“REAL” ESTATE PLANNING: Estate Planning for Real Estate Developers and Investors
Location! Location! Location! That’s the mantra which real estate owners hold as the key to determining a property’s value. However, to protect that property’s value, real estate owners need to understand the ever-important estate planning mantra: Timing! Timing! Timing!
Real estate owners, including developers and investors, too frequently build substantial portfolios of real property and liquid assets, yet see the incredible efforts undertaken to create this wealth squandered by unnecessary and avoidable taxes and administrative expenses upon their disability or death. In part, real estate owners are often victims of these costs because they—like other entrepreneurs—are so focused on building their portfolios and wealth that they neglect to plan for preserving it upon their death. Although they understand the importance of planning, it is a task that is earmarked for the “I’ll get around to it” category of life.
Failing to adequately plan for death can lead not only to significant death taxes and administrative costs, but potential liquidity shortages for the family, which could have been avoided or minimized. The recent convergence of a few factors, including a possible regime change in Washington, the impact of COVID-19, and historically low interest rates, has now brought us to the point where failure to act may very well result in the permanent loss of significant death tax savings to the real estate owner and his or her family and plenty of wishful dreaming for the good old days. These factors present a window of opportunity for real estate owners that can’t be ignored.
Upon death, an individual’s estate is subject to three levies known as death taxes. They are state estate taxes, state inheritance taxes, and the federal estate tax. Fortunately, in Pennsylvania and New Jersey, the state estate taxes are currently dormant. However, both states assess an inheritance tax, most notably Pennsylvania which taxes 4.5% of any assets left even to children and other lineal descendants.
The major tax and the focus of this article is the federal estate tax. It is a levy of 40% on the assets owned at death, exceeding certain exemption amounts. These amounts are currently $11,580,000 per individual and $23,160,000 per couple. (These amounts are adjusted annually for inflation.) The federal estate tax can be reduced by owning less assets at death (by gifting during lifetime) or minimizing the value of what you own. Real estate owners can effectively do both.
Under current law, this exemption amount is automatically reduced by 50% in 2026. So, for example, if the exemption amount at the end of 2025 is $12 million per person, it will be reduced to $6 million per person beginning in 2026, unless Congress passes legislation to keep the current law in place (which most believe is not likely to happen). But we may not have until 2026 to take advantage of this historically high exemption amount. The Federal government will be struggling with significant budget shortfalls and larger deficits as a result of the pandemic, which is likely to create pressure to reduce the estate and gift tax exemption in 2021. This becomes even more likely to occur if there is a regime change in the Federal government after the November elections. Therefore, if you have not already done so, this is the time to get serious about taking steps to use the historically high exemption amount currently available or risk losing half of the exemption (or more) after 2020.
For example, if the exemption goes from the current level of $23,160,000 per couple to $11,580,000 per couple, the estate tax benefit “lost” by not taking advantage of the higher exemption is over $4.6 million. In other words, if you have an estate or expect to have an estate valued at around $25 million or more, and you do not implement a plan using the full $23,160,000 exemption by making gifts before there is a change in the law, it will cost your family an additional $4.6 million when you (and your spouse) die. If you make gifts now using the full $23,160,000 exemption amount, the Treasury has already announced that even if there is a subsequent reduction in the exemption amount, your prior gifts will not be “clawed back.”
The Impact of COVID-19
When considering making gifts, the objective is to use assets which have a lower fair market value today but are expected to appreciate. If we assume you have a property worth $11,580,000 today, which you anticipate in the future will have a value of $16,500,000, you can make a gift today of the property and use your entire exemption of $11,580,000 to avoid paying gift tax. On the other hand, if the gift was made (or you die) when the property is worth $16,500,000, the $4,920,000 in excess of the exemption amount would be taxed at 40% resulting in a gift (or estate) tax of $1,968,000. So, gifting the property before it appreciates will save almost $2 million in gift or estate tax.
