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14-1 Dishing the Dirt on Planning for Real Estate

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14-1 Dishing the Dirt on Planning for Real Estate DISHING THE DIRT ON PLANNING FOR REAL ESTATE INVESTORS Farhad Aghdami1 Williams Mullen, P.C. Richmond, Virginia I. INTRODUCTION. A. Real Estate Owners and Family Businesses. 1. Real estate owners share all of the problems of the family business owner, in addition to the unique problems of owning real estate. However, real estate presents some opportunities that other family businesses do not share. 2. There are three basic goals of estate and gift tax planning for real estate: (a) the reduction of estate and gift taxes upon transfer; (b) the deferral of the estate and gift tax burden; and (c) the provision of the necessary liquidity to pay the taxes imposed on an illiquid asset. 3. Furthermore, while taxes cannot be ignored when planning for real estate, additional goals for the real estate owner, which can be as important as tax planning, include (a) creditor protection, (b) retention of control over the real estate by the client, (c) management succession, and (d) economic support of the family. B. Valuation Discounts. The estate planning goals means that the planner for a real estate owner will be grappling with the discounts in valuation available to limited partnerships and limited liability companies, since the real estate owner will already be using these entities for business purposes. These discounts are much more easily obtained for the real estate owner, in light of the real estate assets held in the entity (as opposed to passive stock portfolios), but the extent of these discounts will still be subject to attack by the Service. C. Management Succession. The issue of management succession is complicated for the real estate owner because the management and investment of real estate calls for knowledge and experience that many family members, other than the real estate owner, often do not possess. In addition, there are not many outside professionals with such knowledge and experience to whom the family can turn, upon the death or retirement of the real estate owner. D. Lack of Diversification and Liquidity. Finally, clients who own real estate usually own only real estate. It is what they know and understand and they generally put any cash flow they receive from their properties back into their properties (or into new properties), to the extent they don’t need it for personal consumption purposes. E. Overview. 1. The purpose of this outline is to examine planning opportunities available to maximize the tax and non-tax efficiencies of liquidity events. 2. Part I (Sections II through XI) focuses on the basics of valuing property for estate and gift tax purposes, including the use of fractional interest, minority, and marketability discounts to achieve substantial transfer tax savings. 3. Part II (Sections XII through XIII) explains how proper planning and implementation will decrease the risk that the IRS challenges a taxpayer’s valuation for gift or estate tax purposes, 1 I am grateful to my co-panelist, Sarah M. Johnson, and my law partner, Daniel J. Durst, for their thoughtful comments and edits to these materials. In addition, I want to thank my assistant, Tammy L. Bracey, for her assistance in formatting these materials and preparation of the table of contents. 14-1 including the use of defined value clauses in transfer documents, including recent decisions from federal circuit courts upholding this strategy. 4. Part III (Sections XIV through XIX) discusses wealth transfer planning techniques that can be well suited for real estate related investments, including a discussion of grantor retained annuity trusts, sales to defective grantor trusts (including the use of self-canceling installment notes or private annuities), beneficiary defective trusts, sale/leasebacks, and personal residence trusts, and explains how clients may use these estate planning vehicles to maximize transfer tax efficiencies. 5. Part IV (Sections XX through XXIV) reviews methods to reduce the estate tax on real estate related assets and strategies to provide for the payment of estate tax including a discussion of Code §§ 6161 and 6166, Graegin loans, and life insurance. 6. Finally, Part V (Sections XXV through XXVII) concludes by offering some practical considerations when guiding clients through the planning process. F. 2017 Tax Act. 1. The 2017 Tax Cut and Jobs Act (whose name was changed shortly before enactment to “To provide for reconciliation pursuant to titles II and V of the concurrent resolution on the budget for fiscal year 2018”) doubled the estate and gift tax exclusion amount from $5.6 million to an amount roughly equal to $11.2 million. Because of a change in the methodology for calculating inflation adjustments to “chained” CPI, it is not certain, as of the date of this outline, whether the increase will be exactly $11.2 million. There are reports of practitioners who have calculated an increase anywhere between $11.18 million and $11.21 million. For purposes of this outline, we will assume that it is $11.2 million in 2018. The GST exemption will also be $11.2 million in 2018 (subject to the prior caveat), the tax rate is 40%, and the Code § 1014 basis adjustment at death is retained. The increase in the exclusion amount is scheduled to sunset after December 31, 2025. 