Commercial Real Estate Planning for Large Estates

I recently have been involved with a couple of different families that have substantial business interest including commercial real estate. The planning for a larger estate is somewhat different than an estate that is not subject to the transfer tax system discussed below.

The similarities between a larger estate and an estate not subject to the transfer tax system for a choice of a business entity are generally identical for asset protection based upon income tax planning. The governing operating documents will have different provisions to avoid certain IRS audit challenges if a business owner is subject to the transfer tax system compared to if he or she is not. Below is a discussion from an article written by Daniel L. Daniels and David W. Kesner dealing with an overview the transfer tax system.

Commercial real estate presents unique opportunities and challenges to the business owner whose estate is over $5,430,000 or if married $10,860,000 during 2015. Several planning strategies are available to place the appreciation of, or the income generated by, real estate outside the transfer tax system. In addition, because commercial real estate transactions often occur on a fractional basis, valuation discounts may well apply to transfer tax valuation of the interests. Some issues, a portion of which are exclusive to planning with real estate, can derail even a carefully considered plan.

Overview of common techniques As complex as lifetime wealth transfer planning can seem, boiled down to its essence the planning is quite simple. If an individual attempts to transfer assets during life in order to avoid an estate tax, the transfer will generally be subject to a gift tax instead. Since the gift tax and the estate tax apply at the same rates and generally have the same exemptions, there should be no incentive for an individual to transfer wealth during life as opposed to waiting to transfer it at death. In effect, by enacting the gift tax as a companion to the estate tax, Congress created an “airtight” transfer tax system. There are, however, leaks in that system.

Types of leaks in the transfer tax system. The three primary examples of those leaks are:

  1. Removing value from the system.
  2. Freezing value within the system.
  3. Discounting values within the system.

Removing value from the transfer tax system is hard to do. In most cases, if an individual makes a gift during lifetime, that gift is brought back into the taxable estate at death. One key exception to this rule is the annual gift tax exclusion ($14,000 in 2015). Gifts using this exclusion are not brought back into the taxable estate at death.

Freezing value within the system often entails the individual making a gift using some or all of his or her lifetime exemption from federal gift tax. For example, an individual might make a gift to a child of real estate having a value of $5 million. At death, the $5 million gift is brought back into the estate for purposes of calculating the estate tax, but only at its date-of-gift value. If the value of the gifted property increases between the date of the gift and the date of death, the appreciation avoids transfer tax. The value of the property is “frozen” at its date-of-gift value.

A holy grail of advance planning has been to find a way of freezing the value of an asset at some number lower than what it is actually “worth” to the donor’s family, commonly referred to as “discounting” values. For example, an individual might own 100% of an LLC holding a rental property worth, say, $15 million. If the individual gives a 50% interest in the LLC to his or her children, the value of the gift should not be $7.5 million. A qualified appraiser would likely apply a discount to reflect the fact that each child receives a noncontrolling interest in the LLC. Assuming for purposes of the example that the discount is 33%, the individual succeeds in freezing the value of the transferred asset at $5 million even though it may be worth $7.5 million to the family as a whole. As a result, even if the real estate never appreciates in value, the family has removed $2.5 million from the taxable estate.

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