Trusts and estates professionals representing high-net-worth clients have become more adept at maximizing planning techniques for specific asset classes as their awareness of the assets' economic factors and the effect of current markets on the assets has grown. For instance, professionals are paying significant attention to assets other than marketable securities despite the continually low “Section 7520 rate” during the past year and the devaluation of equities, with the expectation that they may reverse course in the not-too-distant future.
Consequently, high-net-worth clients are considering gifting and planning opportunities with asset classes that they have greater confidence will appreciate in value and be less likely to depreciate. This includes alternative investments, with their intended low correlation to the public market (for example, private equities and hedge funds). And recently, in many parts of the country, both commercial and residential real estate values have increased significantly. As a result, real estate or real estate-related investments may be viewed as sound. Here are some planning ideas and opportunities related to real estate holdings for the high-net-worth client.
COMMERCIAL REAL ESTATE
Estate planning with commercial real estate can be effective because of its potential to appreciate in value and produce significant income and its conduciveness to various discounting techniques for gift tax-planning purposes, especially under current conditions: a low-interest-rate environment and volatile markets. Typically, property owners transfer commercial real estate to a business entity that is well suited for asset protection, property management and transferability. The entities can be established as limited liability companies (LLCs), S corporations or family limited partnerships (FLPs). The general partner of the FLP should be either an LLC or S corporation to avoid personal liability for an individual acting as general partner.
Depending on state law, LLCs are becoming the entity of choice because they protect against personal liability for managing and non-managing members, and provide partnership income-tax treatment and flexibility within the partnership rules regarding allocation of profits and losses for their members. For asset-protection purposes, the client should consider having a separate LLC for each piece of real property.
The flexibility of voting/nonvoting membership units is conducive to family planning and gifting issues. Not only can the transfer of the nonvoting membership units support lack of marketability and minority discounts for valuation-discount purposes, but the transfer of nonvoting interests also allows the senior family member (presumably the donor) to maintain control of the enterprise. Depending on the restrictions imposed by state law on transferability and liquidation of the entity, discounts on the value of nonvoting interests can be significant.2
Another effective way of discounting the value of the nonmanaging units is to have the senior family member (or junior family member) enter into an arm's length agreement for management services rendered on behalf of the entity. This reduces the profitability of the entity and thereby supports a reduction in the value of the nonmanaging units. The arrangement may also offer flexibility to provide funds to the donor or other family member (provided the arrangement is not a disguised gift).
Effective gifting (or selling) of nonvoting or nonmanaging interests lends itself to numerous planning opportunities, such as:
a grantor retained annuity trust (GRAT);
a grantor trust;
a sale to a grantor trust;
a grantor trust combined with life insurance.
GRATs have certain advantages as well as disadvantages when used in connection with entities that own commercial real estate. Gifting nonvoting membership units (with minority and lack of marketability discounts) into a GRAT (with an additional discount based on the retained annuity interest) may allow for significant discounts, especially in a low interest rate environment. Also, if a final determination for gift-tax purposes increases the value of the property transferred to the GRAT, the grantor's annuity payments are increased.3 Consequently, there would be no increase in the taxable gift. The grantor receives annuity payments, an economic consideration for some grantors. Because the trust is a grantor trust for income tax purposes, the grantor would be responsible for the tax on the income earned and gains realized from the trust (not for the amount of the annuity payments). The property should generate sufficient income to satisfy the annuity payments; if not, the grantor would receive partially discounted business units. This situation would require updated valuations of trust property and reduce the benefit of discounting.
But there are some disadvantages to using a GRAT. If the grantor dies during the term of the GRAT, the assets, including post-gift appreciation, are included in his estate for estate-tax purposes (Internal Revenue Code sections 2036(a), 2039). The amount of used gift-tax credit would be restored. But this situation represents a lost opportunity, albeit one that's hard to quantify, that could have been avoided by choosing another strategy.
Another technique that may be suitable is gifting nonmanaging units into a dynastic or nondynastic grantor trust, for income tax purposes.4 Besides the nontax benefit (for example, spendthrift provisions and distribution control) of gifting the property into a trust, the grantor would be responsible for the tax on the income earned and gains realized from the property. The trust's assets are undiminished by income taxes. This is particularly effective since commercial real estate business entities typically generate significant income.
