In this article I plan to give you a 30,000 foot perspective on strategies that successful apartment owners can use to disinherit the tax man.
In giving seminars to hundreds of AOA members around California on “Estate Planning for Apartment Owners” I have been amazed by how many apartment owners have built big enough estates to worry about gift, estate and generation skipping taxes. [Collectively, we sometimes refer to these as “Transfer Taxes.”]
The number of these owners (most of whom do not think of themselves as “wealthy”) shows how successful apartment owning strategies have been for prudent investors in California.
But, with this success comes a problem: When these members (and their spouses) depart this mortal coil, Uncle Sam is going to want more than a pound of flesh – for the taxable portion of these estates, he wants 40%. [And, if you leave the property to grandchildren, he may want 64%!] In many cases, that will make the government your largest beneficiary.
Experience tells me that most of you would not pick the government to be your largest beneficiary of the wealth you built over decades of hard work and prudent spending. Instead, you should be able to choose who will benefit from that wealth after you are gone, whether it is children, grandchildren, other relatives, friends or good causes (charities) that you selected.
Fortunately, the estate, gift and generation skipping tax systems really are voluntary systems. With careful planning, you can opt out of these systems, disinherit Uncle Sam and pick who gets your property, how much, when and with what restrictions or protections.
You “volunteer” to pay these taxes by not doing sound transfer tax planning, or to pay some of them by not doing such planning soon enough.
That is why my estate planning motto remains “If you fail to plan (well), plan to fail.”
[If you do not anticipate your estate will exceed the Estate Tax exclusion amount, Transfer Tax savings are irrelevant or only a minor issue. But, planning is still important to deal with non-tax issues regarding protection of your heirs, and to optimize income and property tax savings.]
Who Needs to Worry About Estate Taxes?
In the 2012 American Taxpayer Relief Act, Congress made “permanent” the expansion of the lifetime exclusion from gift, estate and generation skipping taxes. Those exclusions have grown with inflation to $5.43 million per person ($10.86 million per couple) in 2015, and will continue to grow at the official inflation rate. While day’s exclusion is so much more than the $600,000 exclusion which existed in the mid ‘90s, it does not protect the families of many California apartment owners.
And, even if your estate is not over the exclusion amount today, most of you probably expect your wealth to grow faster than inflation. If your estate grows at 3% above the inflation rate, in 15 years that means it will grow to an inflation-adjusted 156% of its current value. This means that an $8 million dollar estate today will probably produce transfer tax exposure without further planning in 15 years.
Bottom Line: Even those of you who have wealth equal to 70% or more of the exclusion and believe your wealth will grow faster than inflation, should worry about Transfer Tax exposure.
Principles of Transfer Tax Protection
This article does not have enough words to allow me to explain even a few of the strategies in our tool box that can to protect your heirs from Estate Tax exposure. In future articles, I hope to explain some of these strategies in more detail. But, I can give you an idea of the principles that support most of these strategies and introduce you to a few of them.
FIRST PRINCIPLE – FREEZE VALUES
This involves getting some of the assets you expect will grow in value out of your estate before they grow further. This leverages your exclusions by using them before property has finished growing in value. And, you can usually do this in ways that do not impact on your ability to spend from the wealth you have accumulated.
Sometimes you do not even need to use any of your lifetime exclusion to get assets out of your estate. Some gifts (like direct payments of tuition and medical expenses) are not treated as gifts at all.
Other gifts can use your annual exclusion (currently $14,000 per donee per year) without depleting your lifetime exclusion.
SECOND PRINCIPLE – DISCOUNT VALUES
Fractional interests in property, particularly when held in an entity such as a Family Limited Partnership or LLC, are usually worth less than a pro rata portion of the whole. For example, if your property is worth $1 million and owned in a well-drafted LLC, it is likely that a 10% interest in the LLC is only worth $60-70 thousand, even if it “represents” $100,000 in underlying value.
