Popular Estate Planning Techniques Can Cause Income Tax Horrors For Real Estate Owners
By Stephen M. Breitstone
The real estate wealth created over a lifetime (or over generations) can be lost absent tax and succession planning. For the large real estate portfolio, liquidity is usually a major concern. Therefore, it is essential to plan early and often to preserve the wealth for future generations. In the haste to do proper planning for estate taxes, estate planners often tout the popular estate planning techniques de jour in the hope of saving estate taxes that can amount to 55% or more of the decedent’s estate (even in light of current repeal legislation).
However, income tax considerations particular to real estate are often overlooked. There is a long history of tax laws that encouraged real estate owners to finance growth by refinancings, and that allowed real estate owners to claim tax depreciation and losses. The problem is that these tax benefits must be “recaptured” unless the property is held until death at which time a stepped up basis is allowed – at least until 2010, when the estate tax repeal is scheduled to go into effect.(2)
An otherwise sound estate plan can reek havoc when it is devoid of proper income tax planning. Absent proper attention to income taxation, gifts can trigger income tax gain to the transferor sooner or later. Or perhaps worse, the intended recipients can be saddled with an income tax liability – which can in some cases exceed the value of the gift!
This Article discusses the income tax pitfalls that can result from the use of popular estate planning techniques. It also describes a technique that can be used to avoid those pitfalls. This technique is known as the “preferred partnership freeze.”
The Current Estate Planning Environment
Shortly after the purported repeal of the Federal Estate Tax under The Economic Growth and Tax Relief Reconciliation Act of 2001, the community of estate planning experts and pundits concluded that, at least for the wealthy, estate planning should continue as before or be expanded. This is because the tax legislation leaves open the major question of whether the repeal will ever really go into effect. Although the repeal is scheduled to go into effect at the beginning of 2010, and then to be reinstated in 2011, it is likely that budgetary constraints will require Congress to revisit the entire package long before that time. In the meantime, there is an Estate Tax to contend with for at least the next nine years. Further, when planning for the larger estate, it is dangerous to assume that repeal will go into effect, and if it does, that it will be permanent. Years of advance planning are necessary to contend with the enormous liquidity problems facing the estates of most real estate entrepreneurs. Accordingly, most planning for the very wealthy will continue substantially as before.
Popular Techniques that can Trigger Income Tax Horrors
Tax and estate planning for real estate presents it own challenges due to the heightened importance of income tax consequences. Popular estate planning techniques such as grantor retained annuity trusts (“GRATs,”), installment sales to defective grantor trusts (“IDITS”) and outright gifts may not work well for real estate since they can trigger unexpected gain and income taxes. This can occur with leveraged real estate if there are “negative capital accounts” on interests in partnerships and limited liability companies or, for real estate owned outright, where liabilities are greater than the income tax basis. This scenario is relatively common for real estate interests where cash proceeds of refinancings have been taken or where the property has been fully depreciated. Worse yet, the triggering of this gain can often result in an income tax liability to the transferor that is greater than the potential estate tax savings that were the initial motivation for the creation of the GRATs, IDITS, etc.
Both GRATS and IDITS are, if correctly drafted, known as “Grantor Trusts” within the meaning of section 671 of the Code. The consequences of being a grantor trust is that income earned by the GRAT or IDIT is deemed to be earned by the grantor, and thus taxed to the grantor.(3 In addition, a transfer to a GRAT or IDIT is essentially ignored for income tax purposes.(4) These characteristics generally enhance the tax benefits and estate planning objectives of the grantor. For example, in general, a sale, even of leveraged real estate, to a GRAT or IDIT will not trigger a taxable gain to the grantor. Similarly, a gift of property subject to liabilities in excess of basis (or a partnership interest with a negative capital account) to a GRAT or IDIT will not be a taxable event to the grantor. Contrast this with an outright gift of such property that will, at a minimum, be treated as a taxable sale of the gifted property for the amount of the liabilities.
The problem with this nonrecognition of gain tax treatment is that the taxable event that was avoided when the GRAT or IDIT was created may be triggered later upon the termination of the grantor trust status of the trust. In the case of a GRAT, this occurs upon the expiration of the term of the GRAT. For an IDIT, termination will occur upon the death of the grantor or perhaps sooner.
The GRAT or IDIT transactions also forego a stepped up basis upon death which can extinguish the phantom income tax liability potential inherent in such leveraged real estate interests forever. Although all gifting foregoes a stepped up basis, and that can be a reasonable tradeoff to save estate taxes, in the context of leveraged real estate with liabilities in excess of basis, the loss of a stepped up basis can be fatal to an otherwise sensible plan.
As described below, a technique that can provide the best of both worlds is the Preferred Partnership Freeze. This technique can be used to transfer values out of the estate without foregoing the basis step up which is necessary to eliminate the phantom income attributable to liabilities in excess of basis (in the case of outright real estate ownership) or negative capital accounts (in the case of real estate owned by a partnership or limited liability company).
Illustration of the Problem ,br> Under current law, estate tax rates (up to 50%) are higher than income tax rates with the phase out of the credit for state taxes scheduled to go into effect beginning in 2002. Capital gains can be taxed at a rate as low as 20% (25% for depreciation recapture). A popular misconception is that since income tax rates are lower than estate tax rates, triggering built in gain through the use of GRATS, IDITS and outright gifts is a reasonable tradeoff. However, with leveraged real estate, the amount subject to income tax may be many times greater than the amounts subject to estate tax. This is because the estate tax is imposed on the “equity value” of property in the estate. The income tax, on the other hand, is imposed on the total negative capital account or liabilities in excess of basis – either of which could be much greater in the extreme case.
