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Protecting
Commercial Property from Estate Taxes
Even the savviest investors
can get tripped up by avoiding estate planning
 After
spending their lives cleverly accumulating quality real estate assets,
many investors wind up doing some pretty dumb things when
it comes to passing that property on to their heirs. Experts estimate
that eight out of 10 real estate investors don't bother to do any
estate planning – primarily because they don't like facing
their mortality or acknowledging that they might not always be in
control.
Even some of the savviest owners and developers fail to make adequate
provisions for distributing this wealth to heirs and minimizing taxes
in the process. "It’s foolish to assume that everything
is going to work out without doing any planning," says Karl
Dunajcik, a principal with The Moneta Group, a St. Louis-based wealth
management firm. "The work that is done in estate planning is
not for the person who dies-- it's for the people left behind."
Estate planning for commercial real estate should address:
- Finding liquid assets with which to pay estate
taxes
- Creating ownership structures, including trusts
to house real estate assets
- Moving assets out of a taxable estate
before death
All these plans
should be made as soon as possible: If certain transactions are
not completed as long as three years before death,
they will
be disallowed by state and federal tax officials. Investors should
consult qualified estate-planning attorneys for the relevant
rules.
Investors with significant commercial real estate holdings will
most likely have taxable estates. Currently, any estate
worth more than
$2 million is subject to the federal
estate tax, which ranges as high as 55% and is due nine
months after death. If the family has not set aside funds to pay
the
expected estate tax (this can be accomplished with life
insurance), the
heirs
could be forced to sell commercial properties at a time
when market conditions are not favorable. "Real estate is
not a highly liquid asset, and there are times when it doesn't
sell quickly or at top
value," says Mark Brown, a principal with Brown & Tedstrom,
a Denver-based financial planning and investment advisory
firm. Brown points out.
Don't trust wills
A will, no matter how detailed, is not sufficient to ensure a
smooth, tax-efficient transfer of real estate. Rich Rubino, a
partner with
Rubino & Liang LLC, a Newton, Mass.-based asset protection and
retirement-planning firm, says revocable trusts are usually a better
solution. A trust allows the investor to control all his assets until
death, at which point it becomes irrevocable – meaning it cannot
be changed. The trustee (a trust bank or other fiduciary) manages
the assets and distributes income to the beneficiaries. The trust
can offer other benefits, including protection from: creditors, and
divorce judgments, says Patricia M. Annino, chair of Boston-based
Prince, Lobel, Glovsky & Tye’s estate planning and tax
group.
Lloyd advises that the revocable trust be used in concert
with a bypass credit shelter trust. Normally, when one
spouse dies
and leaves
his or her estate to the surviving husband or wife, there
is no tax due (this is known as the marital deduction).
When the
second
spouse
dies and the estate passes on to heirs, taxes kick in
after $2 million.
A bypass credit shelter trust allows a married couple to pass
on $4 million worth of assets. Without one, the maximum amount
that
can be passed on from a married couple to their heirs is $2 million.
Each spouse should put a bypass credit shelter trust provision
in his or her will because you don't know who's going to die
first.
Unfortunately, there's a lot of confusion about the maximum estate
that can be passed onto heirs without paying taxes. All too often,
a husband will die and leave his estate to his wife. If the wife
absorbs her husband's estate into hers, making it worth more
than $2 million, it cannot be passed on without paying estate
taxes.
A bypass credit shelter trust allows the husband to put all of
his assets into the trust at his demise. His wife assumes the
role of
trustee, controlling the assets in the trust. She can liquidate
it and use the proceeds or just let it sit there. When the wife
dies,
her estate is valued separately from her husband's bypass credit
shelter trust, allowing her to bequeath $2 million to her heirs.
The heirs also inherit the bypass credit shelter trust and do
not have to pay estate taxes on it, even if the value of the
trust
has increased from $2 million since it was fist created.
Look for discounts
Another way to reduce the tax bite is to structure ownership
of real estate holdings so that they qualify for a so-called
minority
discount
from the Internal Revenue Service. The discount can be applied
to assets in which the estate or the heirs have only a minority
interest,
on the theory that there is no ready market for the fractional
shares and the owners of those shares do not exercise control
over the property.
Discounts of up to 40% are common, says Jordon Heller, a partner
at The Schonbraun McCann Group LLP who heads up the firm's wealth
management practice. So, in effect, a $10 million property can
be passed on with a taxable value of just $6 million. The IRS’s
reasoning, says Heller: "If you don't have control over the
property, it's worth less because you need your partner to make economic
decisions."
There are three primary ways to achieve minority discounts:
-
Fractionalizing the original investor’s ownership (making
sure he has less than a controlling interest in any buildings or
partnerships
in assets that will become part of the estate).
- Creating
a family limited partnership (FLP), which divvies up interests
in the property into shares for each family member.
- Recapitalizing
the estate into voting and non-voting interests.
"Each one of these options should put the estate
in the position to argue that a portion of the estate is worth less," Heller
asserts. "All
three are good options."
Start planning early
Changing the ownership structure and moving assets
out of an estate before death helps shift to
heirs any future appreciation
and decreases
the value of the estate. Annino gives this example:
if Mr. Jones moves a $4 million building out
of his estate into an FLP and
it doubles in value by the time he dies, Mr.
Jones and his estate save taxes on the appreciation.
His heirs receive the appreciated
assets
and will pay capital gains upon disposal. OK?
Many real estate owners choose not to shift ownership
to their heirs while they are alive because they
don’t want to relinquish
control or because they still need the income from the assets, Brown
says. But, there are ways to structure the ownership where the patriarch
or matriarch still maintains operational control even though the
ownership shifts.
For example, recapitalizing the estate converts
it into interests that represent 100 percent
of voting
and equity. A father can
pass along to his heirs 90 percent of the value
of the assets (equity)
and retain 10 percent ownership interest. At
the same time, he can retain 100 percent of the
voting
rights.
In contrast, a general partner structure allows
certain partners to receive a larger portion
of income even
though those partners
may not be the largest owners. For example, a
mother may own 10 percent of the partnership
while her
children own 90 percent,
but
she receives
50 percent of the income from the partnership.
Each situation is different, and commercial real
estate certainly adds a layer of complexity to
estate planning.
But that doesn't
mean that one cannot pass along his wealth to
the next generation, experts
say. "The best friend of estate planning is time," DeMeola
says. "The sooner people think about it, the better off they
are."
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