605 / How are payments taxed that are received under a private annuity issued before October 19, 2006?

The basic rules for taxing the payments received by the annuitant under a private life annuity issued before October 19, 2006, are set forth in Revenue Ruling 69-74.¹ According to this ruling, the payments must be divided into three elements: (1) a “recovery of basis” element; (2) a “gain element” eligible for capital gain treatment for the period of the annuitant’s life expectancy, but taxable as ordinary income thereafter; and (3) an “annuity element” that is taxable as ordinary income. Each of these is discussed below.

(1)     The portion of each payment that is to be excluded from gross income as a recovery of basis is determined by applying the basic annuity rule ( Q 527). Thus, an exclusion percentage is obtained by dividing the investment in the contract by the expected return under the contract. The investment in the contract in a private annuity situation is the adjusted basis of the property transferred. If the adjusted basis of the property transferred is greater than the present value of the annuity, the annuitant’s investment in the contract for purposes of IRC Section 72(b) is the present value of the annuity on the date of the exchange.² Expected return and annuity starting date are the same as explained in Q 534 and Q 536.Thus, expected return is obtained by multiplying one year’s annuity payments by the appropriate multiple from Table I or Table V of the income tax Annuity Tables, whichever is applicable depending on when the investment in the contract is made.

If the annuity starting date is before January 1, 1987, the amount calculated to be excludable from income as a recovery of basis (as explained above) is excluded from all payments received, even if the annuitant outlives his or her life expectancy. If the annuity starting date is after December 31, 1986, then the exclusion percentage is applied only to payments received until the investment in the contract is recovered. Thereafter, the portion excludable under the percentage is included as ordinary income.³

(2)     The capital gain portion, if any, is determined by dividing the gain by the life expectancy of the annuitant. Gain is the excess of the present value of the annuity (it may not be the same as the fair market value of the property) over the adjusted basis of the property. The present value of the annuity is obtained from the Estate and Gift Tax Valuation Tables (see Q 921). The life expectancy of the annuitant is obtained from Table I or Table V of the income tax Annuity Tables, whichever is applicable depending on when the investment in the contract is made. This portion is reportable as capital gain for the period of the annuitant’s life expectancy, and thereafter as ordinary income. Recovery of capital gain may not be deferred until the entire investment in the contract has been recovered.⁴

(3)     The remaining portion of each payment is ordinary income.

If the fair market value of the property transferred exceeds the present value of the annuity (as determined from the applicable Estate and Gift Tax Valuation Tables), the difference is treated as a gift to the obligor ( Q 586).⁵

Example. Mrs. White is a widow, age 66, with two adult children. She owns a rental property with an adjusted basis of $30,000 and a fair market value of $135,000. On January 1, she transfers this building to her children in exchange for their unsecured promise to pay her $1,000 a month ($12,000 a year) for life beginning January 31.