As anyone involved with commercial real estate (CRE) knows, COVID-19 has hit certain sectors of the CRE market pretty hard. Owners of shopping centers, office buildings, hotels, apartments, and other sectors have, in general, suffered reduced revenues. For these reasons, those sectors and others hit hard are widely considered to have depressed values and are likely at the low end of historical valuations. In fact, some appraisers are applying a “COVID Discount” in their valuations of CRE.
While our clients expect their portfolios to rebound to their pre-pandemic valuations, no one knows for sure how long that will take. Even without the prospect of the window closing on the higher death tax exemption amount, this would be an ideal time to make gifts of property because of the lower valuations and the uncertainty as to when recovery from COVID-19 will occur. A lower valuation means we can fit more properties into the “exemption bucket” and remove them from your estate by leveraging the exemption with lower appraisals.
More Leverage – Entity Discounts
As you know, real estate developers and investors typically own their properties in single purpose entities (SPEs). While the real estate itself is likely to be valued lower because of the current market conditions and COVID-19 discount, there is a second layer of discounts which you can take advantage of by gifting interests in the SPE rather than gifting the real estate itself. These entity discounts include those for “lack of control” and “lack of marketability.” A qualified valuation expert typically will take the fair market value of the real estate (let’s call that the “enterprise value”) and apply combined discounts in the range of 25% – 40% to further reduce the enterprise value.
As an illustration, assume you own a building which a year ago was worth $17,500,00 but today is worth $15,000,000 (based on the current market’s depressed valuations which reflect the COVID-19 discount) in a limited liability company (LLC). You have a separate company which is designated as the manager of the LLC and individually you own a 50% non-managing member interest in the LLC. A gift of your 50% non-managing member interest in the LLC can come (conservatively) with a 25% discount. Your gift of this non-managing member interest will be treated as making a gift of $5,625,000, not $7,500,000 (50% of the building value), effectively reducing the value of the gift by nearly $2 million. The leveraging achieved by applying discounts in computing the enterprise value and valuing the SPE interests brings the value down from the pre-pandemic valuation of $8,750,000 (50% of $17.5 million) to $5,625,000, a savings of more than $3 million, and a gift and estate tax savings of over $1.2 million (assuming your overall estate exceeds the exemption amount).
While the exemption amount is obviously a target for significant reductions after the November elections, the lack of control and lack of marketability discounts could also be eliminated. The IRS has been clear of its desire to eliminate such discounts, and its attack on them is likely to heat up if there is a regime change. This is still another timing reason to implement your estate planning while these discounts are still available.
If you do not provide all the equity for your real estate ventures and use investors such as individuals, REITs, and other institutions, your company, as the sponsor of these ventures, is likely entitled to certain promote interests once the investors get a pre-defined return on/return of their investment. These promote interests basically constitute your right, as the sponsor/promoter of the project, to take a disproportionate amount of the cash flow from the project beyond the percentage represented by your investment. At the beginning of the project, this “promote interest” is likely to have very little or no value because the project needs to be successful and pay back the investors, which is not a sure thing at the start of the project. You can gift some or all of these promote interests to a family limited partnership and/or trusts for your children at practically a zero value (so no exemption is used), and if the project is successful, the return on the promote interests could be significant. By gifting these interests, when there is little or no value, you will have removed the future distributions and value of the interests from your estate permanently without using your exemption amount. This type of planning can be done regardless of the available exemption amount and becomes even more important to consider if the exemption amount is reduced and/or the discounts are eliminated.
So (Disappearing?) High Exemptions and Discounts, and Low Valuations…Is That All You Got?
Well, no. That’s not all we got. There is another important factor which makes this the perfect time to gift property – record low interest rates.
Let’s say you own significant real estate, and you want to transfer the future appreciation, which would cause you to have assets over the exemption amount, but you do not want to pay gift tax. You can sell the property (or other assets) to a “grantor trust” to accomplish that end.