Private equities invested in commercial real estate can provide such benefits as anticipated high appreciation, long-term holding periods resulting in favorable capital gains treatment, no secondary market that lends itself to lack of marketability discounts for gift-tax purposes and, as stated earlier, a low correlation to the public market. The trust can own the private equity either directly or indirectly through LLC units. The liquidation events typically cause realized gains paid by the grantor, not by the trust or its beneficiaries. This technique can be particularly effective because it uses a combination of benefits, such as discounts, spousal gift-splitting (Section 2513), imposition of income tax liability on the grantor and post-gift appreciation not included in the grantor's estate.
Another variation on the theme: a sale of additional nonmanaging units to the grantor trust. Because the grantor sold the assets to a grantor trust, the sale does not cause income taxation. Commentators typically suggest there be additional assets in the trust valued at a minimum of 10 percent of the value of the assets sold to the trust to avoid a retained-income interest in the grantor's estate under Section 2036(a). The grantor receives a promissory note with interest at the applicable federal rate (AFR) in effect under Section 1274(d).5 The AFR will avoid gift-tax implications on the note's interest-payment portion because this rate is considered fair market value. A grantor's sale of discounted high income-producing assets using a note with a low AFR can create significant estate- and gift-tax savings.
For instance, the April 2003 mid-term AFR was 2.96 percent for annualized payments for a note (a term of more than three years through nine years). If the note's terms provide for a balloon principal payment at the end of nine years, the actual return on trust property (undiminished by income taxes because the grantor is liable for the taxes) will probably be greater. In addition, because the nonmanaging membership units are discounted, a greater amount of property is transferred to the trust, enhancing its return. For example, if the prediscounted value of the gifted property is $1.5 million, and its value is discounted by 35 percent (for lack of marketability and minority interest), the property's value for gift-tax purposes is $975,000.
However, it is the prediscounted property value of $1.5 million, not the discounted value of $975,000, that generates income for the trust. To the extent that the actual investment return on the property exceeds the 2.96 percent rate, the excess passing to the heirs is not subject to gift or estate tax. That difference and the amount discounted can be significant. If the grantor/holder of the note dies during the note's nine-year term, the estate may be entitled to a discount on the note's principal amount for estate-tax purposes.
There are certain benefits of this technique over a GRAT. If the grantor dies during the trust term, the trust property is not included in the grantor's estate. Also, the mid-term AFR is less than the Section 7520 rate (for example, in April 2003, compare the mid-term AFR of 2.96 percent to the Section 7520 rate of 3.6 percent). The grantor can also allocate generation-skipping transfer (GST) tax exemption on making a gift to the trust before the property appreciates in value. The grantor cannot allocate GST tax exemption at the time of the contribution to the GRAT.6
With the grantor-trust approach, the income from the business entity owned by the trust (in other words, the trust provisions provide for accumulation of income) can be used to purchase a life-insurance policy on the life or lives of the grantor and/or the grantor's spouse. Because the trust is a grantor trust for income tax purposes, the accumulated income, not reduced by income tax liability, is available, for premium payments after the interest payments on the note are made. This scenario provides additional liquidity for the family to use to pay estate taxes for what may be a fairly illiquid estate.
Opportunities exist for charitable planning. However, these opportunities are more limited and complex than with noncharitable planning, primarily because the business entity may be considered an active trade or business in a pass-through entity (for example, an LLC). For instance, if a charitable remainder trust (CRT) receives income from real estate or from an LLC with acquisition indebtedness, the income may be treated as unrelated business taxable income (UBTI).7 UBTI causes a CRT to lose its tax-exempt status for that tax year, nullifying the benefit of avoiding immediate capital gains tax on the sale of trust assets or possible deferral of trust income. There may be other situations where there is no UBTI because there is no acquisition indebtedness, or because an exception to the rule applies, which may provide greater opportunities to make contributions to the trust. If properly structured and timed, transferring this type of property into a CRT can provide significant savings or deferral on capital gains taxes if the trust property is eventually sold.
Charitable lead trusts (CLTs) are not tax-exempt entities, like CRTs, and are generally created as nongrantor trusts for income tax purposes. Consequently, the UBTI generated from trust property will not threaten tax-exempt status, but will reduce allowable income tax deductions for the trust. In all likelihood, this will cause the CLT to incur more taxable income than if the trust had not generated UBTI.8 Therefore, careful consideration must be given to the overall income tax effect and to what extent it reduces the CLT property's total return. Also, there are private foundation rules,9 such as those governing self-dealing and excess-business holdings, that must be considered before transferring business entities of this type into either CRTs or CLTs.