This point can be illustrated as follows: Assume a parcel of real property has a fair market value of $1,000,000 and is subject to a mortgage of $800,000. Thus, the equity is worth $200,000. Also assume the property has a cost basis of $50,000. If the property were sold, the gain subject to income tax would be $950,000 resulting in income tax of approximately $237,000 assuming a combined state and Federal tax rate of 25%. Under that scenario, the tax would be $37,500 greater than the equity. To dispose of that property, the owner would have to come “out of pocket” to pay the taxes. If it were possible to transfer that property to heirs, absent a basis step up, you would be transferring a net liability after taking into account income taxes. Contrast this with the estate tax liability (assuming a 50% rate). The estate tax would be $100,000, $137,000 less than the income tax liability inherent in the asset.
Since a basis step up is foregone when property is gifted, sooner or later the recipient of the property will have to pay that built in income tax liability. To forego the basis stepup as in the case of an outright gift, a GRAT or an IDIT, will, in effect, foist a net liability upon the intended beneficiaries.
As discussed above, the problem is that recapture gain can be triggered when the GRAT or IDIT ceases to be a grantor trust. This occurs upon the termination of the GRAT assuming the grantor survives the term. If mortgaged property exists in the trust upon its termination, the IRS will treat the termination as a sale for the amount of the unpaid balance of the mortgage debt.(5) When this debt exceeds the adjusted tax basis of the property, gain is required to be recognized by the grantor.
The income tax results are less clear when an IDIT that owns leverage property ceases to be a grantor trust (i.e., as a result of the grantor’s death). The IRS is likely to take the position that the death of the grantor will trigger a deemed sale for the mortgage or other debt of the trust. (6) If the Service is successful, this can result in gain recognition whenever liabilities exceed basis. It is not clear that the courts would sustain the Service’s position.
Some commentators agree with the IRS’s view taking the position that the cessation of grantor trust status triggers a deemed sale immediately before death.(7) Since the deemed sale occurs pre-death, the stepped up basis is not available to eliminate the gain. Other commentators take the position that the immediately-before-death position is not supportable because the death of the grantor is the cessation event and the deemed transfer from the grantor to the trust therefore cannot take place immediately before death.(8) As a result, the deemed transferor of the property must be the grantor’s estate and there is no gain recognized because there will be a stepped-up basis.
There is little reason to assume this risk when an alternative technique is available that can achieve substantially the same economic objectives. That technique is the Freeze Partnership.
The Freeze Partnership
Like, GRATS, IDITS and outright gifts, the freeze partnership permits future appreciation to accumulate outside of the estate.(9) This effect is often referred to as the “estate freeze.” However, unlike the other techniques, the freeze partnership does not sacrifice the stepped up basis needed to eliminate the inherent tax liability attributable to negative capital accounts or liabilities in excess of income tax basis. Furthermore, this technique is expressly allowed under Federal tax law.(10)
Briefly stated, the freeze partnership typically has two classes of partnership interests. There is a preferred interest, entitled to a preferred return and a liquidation preference (like preferred stock), and a junior equity interest, which is entitled to growth and appreciation (like common stock). The preferred interest is typically retained and the junior equity interest must be worth at least 10% of the value of the partnership at the time of the transfer. The transaction is called a freeze partnership because the value of the preferred interest is frozen at the time the junior interest is transferred and only the junior equity interest appreciates in value over time as the partnership assets appreciate in value. A transfer of noncontrolling, nonmarketable minority interests to the freeze partnership may enhance this technique even further since assets will be contributed to the partnership at discounted values.
Partnership freezes are generally governed by IRC section 2701 and the accompanying regulations. Section 2701 applies where the junior equity interest is transferred to a member of the transferor’s family. Family members include the transferor’s spouse, lineal descendants of the transferor or his spouse and the spouse of any such descendant.(11) In this situation, unless the provisions of section 2701 are followed, the preferred interest is value at zero, thereby inflating the value of the transferred junior equity interest to an amount equal to the entire value of the partnership. This treatment acts as a penalty by artificially inflating the amounts subject to gift taxation.
In order to prevent this result, section 2701 requires that the retained interest be “an applicable retained interest.” An applicable retained interest is an interest that requires, inter alia, mandatory distributions that are cumulative to be paid in respect of the retained preferred interest.
If the requirements of section 2701 are satisfied, the retained preferred interest will not be valued at zero. Rather, the fair market value of the retained preferred interest would be deducted from the fair market value of the capital of the partnership, with the difference being the gift tax value of the junior equity interest. The value of the junior equity interest, so determined, less any consideration paid for that interest, will be a taxable gift. Note that section 2701 deems the junior equity interest to have a value of not less than 10% of the total value of the partnership.
Non-Tax Benefits of the Partnership Freeze
In addition to the tax reasons for considering the partnership freeze, there are numerous non-tax reasons for using the partnership freeze. For example, the creator can retain an interest in the income of the venture for life and like all family partnerships, the creator can retain control, or provide for an orderly transition of control to later generations. In addition, it is easier to manage the real estate portfolio as a whole through a single partnership (that acts like a holding company), rather than being forced to manage the portfolio on a property-by-property basis. The partnership structure also works far better than a management company structure that can be more easily dismantled by competing or conflicting heirs.
A Note of Caution
The freeze partnership technique can be more complex to implement than typical estate planning techniques. It requires not only estate planning expertise, but also an intimate understanding of the workings of the partnership income tax rules that have become one of the most complex areas of the Internal Revenue Code.