Depressed Commercial Real Estate Values Create Valuable Opportunities for Family Wealth Transfers
|Depressed Commercial Real Estate Values Create Valuable Opportunities for Family Wealth Transfers
Act Now Before Estate and Gift Tax Rates Increase
|The continuing recession has played havoc with commercial real estate values. These depressed valuations combined with a very low-interest rate environment, however, have created valuable opportunities for passing wealth to your children and grandchildren. Valuations of commercial real estate have been hit very hard (even for properties that have good cash flow and are not over leveraged). Just a few short years ago, properties were being valued as high as 20 times cash flow. Now, appraisals can come in around 10 times cash flow or less. When you take valuation discounts into account to reflect lack of marketability and minority interest, a possible valuation can be as low as 6-7 times cash flow (although there are many methodologies appraisers use to determine value). These reduced values create tremendous opportunities to advance your estate planning. Do not ignore one of the few advantages of the recession by allowing these opportunities to pass you by!
Unless Congress acts, the estate tax will be reinstated beginning January 1, 2011. The estate tax rate is expected to be as high as 55% with an estate tax exemption of only $1 million. We do not anticipate Congress acting. By doing nothing, the White House can get an enormous tax increase and blame it on Congress and the Bush administration. If you do not take steps to move illiquid assets out of your estate, not only will a 55% tax likely be due (within 9 months of the date of death), but the real estate investments may have to be sold in order to pay the tax. Don’t let the government take the biggest share of your estate.
Real estate is typically owned in a Limited Liability Company (LLC) or Limited Partnership (LP). To move your interest in the LLC or LP out of your estate, we usually recommend first having the entity appraised on a discounted basis to reflect discounts for lack of marketability and minority interest. The service of a reputable appraiser is necessary. Simultaneously, you will create an irrevocable grantor trust for the benefit of the family. The grantor trust is funded with seed capital (usually through annual exclusion gifts or gifting a portion of the $1 million lifetime gift tax exemption). The seed capital must equal at least 10% of the sale price. Once the appraisal is complete, you will sell your interest in the LLC or LP (or a portion thereof) to the grantor trust in exchange for a promissory note. This sale is not a taxable event for income tax purposes.
As stated, the LLC or LP interest is sold to the grantor trust in exchange for a promissory note. If the note is less than 9 years, the IRS stated Applicable Federal Rate for November 2010 is only 1.59%. The cash flow going into the trust (now as the owner of the LLC or LP interest) will be used to pay down the interest and principal on the note. Once it is paid off, future cash flow can remain in the trust and grow outside of your estate (instead of accumulating in your estate and eventually being taxed at 55%).
A tremendous benefit of a grantor trust is that transactions between you and your grantor trust are not taxable. Thus, a sale of an LLC or LP interest to your grantor trust is not a taxable event. However, if an interest representing 50% or more of the underlying property is sold within a 3 year period, there can be NYS/NYC real property transfer taxes of about 3%. This can be avoided by selling less than a 50% interest in the underlying property. In some circumstances, however, it makes sense to pay the 3% real property transfer tax in order to avoid a 55% estate tax.
Having assets owned by trusts can substantially enhance tax planning benefits. An added benefit to using a trust is that your descendants will be provided with asset protection in the event of a divorce or lawsuit as long as the investment remains in trust. Furthermore, you, as the grantor of the trust can continue to pay the income tax on any trust income. The income tax that you pay for the trust is a tax free gift! The grantor trust can be used as a FAMILY BANK to make tax free gifts to your children if they need to buy a home or make a business investment.
We strongly encourage you to consider one of the few bright sides of the current economic environment and take advantage of it for estate planning purposes. It is generally believed that interest rates will soon begin to rise. Inflation may also increase valuations. The fact that Treasury Inflation-Protected Securities (TIPS) recently sold for a negative yield is evidence the market expects inflation to return soon.
If you have a commercial real estate investment, you should seriously consider implementing an estate plan to move these assets out of your estate now!