Most of the many apartment owners we have met after our AOA seminars in Los Angeles and the San Fernando Valley have already built living trust based estate plans.  They cared enough about preserving and protecting wealth for their heirs to already take significant planning steps. 

Unfortunately, almost all the plans we reviewed have now become “HAZARDOUS TO FAMILY WEALTH.”

These hazards generally do not reflect defects at the time the plans were done.  Instead, they mostly reflect the impact of changes in tax law.  However, a few hazards resulted from planning that was not sufficiently sensitive to risks well-advised owners could have protected against with good planning. 

Sound planning for apartment owners in today’s legal environment demands an emphasis on the income and property tax aspects of such planning.  For most, this deserves as much, or more, emphasis than the estate tax aspects.   

The New World of Estate Planning

When “The American Taxpayer Relief Act” (“ATRA”) became law in 2013, the principles that supported good estate tax planning before such law ceased to be meaningful for most taxpayers.    

Before ATRA, the tax considerations of sound estate planning for apartment owners usually focused on reducing or eliminating the dreaded “death” tax (estate tax). 

Four factors have now made it much more important for most apartment owners to refocus their planning on income and property tax consequences: (1) the expansion of the amount you could exclude from estate taxes under ATRA, (2) “portability” that allows one spouse to leave his or her exclusion to a surviving spouse, (3) sharp increases in California and Federal income tax rates, and (4) rapid and significant increases in the value of California income property. 

Now, if you leave an estate of less than $5.43 million as an individual, or $10.68 million as a married couple, estate taxes are usually no longer a problem, but plans intended to save estate taxes may create new tax problems.  [If your estate exceeds these limits, we can show you advanced strategies that can both minimize estate taxes and allow for a step-up in basis.]

Planning done under the old law was designed to maximize estate tax exclusions.  That came at a cost that has now become fearful:  It usually reduced the step-up in basis at death.
Such reduction is “hazardous” in today’s tax environment.

If the estate tax oriented features of older plans (done before 2013) were only unnecessary, and not potentially harmful, you could just ignore them.

But the BOTTOM LINE now is:  Old provisions intended to save taxes now usually have the effect of unnecessarily increasing income taxes, with no offsetting benefit!   

Importance of the Step-Up in Basis

Your income tax basis has dual significance.  First, if you sell property, you pay taxes on the gain, which is measured by your sale price (less most closing expenses) minus your income tax basis.  Second, your income tax basis on improvements provides ongoing tax deductions that often allow you to have tax-free cash flow from your property. 

Your income tax basis on improvements (generally, everything not allocated to raw land value) is the amount you allocated to the cost of the improvements when the building was purchased, less the accumulated depreciation you actually took (or could have taken). 

For many apartment owners, the income tax basis now represents only a small fraction of the value of their property, as a result of a combination of prior depreciation (which reduced basis) and years of market value appreciation.  Many owners have no remaining basis they can depreciate, while others will get very little depreciation in comparison to the appreciated value and current rents.

But, the law has long had one great loophole:  When you die, the property in your estate gets a new step-up in basis to its then current fair market value.  So, if you bought that building for $150,000, depreciated it down to $50,000, and die when it is worth $1,500,000, $1,450,000 can get added back to basis at your death.  But this addition, or “step-up”, applies only to the extent that the property is included in your estate for estate tax purposes.  If included, you get the step up whether or not any estate tax was paid or due. 

At top capital gains rates in California, that step-up can save your heirs more than $530,000 if they sell the building, or shelter hundreds of thousands in future cash flow from ordinary income tax rates (as high as 50+% in California) through new depreciation deductions.

This provides a massive tax saving.  It is one of the biggest “loopholes” in the tax system.  The loophole is so big that President Obama recently proposed to eliminate it (although we seriously doubt that this Congress will even consider his proposal). 

How Old Style Planning Endangers Step-Ups for Spouses

In old style planning, most of the property of the first spouse to die is allocated to a “B”, “Credit Shelter”, “Exclusion”, or “Bypass” Trust.  Such a trust is structured to stay outside the estate of the surviving spouse, and use the deceased spouse’s estate tax exclusion. 

However, by keeping the property of such trust outside the surviving spouse’s estate, it will not get a further step-up in basis when the surviving spouse passes away.  This can have a major adverse income tax impact on your heirs.

With proper planning and taking advantage of the portability of the deceased spouse’s estate tax exclusion, you can get a step-up in basis when the first spouse dies, and then get another step-up when the second spouse dies.  However, this usually requires changing the way your trust works, by amending or restating it. 

