Estate Planning Considerations for Real Property Owners
Three major parts by Julie Martiniello, Kell Rabern + Roger Bowlin
As we live life, we seldom take time to recognize our mortality which makes estate planning an often-neglected topic. Layer on the overwhelming number of available succession options and inherent unpredictability of life 5, 10, or 20 years down the road and it is no wonder that many investment property owners default to less than ideal succession plans or, even worse, no plan at all.
In the following three sections, we will address important considerations in establishing a succession plan, the estate tax rates and key quantitative factors, and propose one approach that a real estate owner could take that can allow for a smooth and equitable transfer of real estate from you to your beneficiaries.
Avoiding Family Conflict
A discussion on proper estate planning for investment property owners
Julie Martiniello | Managing Partner | Dimension Law Group
For investment property owners estate planning can be complicated. For many the difficulty comes down to whether you can fairly divide your estate as you wish, if you want to put a succession plan in place to pass down your investment property, or liquidate your estate. For others with more complicated family dynamics, other considerations come into play. Below are some common scenarios discussing the emotional and family dynamics of estate planning.
Simple Family Scenario
In a single unit family with a Husband, Wife, and children, most clients will choose to leave everything to their spouse (either outright or via Trust), and then ultimately have everything go to their children upon the death of the surviving spouse. The main issue to consider here is whether you have one or more children that want to continue to operate the investment properties and if so, do you have the right assets to pass the property on while still allowing equal estate distribution to all children. If you cannot easily divide your assets then advanced planning should be done to try and avoid future conflict between siblings, possibly with insurance or diversification of assets. If you feel that conflict may be unavoidable in passing down your investment property or do not have an heir that wishes to operate the business, diversifying your estate with more liquid assets should be considered. If one chooses to make their estate more liquid while still living, capital gains and other taxes come into play. To avoid these taxes many use a 1031 exchange. However if your goal is to make your assets more liquid, exchanging with a Delaware Statutory Trusts is an option worth considering, which is explained in greater detail in Roger Bowlin’s article.
If you do have an heir or heirs that you wish to pass on the operation of your investment property the issue to tackle becomes succession planning. The successor should be someone who has demonstrated a passion and has the capabilities to operate the business. Once the successor is identified, developing a succession plan is key. If the successor is a family member forming a family partnership or company is usually recommended. This allows for transition while you are living and gives the added benefit of a deduction for estate tax purposes if done correctly.
Complex Family Scenarios
For many property investors family dynamics are not so simple.
Below are the most common family scenarios which require special planning.
Blended Family
Second or third marriages have become more prevalent in our world. With them come special estate planning considerations, especially when you have children from prior relationships. Careful steps should be taken to ensure that you are able to provide for your spouse while still making sure your own children receive the bulk of your estate. It is generally not advised to have all assets go directly to your spouse or for assets to become jointly owned between a child and step-parent. These scenarios often create conflict. Proper planning can be done through Trusts, diversifying your assets so they are easily divided between those you want to provide for, or starting the succession of the investment property among other things.
Beneficiaries With Addiction / Special Needs
While you may know where you want your assets to go and have a plan in place, if one of your beneficiaries has special needs or addiction issues it is never recommended to give them assets outright. This circumstance typically calls for a special needs trust or more a restrictive trust to protect the beneficiary from losing governmental benefits or from using the assets unwisely. Similar but less restrictive trusts are also suggested for minor or youthful beneficiaries.
Conflict Between Family Members
Unfortunately not all family members get along, especially siblings. This tension can be exacerbated after the death of a parent. If sibling conflict exists, it is imperative to have a well laid out estate plan. This may involve appointing a third party to serve as the executor or trustee to minimize interaction between siblings. It may also be prudent to ensure that your assets can be easily divided between siblings to avoid prolonged fighting and feelings of inequality.
As one can see developing a comprehensive estate plan that includes taking stock of your assets and planning in the now is important for all investment property owners in making future transitions easier on your family.
Transition Planning for the Property Rich & Cash Poor
Kell Rabern | CPA | Hutchinson & Walter
Many real estate investors in the Puget Sound have experienced significant appreciation in their properties. However, rapid appreciation can leave investors property rich and cash poor — creating a dilemma when it comes to estate taxes. With recent increases in real estate values, a plausible hypothetical “before and after” scenario may look like this:
While it is true that estate tax exclusions increase annually, the rate of increase rarely keeps up with strong real estate markets. The increases in this year’s exclusion limits compared to real estate values can be seen below:
Continuing our earlier scenario, let’s assume one spouse passed away in 2017. If the surviving spouse also passes away in 2017, they would first receive the Washington State exclusion of $2,129,000 leaving a remaining taxable estate of $2,471,000. The remaining estate would be taxed at a rate between 10% and 20% — creating a tax liability of $310,650. Were the estate worth more than the Federal exclusion, the excess value of the estate would be taxed at a rate ranging from 18% to 40%. The total maximum is 52%, after a deduction on the Federal return for state tax.