A “grantor trust” is a trust which is effectively ignored for Federal income tax purposes (so that instead the income it earns is reported as if you earned it) even though the assets owned in it are removed from your taxable estate for gift and estate tax purposes. These trusts are also sometimes referred to as “Intentionally Defective Grantor Trusts.” If you establish a grantor trust and sell property (or other assets) to it, you are considered to be selling the property to yourself for income tax purposes, and therefore there is no income taxable event. The sale to the grantor trust is accomplished by the grantor trust giving you, as grantor, a promissory note to buy the property at its current (depressed) value (or you can sell your SPE interests instead and possibly pile on other valuation discounts as noted above).
The cash flow from the property sold is used to service the debt to you as the grantor. The IRS imposes a certain minimum interest rate, known as the “applicable federal rate, or “AFR,” that must be charged. If a lower interest rate is charged, less of the cash generated from the property will be needed to service the note to you, and as a result, more appreciation and cash flow can be transferred to your heirs. Basically, you are freezing the value of your estate by swapping a depressed valued property, which is likely to appreciate, for a promissory note with a fixed principal amount and a low interest rate. Today’s interest rates are historically low. For example, the AFR for a 10-year note issued in October 2020 is only 1.12%.
As a result, not only can real estate owners gift their discounted real estate properties or entities to trusts for children, they can also sell those discounted entities to grantor trusts in exchange for promissory notes bearing these low interest rates. Any cash flow generated by the property in excess of the debt service using a 1.12% interest rate will stay in the grantor trust and not be added to your estate. The historically low interest rate provides another technique to transfer cash flow from properties to your heirs without the transfer being considered a gift (so no exemption amount is used).
There is a risk that this technique may also be eliminated along with the valuation discounts listed above. President Obama had unsuccessfully attempted to eliminate the estate and gift tax planning benefits of the grantor trust, but this could come back into play if there is a regime change in Washington.
As you can see, timing is the key to maximize your opportunity to move real estate (and other assets) out of your estate using valuations at the low end and the historically high exemption amounts, and applying valuation discounts (which can be eliminated at any time), resulting in the potential to save significant death tax dollars.
Are There Other Things I Need to Consider?
As a real estate owner or investor, you have concerns specific to owning property that needs to be considered, such as:
- The transactions described above may require you to give notice to and/or get approval from your mortgage lender. Many loan agreements do permit certain transfers done for estate planning purposes, but the loan agreement needs to be reviewed to assure you comply with its terms.
- Realty transfer taxes must also be considered. In many states, transfer of real estate triggers the imposition of realty transfer taxes. In addition, in some states, including Pennsylvania, transfers of significant interests in the SPE can trigger the same tax. However, there are often exceptions to these rules, such as where the transferee is a trust in which all the beneficiaries are family members.
- Owners are generally reluctant to lose control over the property decisions, even if they are willing to give up equity. This control can be preserved by certain techniques such as gifting away non-voting interests (e.g., a limited partner interest in a limited partnership), or transfers to a family limited liability company where the transferor may continue as the manager.
- Owners of CRE may be reluctant to give up the cash flow from the gifted properties. This may be addressed by looking at other techniques, such as gifting property to a trust for the benefit of the real estate owner’s spouse (known as a Spousal Lifetime Access Trust, or “SLAT”). Any accumulated income in the SLAT would ultimately pass to the real estate owner’s children; however, if funds were needed, the trustee of the SLAT could distribute cash to the owner’s spouse, and he or she could use those distributions to indirectly support the couple’s lifestyle.
Failure to act now will leave taxpayers looking back at 2020 as the good old days. A conference with one of the members of Kaplin Stewart’s estate planning group could be of great benefit. We are available to speak with you about these issues whenever you wish. Please contact any one of the following persons:
Maury B. Reiter, Managing Principal
Thomas D. Begley, III, Principal
Devin S. Fox, Associate