Although the Treasury Department has threatened to restrict the use of these discounts sometimes this year, it has not done so as of the date this article was written. And, we think that there will still be meaningful ways to get these discounts (particularly for income property owners) even if the new regulations come out.
THIRD PRINCIPLE – “SQUEEZE” YOUR ESTATE
If you want to enhance the wealth transferred when you pass away, the Internal Revenue Code allows you to set up a special kind of trust where all the income and growth accumulates for your heirs, but you pay the income taxes. I call this kind of trust a “Family Security Trust” or “FST.
Due to a 60 year-old provision in the law, the income taxes you pay do not get treated as gifts to your heirs, even though they are the economic equivalent of such gifts. Over a decade or so, this creates great benefits for your heirs outside the Transfer Tax system.
In the meantime, your payment of the income taxes on the property in an FST “squeezes” down the value that remains in your estate for Estate Tax purposes. Often it is enough, when combined with freezing (and, maybe, discounts), to eliminate estate tax exposure entirely.
Of course, this makes sense only if you have kept access to enough of your wealth to pay both the income taxes and your living expenses. I often help clients create realistic projections to analyze whether they can afford “squeezing.” I also generally construct an “escape clause” that will allow you to terminate your personal tax obligation for income in the FST if that later becomes important.
FOURTH PRINCIPAL – LEVERAGE AND THE TIME VALUE OF MONEY
In larger estates, freezing, discounting and squeezing may not provide as much Estate Tax protection as you desire without creating gift tax liabilities.
In those cases, you can make partial outright gifts to a trust, and then, sell additional property to the trust at a very low effective rate of interest allowed under IRS regulations (in October, 2015, this rate is as low as 0.55% per annum on some transactions). This can include sales for an installment note, sales in exchange for an annuity (in a Grantor Retained Annuity Trust, or “GRAT”) and sales in exchange for a Self-Cancelling Installment Note (a “SCIN”, which is a note that cancels if you die before it is paid off).
If the trust is structured as an FST, the sale has no income tax effect as you are still deemed to own the property for income tax purposes. So, you generally do not need to recognize gain on the “sale.”
This principle works when the assets in the FST grow at a faster rate than the IRS requires on the note, or which the IRS uses to calculate the annuity.
FIFTH PRINCIPLE – SPLIT INTEREST CHARITABLE TRUSTS
Clients usually assume that charitable trusts work only for those who are really philanthropic. However, they can also be used to enhance the amount you can ultimately spend and/or pass to your heirs. A Capital Gains Bypass Trust (“CBGT”) can help you avoid capital gains taxes when you sell property and reduce Transfer Taxes, while a Charitable Lead Trust can provide some current charitable gifts and reduce the Transfer Tax value of the remainder that will go to your heirs.
Although the remainder in the CGBT will go to charity after you, or your designated heirs, are gone, the income stream (enhanced by NOT paying capital gains taxes) can, in some cases, produce more wealth for you and your heirs than you would have been able to produce/retain after a taxable sale.
Some Strategies that Use These Principles
Without trying to give you an exhaustive list, here are a few words about the strategies that are most likely to work for apartment owners:
- Sell Assets to an FST for an Installment Note or Annuity. This usually combines Freezing, Discounting, Squeezing and Leverage. With careful planning, it can save Transfer Taxes AND allow your heirs to get a step-up in income tax basis when you die, while also maximizing your ability to avoid property tax reassessment. This is the strategy that works best for more apartment owners than any other strategy. For married couples, an installment note can work well and still avoid unpleasant property tax reassessment. For unmarried clients, a GRAT works better unless you are not concerned about property tax reassessment.
- Transfer Highly Appreciated Property (like that apartment building you are tired of managing?) to a Capital Gains Bypass Trust (“CGBT”). The CGBT can sell the property and reinvest the proceeds to produce income for you and/or your designated beneficiaries, without reduction from capital gains taxes. And, you can get a current income tax deduction as well. Furthermore, if you still have substantial income tax basis, it can even be structured to provide you with tax-free cash flow while you are alive, and then a substantial income stream for your heirs after you are gone.
