How a Private Annuity Works and Who Uses One

What a private annuity is

A private annuity is a contract between you and another person — usually a family member or a trust — where you transfer an asset (typically real estate or a business) to them in exchange for regular payments for the rest of your life. Unlike commercial annuities sold by insurance companies, private annuities are negotiated directly between two parties and are not regulated by insurance regulators.

The person receiving your asset becomes responsible for making those payments. The amount and timing of payments are determined by IRS life expectancy tables and the value of what you transferred. If you transfer a $500,000 property to your adult child, for example, the IRS calculates how much they must pay you each month based on your age and life expectancy at the time of the transfer.

Private annuities are used most often in family situations where someone wants to move an asset to the next generation while securing income for themselves. They can also be used between unrelated parties, though that is less common.

Key Takeaways

• A private annuity transfers an asset to another person in exchange for lifetime payments calculated using IRS life expectancy tables.
• The payments are based on the asset's fair market value at the time of transfer, your age, and IRS interest rates — not on what you and the other person agree to informally.
• Private annuities are not insured by any government agency, so your income depends entirely on the other person's ability and willingness to pay.
• The IRS requires a formal written contract and an independent appraisal of the asset being transferred to treat the arrangement as a valid annuity for tax purposes.
• Private annuities can reduce estate taxes but create income tax obligations and carry the risk that the other party will not pay or will become unable to pay.

How the payment amount is calculated

The IRS publishes Section 7520 interest rates each month. These rates, combined with IRS life expectancy tables, determine the minimum payment you must receive. The calculation is not negotiable — you cannot agree with the other person to pay less than the IRS formula requires.

To calculate the payment, an appraiser determines the fair market value of the asset on the date of transfer. That value is then run through the IRS formula using your age and the current Section 7520 rate. If you are 70 years old and transfer a property worth $400,000 when the Section 7520 rate is 5%, the formula produces a specific annual payment amount. That payment remains the same for your entire life, regardless of whether the property increases or decreases in value.

Because the payment is fixed for life, inflation erodes its purchasing power over time. A $20,000 annual payment in your 70s may feel adequate, but it will be worth less in your 80s and 90s.

Tax treatment of private annuities

Private annuities have three separate tax consequences: income tax on the payments you receive, capital gains tax on the asset transfer, and potential estate tax savings.

Each payment you receive is split into two parts: a return of your cost basis (the original value of the asset) and a gain. The gain portion is taxable as ordinary income. The IRS calculates this split using life expectancy tables — if you are expected to live 15 more years, one-fifteenth of each payment is treated as return of basis and the rest as gain. This means your tax bill is highest in your early years of receiving payments and decreases as you age.

The asset transfer itself may trigger capital gains tax. If you transfer real estate that has appreciated significantly, you owe capital gains tax on the difference between your original purchase price and the current fair market value. This tax is due in the year of transfer, even though you are receiving payments over time.

Private annuities can reduce your taxable estate because you no longer own the asset. This may lower estate taxes owed by your heirs, though the benefit depends on your total estate size and your state's rules.

Private annuities versus commercial annuities

A commercial annuity is purchased from an insurance company with a lump sum of money. The insurance company guarantees the payments and is backed by state insurance regulators and the state guaranty fund if the company fails. A private annuity has no such may provide — the payments depend entirely on the other person's financial stability and honesty.

Commercial annuities are standardized products with clear terms published by the insurance company. Private annuities are custom contracts negotiated between two parties, which means more flexibility but also more room for misunderstanding or dispute.

With a commercial annuity, you give up control of your money but gain security. With a private annuity, you keep the relationship with the asset (it stays in the family, for example) but accept the risk that the other person may not pay.

Risks and limitations of private annuities

The largest risk is that the other person stops paying or becomes unable to pay. If your adult child receives your $500,000 property and then faces financial hardship, loses a job, or declares bankruptcy, your income stream may stop. You would need to pursue a lawsuit to recover payments, which is expensive and may recover nothing if they have no assets.

Private annuities also create a potential conflict within families. If the property increases in value significantly, the other person may resent making fixed payments on an asset now worth much more. If the property decreases in value, you receive the same payment even though the asset is worth less.

There is no secondary market for private annuities. If you need a lump sum of money, you cannot sell your future payments to someone else the way you can with some commercial annuities. You are locked into receiving payments from that one person.

The IRS scrutinizes private annuities closely. If the contract does not meet strict requirements — including a formal written agreement, an independent appraisal, and payments that match the IRS formula — the IRS may disallow the arrangement and treat it as a gift or a sale, which changes the tax consequences significantly.

When private annuities are used

Private annuities are most common in situations where a parent wants to transfer a family business or real estate to adult children while securing retirement income. A farmer might transfer the farm to a son or daughter in exchange for monthly payments. A business owner might transfer the company to a child in exchange for an annuity.

Private annuities can also be used with trusts. Instead of transferring an asset to a person, you transfer it to a trust that is obligated to make payments to you. This structure can provide more protection and flexibility in how the asset is managed after your death.

They are less common between unrelated parties because the financial risk is higher and there is no family relationship to rely on if disputes arise.

Requirements for a valid private annuity

The IRS requires several things for a private annuity to be treated as valid for tax purposes. First, there must be a written contract that specifies the asset being transferred, the payment amount, the payment schedule, and the length of the annuity (your lifetime). A handshake agreement or informal understanding is not enough.

Second, the asset must be appraised by an independent professional appraiser who has no financial interest in the transaction. The appraisal establishes the fair market value used in the IRS calculation. The appraiser's report becomes part of the contract.

Third, the payment amount must follow the IRS formula using the Section 7520 rate in effect during the month of transfer. You cannot pay less than the formula requires, even if both parties agree to it.

Fourth, the other person must have the financial capacity to make the payments. If they cannot afford the payments, the IRS may challenge the arrangement as a disguised gift.

Frequently Asked Questions

What happens to the payments if I die before the expected life expectancy?

The payments stop. The other person keeps the asset and owes nothing more to your estate. This is why private annuities carry risk — if you die early, you receive fewer total payments than the asset was worth. Some private annuities include a "period certain" clause that guarantees payments for a minimum number of years even if you die, but this reduces the monthly payment amount.

Can I change my mind and get the asset back?

No. Once a private annuity contract is signed and the asset is transferred, you have given up ownership. You cannot reclaim the property. If the other person refuses to pay, your only remedy is to sue for breach of contract, which is expensive and may recover nothing.

Do I need a lawyer to set up a private annuity?

Yes. The contract must meet strict IRS requirements, and mistakes can result in the arrangement being disallowed for tax purposes. An attorney experienced in annuities and estate planning can draft the contract, coordinate the appraisal, and may support the payment formula is correct. This typically costs $1,500 to $3,000 depending on the complexity and your location.

Can I use a private annuity to transfer a house to my child?

Yes. Real estate is the most common asset transferred through private annuities. Your child receives the deed, and you receive monthly payments for life. Your child can live in the house, rent it out, or sell it — but they must continue making payments to you regardless of what they do with the property.

What if the Section 7520 rate changes after I set up the annuity?

The rate used is the one in effect during the month of transfer. Future changes to Section 7520 rates do not affect your payment amount. Your payment stays the same for your entire life.