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IRS recently issued a Private Letter Ruling (PLR 199937042) involving a non-qualified deferred annuity that was interesting for what it didn’t discuss rather than what it did.

The taxpayer had entered into an arrangement with a mortgage lender that worked like this: the taxpayer bought a house and instead of making a cash down-payment, used that amount of money to purchase a non-qualified single-premium deferred annuity. At closing, the taxpayer pledged the annuity contract, to the extent of the original investment, as collateral for the purchase of the house and the lender entered into a mortgage for 100% of the purchase price.

Later, the taxpayer desired to exchange the pledged annuity for one or two new annuities either with same insurer or a new one. The new contract or contracts would be pledged to the mortgage lender, to the extent of the original investment, as collateral on the mortgage loan. The taxpayer requested a ruling that no taxable gain or loss would be recognized on the transaction.

The IRS gave a favorable ruling that stated no taxable gain or loss would occur as long as the replacement contract or contracts remained as security for the mortgage loan, all the cash value in the original contract was transferred to the new contract or contracts, and none of the cash value was distributed to the taxpayer. The Service based its ruling solely upon a reading of Code section 1035 and prior tax-free exchange rulings. Interestingly, the taxpayer did not ask, nor did the IRS rule, on the tax consequences of the original arrangement.

Asset Integrated Mortgages (AIM)
We began hearing about programs similar to this several years ago. One such program was named the Asset Integrated Mortgage or AIM. The lender’s interest in such a deal is apparent – it allows the lender to write a substantially larger mortgage on a piece of property while maintaining an identical degree of security.

What’s the buyer’s advantage? Proponents claimed the buyer gained an increased tax-deductible mortgage interest writeoff, while enjoying tax-deferred build-up of cash value in the annuity. Remember, the buyer pledged or assigned only the original investment; any cash value increase in the contract belongs to the contract owner without limitation. Assuming the mortgage is paid off according to its terms, the annuity belongs to the owner free and clear.

A few readers may be asking: "Doesn’t Code section 72(e) prohibit the pledging of an annuity contract?" In fact, the Code doesn’t prohibit the pledge of an annuity contract, but section 72(e)(4)(A) does say a pledge, assignment, or contract loan is treated as a taxable distribution when made. Remember, the pledge of the contract in the above arrangement occurs immediately after purchase. At that time the contract has no taxable gain; therefore, treating the pledge as a distribution results in no recognition of income.

Revenue Ruling 95-53
Collateralized mortgages are not new. For years, banks have insisted that borrowers maintain deposits with them in savings accounts or CDs as a precondition to obtaining a mortgage. The arrangement doesn’t endanger the borrower’s mortgage interest deduction; the IRS approved the technique in PLR 9038023. But, can a borrower deduct the interest paid on a mortgage, use an annuity as collateral and enjoy tax-deferred annuity growth?

The IRS said "no" in Revenue Ruling 95-53. The Service ruled Code section 264(a)(2) disallows a deduction for that portion of the interest on the mortgage loan collateralized by the annuity contract. Under the Code, amounts paid or accrued on indebtedness incurred or continued, directly or indirectly, to purchase or continue in effect a single premium annuity contract are not deductible. There is an indirect borrowing of funds when an annuity is bought and immediately pledged or assigned as collateral for the mortgage loan.

Printed with permission of Advanced Underwriting Consultants

Last Updated: 12/15/2002 10:49:00 AM