- Put Property into a Charitable Lead Trust (“CLT”). The CLT pays a fixed amount or percent of income each year to charity, but the remainder to your heirs. The IRS usually treats the value of the remainder for your heirs as a gift when you establish the CLT. In today’s low interest rate environment, you can often structure a CLT in today’s low interest rate environment so that the amount deemed to be a gift to your heirs is less than 10% of the value of the property today.
- Maximize the Use of Your Annual Exclusions. Give the maximum amount you can under the annual exclusion to a trust for multiple heirs. Invest the property to grow so that the proceeds to your heirs far exceeds the amount you give. Sometimes life insurance can be a good way to leverage this growth free of income and Transfer taxes.
Fifty years ago science fiction writer Robert Heinlein, in The Moon Is a Harsh Mistress, warned us that “There Ain’t No Such Thing As A Free Lunch” (“TANSTAAFL”). The same thing can apply to most advanced Estate Tax Protection strategies.
Many of the strategies discussed above, and variations thereon, may have other “costs”, including legal fees, possible adverse income tax consequences, loss of the step-up in basis at death and possible adverse property tax consequences.
Good, careful planning can minimize these costs, often preserving low property tax valuations and allowing your heirs to get both Transfer Tax saving and step-ups in basis. When we achieve this estate planning nirvana, we can help you substantially enhance the wealth of your heirs for generations
PLAN WELL – The Solution to the “TANSTAAFL” Problem
PLANNING WELL requires time. You need to work with an experienced estate planning lawyer who will help you analyze your estate and your goals, will work to develop a plan that meets your non-tax goals and who can help you optimize all of the tax consequences (Transfer Taxes, income taxes and property taxes) based on your unique situation.
If you have a multi-million dollar estate, your family cannot afford to let you pass it without good planning. The failure to do good planning can cost your heirs millions of dollars, often up to 1000 times the cost of good planning!
You will be hard pressed to find another investment that can produce as high an after tax return for your family as really good PLANNING. Find a lawyer who cares about doing good planning designed to meet your goals, and you can achieve great results for your family.
Kenneth Ziskin is a Los Angeles (Sherman Oaks) estate planning attorney who concentrates his practice on integrated estate planning for income property owners throughout California, from San Diego to the Bay Area. Ken is a member of AOA, and lectures regularly to its members. He focuses on integrated planning to save income, property, gift and estate taxes. He holds the coveted AV Preeminent peer reviewed rating for Ethical Standards and Legal Ability from Martindale-Hubbell, and a perfect 10 out of 10 rating on legal website AVVO, which also presented him its Client Choice Award in 2014.
Ken recently rewrote AOA’s guide “Holding Title to Your Property – A Matter of Life, Death and Taxes…”
Kenneth Ziskin will present his seminar in conjunction with the AOA on “Estate Planning for Apartment Owners” in San Diego on Thursday, December 3, 2015 from 10 am to 12:30 PM.
Ken is proud that San Diego attorney John Demas will join him in presenting the seminar. Ken and John work together on many San Diego clients. John also has a 10 out of 10 rating on AVVO, and teaches both tax and real estate law at the University of San Diego. To book a consultation with Ken, call (818) 988-0949 or email [email protected]
Ken’s recent seminars were overbooked, so please reserve early. For seminar reservations, call (800) 827-4262 or register online at www.aoausa.com
This article is intended to assist readers to get a general understanding of some estate planning concepts which are relevant for income property owners. To keep it concise, it does not discuss all of the exceptions, qualifications and other concepts that might affect their utility in your situation; some of the calculations are approximations. You need to obtain careful planning from expert counsel to determine the extent to which these concepts may be appropriate for you. You can only rely on counsel you specifically retain, and not on these materials, in connection with your planning.