Community Property

The step up can be even more important for married couples.  If they (or their living trust) hold property as “community property”, both the share of the spouse that died, and the share of the surviving spouse, get a step-up in basis on the first spouse’s death.

Unfortunately, just putting your property in a joint trust does not make it community property.  California law, and the tax man, both presume that, if the property was not held as community property before it went into the joint trust, it will not become community property just by putting it in your trust.  And, most properties were originally acquired, even by spouses, as joint tenants, not as community property. 

A good living trust and community property agreement can correct this without requiring new deeds, but you need to take action while both spouses re still alive to be sure you get the community property step up. 

You also need good planning to be sure that the detriments of community property (including joint control, potential exposure to creditors of one spouse, and the potential to lose a part of separate property in a divorce) do not outweigh the tax benefits of community property. 

The Problem with Gifting and Discounting

When estate tax exclusions were smaller, estate tax rates were higher, and income tax rates were lower, it often made sense to give property away during one’s life.  Clients often leveraged the favorable estate tax impact of the gifts by using LLCs, Family Limited Partnerships (“FLPs”), and other discounting strategies. 

While these gifting and discounting strategies reduced estate taxes, they also reduced the step-up in basis two ways. 

First, the assets given away during life would get ZERO step-up in basis when you or your spouse die. 

Second, to the extent you used an LLC or FLP to discount what you gave away, you would reduce your ability to get a full step-up in basis at death.  The same principles that discounted the value of the LLC or FLP interest you gave away would discount the amount you retained, both for estate tax purposes and for step-up purposes.

In many cases, the income tax benefits lost as a result would exceed any estate tax savings, particularly if the expanded exclusion (nearly $11 million per couple) protected your family from estate taxes. 

If you have given property away, or build a discounting structure, it may now actually increase the family’s tax burden, instead of decreasing it.  Fortunately, in many (but not all) cases, an experienced estate planning lawyer may be able to help you reverse the adverse impact of gifting and discounting.   

Don’t Forget About Property Taxes

If you have owned your income property for a long time, you are saving a lot of money each year as a result of Prop. 13 keeping your property tax valuation below the market value of the property. 

Certain provisions in existing trusts, and the use of LLCs or Family Limited Partnerships, can nullify exclusions from reassessment after you pass away.  This can eat up as much as 15-20% of the cash flow for your heirs unnecessarily.  Over your heirs’ lifetimes, that can cost hundreds of thousands, or millions of dollars, in unnecessary additional property taxes

Sadly, most estate planners do not take these property tax issues into account in setting up trusts, LLCs and FLPs.  You should have your plan reviewed to see if it includes any of these problems, which can usually be solved during your life. 

Taxes Are Important, but Non-Tax Planning Is Equally Important

Clients understand that unnecessary taxes detract from the value of their wealth, both to themselves and their heirs.

Yet good non-tax planning remains important and should be a key element of your planning.  It can protect the inheritance you leave behind from pesky creditors and predators (ex-spouses).  It can encourage your heirs to maximize their potential.  It can help you pass your core values down multiple generations.  And, it can provide a structure to deal with, conflicts among heirs. My Motto:  “IF YOU FAIL TO PLAN WELL, PLAN TO FAIL”.

My experience is that owners of apartments and other income properties care about planning.  As a result, most of them have living trust based estate plans. 

Unfortunately, due to changes in the tax laws, and factors that many estate planners often ignore, those plans may no longer work as well as they were intended to work. 

How to Learn More

You can attend this FREE seminar on “Estate Planning for Apartment Owners” – Wednesday, April 8, 10:00 a.m. at The Scottish Rite Center, 1895 Camino Del Rio South, San Diego.  At the seminar, I will help apartment owners understand the principles behind modern estate planning as it applies to apartment and other income property owners, and show YOU strategies that could save millions of dollars in taxes.

As a bonus, attendees will receive a certificate entitling them to a free review of their existing estate plan, along with a personalized, no obligation consultation about their plans.

Advance reservations are required.  To register, call (800) 827-4262 or go online at www.aoausa.com        

Kenneth Ziskin, an estate planning attorney, focuses on integrated estate planning for apartment owners 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.  Ken’s website is www.Family-Wealth-Strategies.com    

This article is general in nature and not intended as advice for clients.  Please get advice from counsel you retain for your own planning.