However, charitable lead annuity trusts can be effective in a low interest rate environment, that is, when there is a low Section 7520 rate. The present value of the non-charitable remainder beneficiaries' interest is reduced for transfer-tax purposes. The actual investment performance, which exceeds the Section 7520 rate, passes free of estate or gift taxes.
Commercial real estate business entities can create significant liquidity needs for the owner's estate in the form of estate taxes, debts and administration expenses. The three approaches that follow can help satisfy liquidity needs:
First, life insurance owned either in an irrevocable life insurance trust or used in conjunction with a buy-sell agreement can provide liquidity. Clauses concerning purchase price formula — which satisfy the requirements of Section 2703, if applicable — can be incorporated into the agreement to mandate a sale of the property on the owner's death, and establish a purchase price and value for estate-tax purposes as well as a payment schedule to the estate by the purchasing parties.
Second, if the value of the closely held business entity represents more than 35 percent of the deceased owner's adjusted gross estate, tax payment deferral may be allowed on an installment arrangement.10
Third, the business entity or third-party lender enters into a bona fide lending arrangement with the owner's estate. Fixed interest payments (no prepayment of interest is permitted) are expenses necessarily and actually incurred for the purposes of using the loan proceeds to pay estate taxes. If the arrangement is properly structured, the aggregate amount of interest payments to be made by the estate to the lender may be treated as an administration expense and an allowable deduction for estate-tax purposes.11
RESIDENTIAL REAL ESTATE
The primary planning technique with primary or secondary residences is the qualified personal residence trust (QPRT).12 However, there are reasons very high-net-worth clients do not use this technique on a regular basis:
First, QPRTs are more effective when the Section 7520 rate is high. A low interest rate environment reduces the grantor's income interest and increases the value of the taxable gift of the remainder beneficiary's interest. Second, if the residence has a mortgage, the monthly mortgage payments attributable to principal are taxable gifts, and do not qualify for the annual exclusion gift because they are not present interests.13
Third, many of these residences have significant values. To adequately reduce the value of the gift for tax purposes, the trust term would typically be for an extended period. This increases the likelihood the grantor would not survive the trust term and the trust property would be included in the grantor's estate for estate-tax purposes. The grantor may make a gift of a partial undivided interest in the residence while retaining the balance of ownership in the house, but this tends to be impractical. Also, there is a natural reluctance on the part of high-net-worth clients to relinquish ownership of substantial residences. Vacation residences may be placed in QPRTs, but for the very wealthy, this technique may reduce transfer taxes insignificantly.
CHANCE FOR CREATIVITY
Many opportunities exist when planning for commercial real estate or for business entities with commercial real estate as an underlying asset. Planning with this asset class allows the client and tax practitioner to be creative and proactive in structuring techniques to complement the client's objectives while maximizing the particular attributes of the property.
The Citigroup Private Bank and Citigroup Trust do not provide tax or legal advice. The client should always consult independent counsel/tax advisors in connection with matters covered in this article. This article is for informational purposes only and does not constitute a solicitation to buy or sell insurance products. Opinions expressed are solely those of the author, and may differ from the opinions expressed by other departments, divisions or affiliates of Citigroup. Although information in this article is believed to be reliable, Citigroup and its affiliates do not warrant the accuracy or completeness and accept no liability for any direct or consequential losses arising from its use.
- IRC Section 7520, Treas. Reg. Section 20.7520-1, et seq. The rate used for determining the present value of an annuity, an interest for life or a term of years, or a remainder or reversionary interest. This rate is adjusted each month.
- IRC Section 2704(b)(2), Treas. Reg. Section 25.2704-2.
- Treas. Reg. Section 25.2702-3(b)(2).
- IRC Sections 671-679.
- Also see IRC Section 7872.
- Treas. Reg. Sections 2632-1(c)(1) & (2). The estate-tax inclusion period (ETIP) precludes allocation of GST tax exemption during the period in which the property will be in the grantor's or spouse of the grantor's estate.
- IRC Section 512, IRC Section 681(a), Treas. Reg. Section 1.664-1(c), see exception to debt acquisition rule IRC sections 514(c)(2)(A) and 514(c) (2)(B). Practitioners should consider the bargain-sale rules under IRC Section 1011(b).
- IRC Section 642(c).
- IRC Sections 4941-4945.
- IRC Section 6166.
- Estate of Graegin v. Commissioner of Internal Revenue, T.C. Memo 1988-477 (U.S. Tax Court, 1988).
- IRC Section 2702, Treas. Reg. Section 25.2702-5.
- IRC Section 2503(b)(1).