Federal law allows a Deceased Spouse Unused Exclusion (“DSUE”) — meaning that the second spouse to pass away can use the unused Federal exclusion allocated to the first spouse, in addition to their own. The “DSUE” effectively doubles the Federal exclusion amount. Unfortunately, Washington State does not have a DSUE concept.
You Can Run, But You Can’t Hide
Tom Stewart was a Washington business man who owned Food Services of America. He moved from Vashon Island after Washington State changed its estate tax laws, passing away in Arizona.
Real estate is not something you can take with you. The property he owned within the state remained taxable by the state. Washington has what is referred to as “tax apportionment” for decedents who own property in the state.
Entity Shares
What about owning shares of an entity, which owns real estate? Can you leave the state with the shares?
Washington State says, “Real property owned by a limited liability company (LLC) operating for a true business purpose is considered an intangible asset and is allocated to the decedent’s state of domicile” (Washington State Dept. of Revenue — “Estate tax apportionment for out of state property”). Thus, the answer is “Yes”, you can leave Washington with LLC shares and avoid tax apportionment.
Reducing Tax Burden Without Relocating
Ownership of minority shares of non-public entities (LLCs, DSTs, etc.) can receive a “discount for lack of marketability” (DLOM) for estate tax purposes. DLOMs are alive and well, for now, and can contribute significantly to reduce the values of estates that own real estate when structured appropriately. For example, you want to give a $3 million property to three children, as undivided interests (Tenants-In-Common or “TIC”) or as shares of an LLC. Assuming LLC shares get a 35% valuation discount, compare as follows:
Annual exclusions do not count against your lifetime exclusion, but the taxable amount does.
Washington does not have DSUE, but it does have GABE, Gift Add-Back Exclusion. Gifts are not taxed and do not add back later.
An Equitable Approach to Estate Transference
Roger Bowlin | Founder | Real Estate Transition Solutions
As time passes and new chapters of life begin, investment real estate owner’s financial and lifestyle objectives change. We often work with owners who no longer want to spend time managing tenants, addressing new regulatory issues and paying for large capital projects such as new roofs or updating appliances. Instead they want to spend time with their children and grandchildren, travel, and pursue hobbies. We often hear these owners say, “I want to simplify my life”, which is a very worthy goal.
Around the time of life in which owners begin to place a higher value on free time, they should also begin addressing estate planning. Estate planning brings with it additional considerations as Julie Martiniello outlined. However, simply choosing to sell highly appreciated investment real estate because it seems like the easiest option can expose owners to a large capital gains tax liability and eliminates the opportunity to use real estate to reduce one’s future estate tax liability. If owners of investment real estate find themselves in this situation, they should consider the approach outlined below.
Highly appreciated property can be sold and, if suitable, 1031 exchanged into Delaware Statutory Trusts (DSTs). DSTs are funds of institutional real estate managed by national real estate sponsors and are considered “like-kind” property for 1031 exchange purposes. Generally, DSTs have the following objectives:
Owning strong, stable institutional property such as large multi-family buildings, self-storage, medical-office, etc.
Third party management, eliminating the headaches of active management by the owners of the “beneficial interests” in the trusts
Producing predictable cash flow potential
Here we see that DSTs can allow for a far more even allocation of assets among beneficiaries. Furthermore, the beneficiaries do not need to actively manage the property and are free to pursue their careers and busy lives while still reaping the benefits of ownership such as potential for predictable cash flow and the opportunity to continue to tax defer through exchanges.
As discussed by Kell Rabern, ownership of beneficial interests in Delaware Statutory Trusts is considered ownership of a “minority share of a non-public entity” meaning they are eligible for a “discount for lack of marketability” (DLOM). This discount can reduce the value of the real estate owned by as much as 35% from fair market value when calculating the total assets within the estate.
Furthermore, since ownership of beneficial interests in DSTs is tangible real property, a surviving spouse would still receive a complete step-up in tax basis in a community property state such as Washington.
There are many ways to approach estate planning considerations and the right approach is dictated by your individual objectives, assets and family dynamics. Delaware Statutory Trusts tend to be a versatile form of ownership that can potentially satisfy many objectives of owners who are in the third and fourth quarters of life, both during their own lifetime and in the transference of assets to their beneficiaries.
Our hope is that this article sheds light on the considerations that should be addressed when establishing a succession plan. Like anything of significance, the earlier you start the process, the higher the likelihood that you will be pleased with the outcome. Please do not hesitate to reach out to Julie Martiniello, Kell Rabern, or Roger Bowlin if you have specific questions regarding your particular situation.
