Building A Future-Proof Estate Plan For Real Estate Wealth

Estate Planning for real estate investors requires balancing tax efficiency, asset protection, and expectations about the amount of control one wants to maintain over their legacy.  For many investors, real estate is the cornerstone of their wealth.  The illiquid nature and tax complexities of real estate, however, provide a unique challenge to estate planning.  The following are some potential challenges and tips to consider when including real estate in your estate plan.

Retained Interest And Gross Estate Inclusion

Certainly, retaining ownership will result in the real estate being included in investors’ gross estate.  Creating a family investment vehicle will not always prevent includability of real estate investment properties into the gross estate.  IRC Section 2036 provides for inclusion in a decedent’s estate for the value of all property in which the decedent retained a lifetime income interest or the right to the possession or enjoyment of the property.

When it comes to a family office or family limited partnership, that in this case holds real estate investment properties, if the investor retains the sole ability to amend the operating agreement, dissolve the partnership, or make distribution decisions, they could be considered to have sufficient ability to control the beneficial enjoyment of the property which could result in inclusion.

Therefore, because retaining a life estate in real estate or creating an appearance of continued control could trigger issues involving ongoing use or ability to control beneficial enjoyment, such structures should be reviewed as part of the estate plan to minimize inclusion in the gross estate.

Leveraging Valuation Discounts

When real estate is held in certain ownership structures such as partnerships, LLCs, or trusts, its value for tax purposes isn’t always the same as its appraised market value.  Valuation discounts adjust the market value of real estate downward based on factors that reduce its desirability or liquidity.

The two most common types of valuation discounts are the lack of marketability discounts and the lack of control discounts.  A lack of marketability discount will typically apply when a property interest can’t be easily sold or converted to cash such as with a minority interest in a family LLC.  Whereas a lack of control discount reflects the reduced value caused by an interest that lacks decision-making power.

Discounting can play an important role in estate planning for real estate investors.  By placing real estate interests into a family LLC and transferring the minority discounted interests either during life or at death as part of the real estate investor’s estate plan, larger portions of the gift tax exemption can remain intact and/or the gross taxable estate can be reduced.

There are, however, some important considerations.  The IRS closely scrutinizes these arrangements so operating the business formally will help with the IRS upholding the structure, as well as provide greater protection from creditors.  This is not an inexpensive estate planning structure as qualified business valuations and gift tax returns will also need to be done in the years in which interests are transferred.  There are also ongoing expenses such as administrative costs and tax filings.

Also, if family LLC assets are gifted to an irrevocable trust, the beneficiaries will be unable to step up their basis and depreciate certain real estate assets.

Therefore, while taking advantage of valuation discounts provides a strategic advantage for estate planning purposes, appropriate structuring and formalities must be followed.

Liquidity Issues

Being an illiquid asset, real estate investors often do not have sufficient cash to pay estate tax liabilities upon death.  With taxes due nine (9) months after death, estates with insufficient cash may need an extension.

IRC 6161 provides the IRS with the discretion to grant an extension of time to pay estate tax.  If approved, such an extension relieves the estate from penalties, but not from interest.  If the estate can prove an undue hardship, the extension can be granted annually for up to ten (10) years.

Under IRC 6166, the estate tax attributable to an interest in a closely held business can be paid over a period of fourteen (14) years.  Indeed, payment can be deferred for five (5) years and, thereafter, paid in ten (10) equal installments.  There are downsides, however, including variable interest rates, IRS loan terms, and potential acceleration under certain circumstances.

In addition to the extension possibilities discussed above, a loan called a Graegin loan can be used.  These loans can come from a financial institution, family business, or irrevocable life insurance trust.  When properly structured, all of the interest due over the term are immediately deductible for estate tax purposes.

Finally, illiquidity can be planned for using either term or permanent insurance on the life of the real estate investor.

Therefore, depending on the size and value of the real estate holdings, a family limited partnership, LLC, or life insurance should be considered.

Maximizing Basis Benefits

Retaining real estate until death, either by holding or through 1031 like-kind exchanges, provides a step up in basis for the beneficiaries.  This benefit can be potentially further magnified when held in a family partnership.  For assets made in a partnership, a Sec. 754 election can potentially provide a step up in basis for both the partnership interests as well as the underlying assets.

Assets held in an irrevocable grantor trust can trigger tax liability corresponding to negative capital accounts upon the trust becoming non-grantor during the grantor’s lifetime.  Additionally, assets owned by an irrevocable grantor trust generally are not eligible for step up basis.  However, if properly drafted, an irrevocable grantor trust can allow the grantor to swap assets of equal value with the trust providing the opportunity to use loans to preserve step up basis.

Preserving Preferential Income Tax Treatment After Death

People who are able to meet the IRS definition of a real estate professional are able to overcome the presumption that all rental income is per se passive, thereby permitting the deduction losses from rental income against other ordinary income.

By appointing an executor or trustee who may qualify for material participation with respect to the real estate owned in a trust or estate, these favorable deductions can be preserved.

Multigenerational Planning

Many real estate investors spend their lifetime accumulating assets.  Often, the goal is to provide wealth for many generations in their bloodline.  While many may be familiar with the gift and estate tax exemption, each taxpayer also has an equal amount of generation-skipping tax (“GST”). GST tax is a federal tax on wealth transfers that “skip” a generation.  A skip person is a grandchild, great grandchild, or any non-related person at least thirty-seven (37 ½) years younger than the transferor.  GST tax is a flat rate equal to the maximum estate and gift tax rate, currently at forty (40%) percent.

Protecting your real estate legacy in trust with GST exemption allocated to it will prevent additional estate, gift, and GST taxes from being imposed on those assets for future generations.

Carried Interest Gifting

Carried interest is a share of the profits earned from a private equity or venture capital fund’s investments and is allocated to a fund’s general partners as a form of compensation provided to fund managers.  Carried interest is often taxed as a capital gain rather than ordinary income.

Carried interests are commonly held assets for some real estate investors.  Gifting carried interest does have some limitations.  IRC 2701 greatly restricts the ability to gift carried interest to family members and still retain the capital interest.  Therefore, if a general partner transfers their entire carried interest in the fund, that interest, inclusive of the underlying capital investment, would be considered a gift.  There are methods to mitigate the Sec. 2701 special valuation rules, such as making a gift of an equal portion of each interest (a “vertical slice”) or through the use of carry derivatives.

Carried interest strategies are complex, but working with a skilled estate planning attorney familiar with these strategies and vehicles such as specifically drafted trusts and family limited partnerships can create significant value to your estate plan.

Estate planning for real estate investors is complex and demands a comprehensive and collaborative approach.  This approach typically involves a team of attorneys, accountants, and financial advisors.  And once completed, the estate plan should be regularly reviewed. To ensure your real estate legacy is protected and future-proofed, partner with the experienced team at Aptt Law LLC—your trusted advisors in building a lasting estate plan.

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