2. The planning implications of the new tax law are significant. For married clients with assets below $22.4, the need to engage in sophisticated planning described in the balance of this outline is diminished. There is, of course, the risk of a repeal of current law and a return to the lower exemption amount. 3. The risk of engaging in lifetime gift planning is the loss of the basis adjustment at death which, for real estate investors and developers, can be significant. Steve Akers has noted that “a gift of a $1 million asset with a zero basis would have to appreciate to approximately $2,470,000 (to a value that is 247% of the current value) in order for the estate tax savings on the future appreciation ($1,469,135 x 40%) to start to offset the loss of basis step-up ($2,469,135 x 23.8% for high bracket taxpayers). The required appreciation will be even more if state income taxes also apply on the capital gains.” 4. Clients who have placed assets in entities structured to foster the availability of valuation discounts may wish to consider unwinding such planning or doing additional planning to cause estate inclusion with respect to those assets, so as to obtain a basis adjustment at death. 5. For clients with assets significantly in excess of estate and gift tax exclusion amount, the change in law presents wonderful additional planning opportunities and fresh, new “dry powder” with which to engage in additional strategies. For example, a husband and wife considering a sale to a grantor trust could fund a trust with a 10% “seed money” gift of $22.4 million and then sell $201.6 million of assets to the trust. 14-2 PART I - VALUATION II. VALUATION BASICS. A. Introduction. 1. The applicability and amount of valuation discounts (and premiums) are some of the most frequently litigated areas in estate and gift tax planning. The inherently subjective nature of valuation lends itself to frequent disputes between taxpayers and the Internal Revenue Service (the “Service”). 2. In Estate of Auker v. Commissioner, T.C. Memo 1998-185 (1998), Judge Laro wrote: Disputes over valuation fill our dockets, and for good reason. We approximate that 243 sections of the Code require fair market value estimates in order to assess tax liability, and that 15 million tax returns are filed each year on which taxpayers report an event involving a valuation-related issue. It is no mystery, therefore, why valuation cases are ubiquitous. Today, valuation is a highly sophisticated process. We cannot realistically expect that litigants will, will be able to, or will want to, settle, rather than litigate, their valuation controversies if the law relating to valuation is vague or unclear. We must provide guidance on the manner in which we resolve valuation issues so as to provide a road map by which the Commissioner, taxpayers, and valuation practitioners can comprehend the rules applicable thereto and use these rules to resolve their differences. Clearly articulated rules will also assist appellate courts in their review of our decisions in the event of an appeal. B. Fundamental Concepts of Transfer Tax Valuation. 1. Fair Market Value. Fair market value is the price at which the property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or to sell and both having reasonable knowledge of the relevant facts. United States v. Cartwright, 411 U.S. 546 (1973). See also, Treas. Reg. §§ 20.2031-1(b) and 25.2512-1. 2. Willing Buyer – Willing Seller. a. The willing buyer and the willing seller are hypothetical persons, rather than specific individuals or entities, and the individual characteristics of these hypothetical persons are not necessarily the same as the individual characteristics of the actual seller or the actual buyer. See, e.g., Estate of Bright v. U.S., 658 F.2d 999 (5th Cir. 1981); Propstra v. United States, 680 F.2d 1248 (9th Cir. 1982). b. The “willing buyer-willing seller” principle is an objective test rather than a subjective test. The court in Estate of Watts v. Commissioner, T.C. Memo 1985-595 (1985), explained that the test requires the transaction be analyzed from the viewpoint of a hypothetical seller whose only goal is to maximize his profit on the sale of his interest. c. In Morrissey v. Commissioner, 243 F.3rd 1145 (9th Cir. 2001), rev’g Kaufman v.
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