The panel consisted of Doug Moore, managing director at U.S. Trust Bank of America, David Sullivan, a director at Institutional Real Estate Fund Marketing CBRE and Hugh H. Woodside, managing director at Empire Valuation Consultants LLC.
Moderator Doug Moore began by stressing three key elements that make commercial real estate such an attractive vehicle for wealth transfer in the current tax environment: First, transfers of real estate are extremely easy to discount for gift and generation skipping transfer tax purposes, which, combined with the current $5 million exemptions, can shield large amounts from taxation. Second, real estate carries great potential for appreciation post transfer, all of which will escape the estate tax. Third, commercial real estate properties tend to be high income producing. If you transfer them now, at current value, that will allow all of that future income to accrue outside of the taxable estate.
The panel next discussed the value of trusts in transferring real estate assets. The consensus was that a grantor trust, in which the grantor retains some control of the assets and all income is taxed to the grantor, is extremely effective in this regard.
One way to use a grantor trust is through gifting. By giving a gift of non-voting shares to a grantor trust, you can take full advantage of discounting, because non-voting shares will receive discounts for lack of marketability and lack of control, while allowing the grantor to retain the voting shares that determine actual control of the company.
A sale to a grantor trust can also be effective. Most commonly, a sale to a grantor trust will be in exchange for a 9-year note, payable to the grantor, which, if made within the same family, would only require an interest rate of 1.07%. As the property appreciates in value, the difference between the appreciation and the interest effectively passes out of the estate tax free. Further, the grantor is not required to pay additional income tax on any interest received under the terms of the note, as it is effectively similar to moving money from one pants pocket to the other.
The advantages of a grantor trust can be pressed even further through the use of administrative or directed trusts, whereby the trustee can provide access to a more favorable situs and be freed from the conflicts of interest that can arise from the interaction between concentrated commercial real estate investment positions and the prudent investor standard to which he must otherwise adhere. The grantor can also retain the right to substitute property of equivalent value for trust property, which provides a large degree of flexibility.
Given the numerous permutations of trusts, and the beneficial tax effects they can have when used in consort with commercial real estate assets, it’s imperative that business advisors be involved in the estate planning process from the very beginning. Documents need to be drafted in a way that allows for maximum discounting on the asset, and familiarity, or lack thereof, with the estate planning documents can affect the way a business advisor handles transaction during a client’s life, as well as at death.
It’s also important that the entities be set up properly to take full advantage of what the trust offers. Commonly, this takes the form of an LLC set up with 2% voting shares and 98% non-voting shares. This format opens up additional discounting opportunities on both sets of shares. For instance, where each spouse owns a 1% voting interest (or 50% control), when the first spouse dies, he can leave his 1% in a marital trust for the benefit of the survivor. This effectively maintains the split of control. Now, when the survivor dies, she didn’t technically have full control, which opens the door for further discounting on her shares. It should be noted that the IRS is aware of this popular 98-to-2 split, so it’s unwise to blatantly transfer all 98% of the non-voting shares in one large transaction. It’s best to make multiple transactions in order to set off fewer alarms.
The panel next tackled the topic of discounting and valuation. The two most typical types of discount applied to commercial real estate are: 1) lack of control, and 2) lack of marketability. The level of these discounts can vary wildly depending on the exact nature of the property owned. A high cash flow property will probably receive a discount on the low end, while a development property will tend towards a higher rate.
That being said, there is no hard and fast rule followed by the IRS, and treatment will vary from region to region. These situations are highly facts-based and it’s imperative that you have a good argument based on sound logic. Since each valuation is effectively a negotiation, a strong, honest initial appraisal based on an effective argument will get things off on the right foot and lessen scrutiny from the government. It's important to note when making this initial valuation, however, that you can’t count on the IRS to only target the big ticket numbers. It’s unlikely that you will be able to slip something small under their radar, and an attempt to do so may poison the entire valuation/negotiation process. The panel then urged advisors to adequately fill out their gift tax return with all required information on the transaction. If you don’t, the IRS will toll the statute of limitations on auditing the transaction.
Finally, the panel thought it important to point out that the law governing LLC agreements in New York changed in 1999. Previously, if no right to withdraw was specified in the creation instrument, then parties could still withdraw before termination. Under the revised law, a right to withdraw is not assumed, unless otherwise enumerated. This can prevent discounts under certain agreements made prior to 1999, which haven’t been updated yet. If looking to maximize discounts, clients must now specify the terms. However, the functionality of the entity is still important in the eyes of the IRS. So, a balance must be struck between creating purposely restrictive terms for future discounting purposes and the fact that the IRS will not honor the discounts if the entity does not abide by that same highly restrictive structure.