for the rest of your life. No insurance company is involved. No commercial annuity product backs the arrangement. The buyer is usually a family member or closely held entity, and the obligation is a personal commitment, not a registered financial product.
Think of it as a private installment sale structured around your lifespan rather than a fixed term.
You identify an asset with substantial appreciation, such as a business interest worth $3 million with a cost basis of $200,000. You transfer that asset to the buyer. In exchange, the buyer commits to making fixed payments to you each month or year for as long as you live.
The Internal Revenue Service requires the annuity payments to be calculated so that their present value equals the fair market value of the transferred property. That present value calculation uses the Internal Revenue Service Section 7520 discount rate published monthly based on prevailing interest rates. If you live longer than your life expectancy, you receive more than the asset was worth. If you die early, the buyer has received the asset for less than its full value.
The most common reason for using a private annuity is the treatment of capital gains. In a traditional sale of appreciated property, you recognize the full capital gain in the year of the sale. In a private annuity, you spread the gain recognition over the payment period. Each payment you receive consists of three components: return of basis, capital gain, and ordinary income.
This installment sale treatment defers the capital gain over your lifetime rather than accelerating it to the year of transfer. For a business owner facing a $2.8 million capital gain on the sale of their company, spreading recognition over 20 years of retirement can be dramatically more tax-efficient than paying the full gain in a single year.
Because the private annuity obligation dies with you, no value passes to your heirs through the annuity payments. The asset has left your taxable estate at the time of transfer. If you die before receiving the full present value equivalent of the transferred property, the remaining unpaid value passes to the buyer free of gift and estate tax.
This feature makes private annuities attractive for business succession planning where a parent wants to transfer a business to an adult child while removing the asset from the estate and receiving income during retirement.
The entire arrangement rests on the buyer's ability and willingness to make payments for your lifetime. There is no insurance company guaranteeing performance, no trust protecting assets, and no regulatory framework requiring the buyer to fund the obligation. If the buyer cannot pay or refuses to pay, your recourse is a lawsuit against a family member or a closely held company that may not have the resources to honor the commitment.
Private annuities became significantly less attractive after 2006, when the Internal Revenue Service issued regulations requiring immediate gain recognition if the annuity payments are secured by the transferred asset. Before 2006, practitioners routinely backed private annuities with collateral; they rarely do so today because it eliminates the installment sale deferral benefit.
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