To make use of the current record high federal gift tax exemption amount,1 estate planners may find that many ultra-high-net-worth clients are considering lifetime gifts of illiquid assets, such as real estate. A gift of real estate can be an attractive proposition because it may: (1) allow a client to engage in wealth transfer tax planning while retaining liquid assets to cover expected living expenses; (2) provide an opportunity for attractive valuation discounts; (3) maximize the value of assets outside of a client’s estate if the real estate appreciates more quickly than other asset classes; and (4) produce an income stream to support the client’s intended beneficiaries. As a practical matter, a client may wish to consolidate ownership of family property for the family’s use and enjoyment through future generations, and transferring the real estate to a trust can accomplish this goal as well. Estate planning for an owner of real estate is often accomplished with a gift and/or sale of real estate or interests in an entity holding real estate to a grantor trust. Transferring real estate to a grantor trust permits any sale to be ignored for income tax purposes, and the real estate owner continues to enjoy all income tax benefits of real estate ownership such as Internal Revenue Code Section 1031 exchanges and depreciation deductions.
With those benefits, however, come certain complexities as well as potential pitfalls for the estate planner facilitating the transfer. We’ll review some of the most common considerations involved in transferring real property to a trust and provide recommendations for addressing them.
Estate-Planning Opportunities
Planning with real estate can provide an excellent leveraged opportunity for transfer tax planning. In our experience, the most successful real estate planning transactions are a result of a coordinated gift and sale of an entity holding one or more commercial real properties. Indirect ownership through an entity provides the client with many benefits, including the possible application of valuation discounts that depress the value of the transferred interests due to lack of control and lack of marketability, as well as the ability to continue to control as entity manager the entity’s investments after the transfer. Once the entity is transferred to a trust, the income generated by the properties can support property maintenance, operating expenses and any promissory note payments owed to the client. As each property appreciates, the trust is able to sell the property and purchase a more expensive one (often in a tax-deferred IRC Section 1031 transaction) with higher cash flow. The result is a trust that’s well-endowed to support many generations with increasingly valuable assets and increased cash flow.
Practical Challenges
Real property, particularly commercial investment property, is often encumbered by one or more mortgages. Mortgage debt raises both tax and practical aspects to consider when transferring the property.
You should first review each mortgage contract, as it will contain provisions regarding the transfer of the encumbered property. Commonly, mortgage contracts will require lender consent for the direct or indirect transfer of the encumbered property and will consider it a default on the mortgage if the property or beneficial ownership is transferred without consent. In that case, it’s important to obtain the lender’s consent to the contemplated transfer to avoid an inadvertent default. Often, lenders are amenable to the transfer, particularly in cases involving real estate professional clients who may do repeated business with the lender. If the property isn’t yet encumbered but a mortgage is expected prior to transfer (such as in situations in which a construction or bridge loan has been taken out for the initial construction), the client should request in advance that the mortgage documents include an exception to the transfer restrictions for transfers to a family trust for estate-planning purposes.
An additional consideration is that lenders may require the individual owner to provide a personal guarantee for the mortgage. While this makes sense when the individual owns the property, complications arise if the property is transferred to a trust. Many lenders don’t allow a trust to act as a guarantor and may require the individual to remain a personal guarantor on the mortgage even after the property is transferred to the trust. This creates a disconnect between the new owner of the property (the trust) and the guarantor of the mortgage debt (the trust grantor).
In such cases, the grantor is arguably providing an ongoing benefit or gift to the trust, as the trust couldn’t otherwise own the mortgaged property without the guarantee. To address this disconnect, the first strategy is to negotiate with the lender to allow the trust to guarantee the mortgage. If the lender requires the individual to continue to act as guarantor, then the trust should pay the individual a small fee for providing the guarantee to the trust. In our experience, such fees are typically around 1% of the amount guaranteed. Although not a perfect solution, a guarantee fee helps to defend against an argument that the grantor is providing an ongoing benefit to the trust without fair and adequate consideration.
State/Local Tax Considerations
Many states and localities impose a transfer and/or documentary tax on the transfer of real estate, and some also impose a tax on the transfer of an interest in an entity that holds real estate. Although there’s often an exception for gratuitous transfers, take care when structuring an estate-planning transaction to avoid unintentionally triggering transfer tax.
For example, say your client owns a vacation home in the Hamptons on the east end of Long Island, New York, and wishes to engage in lifetime transfer planning. New York state imposes a tax on the direct transfer of real estate (other than gift transfers), as well as an additional 1% “mansion tax” for residential real estate valued at over $1 million.2 If property is held indirectly through an entity (such as a limited liability company (LLC), partnership or corporation), the transfer tax will be imposed if a controlling interest in the entity is transferred. Thus, if the client doesn’t wish to pay transfer tax, the client has two options: (1) gift the property; or (2) contribute the property to an LLC and sell a non-controlling interest (less than 50%) to a family member or family entity, such as a grantor trust.3
Some clients may prefer to pay the transfer tax because the benefit of removing the entire property from the client’s estate outweighs the transfer tax cost. In that case, it’s important to confirm the value on which the transfer tax is imposed and the applicable rate. A common trap for the unwary is that certain jurisdictions will impose the transfer tax on the fair market value (FMV) of the property without any reduction for mortgage debt or discounts.4 Understanding how and when transfer tax is imposed will prevent unpleasant surprises when the client needs to write a check to the government.
In California, if a transfer of real estate results in a “change in ownership” or “change in control,” then the transfer will result in a reassessment of the property for local property tax purposes.5 Absent reassessment, California limits increases in the assessed value of properties to 2% annually,6 providing significant property tax savings for owners whose properties have appreciated above the 2% annual cap. In some cases, California property is taxed at a rate reflecting only a small fraction of its current market value. Triggering reassessment inadvertently through an estate-planning transfer could result in the loss of this valuable tax treatment, as property tax would then be assessed on the full market value of the property at the time of transfer. There are limited exceptions to property tax reassessment for certain types of transfers, and you should consider whether a transfer can be structured to qualify for one of these exceptions.
Certain states, for example, Florida and Texas, offer a homestead exemption that provides many benefits, including creditor protection and protection from property tax reassessment. Be careful to avoid the unintentional loss of the homestead exemption. In some cases, the property can be transferred to a trust while preserving the homestead exemption if the trust grantor retains certain rights in the property (such as a long-term lease). Whether a transfer of property with retained homestead status is possible will depend on state and local rules.
Transaction Costs
The client should obtain an appraisal to value a transfer of real estate reported on a gift tax return. Appraisals are strongly recommended for gifts, but should be obtained for sales as well, particularly if the client reports the sale of real estate on a gift tax return as a non-gift transaction, which will begin running the statute of limitations.
If the property is held through an entity and entity-level discounts are applicable, the client should obtain an appraisal for the transferred entity interest as well as an appraisal of the underlying real estate. The number of properties, their locations, sizes and uses will determine the appraisal costs, which can be considerable.
If the property is income-producing, income may cover the cost of maintaining the property in the trust. However, if the property isn’t income-producing or doesn’t produce sufficient income to cover maintenance costs, give some thought as to how to capitalize the trust to cover property maintenance and operating expenses to the extent the trust doesn’t have sufficient liquidity from other assets. In some cases, ongoing Crummey gifts to the trust may be sufficient to cover expenses, whereas in other cases, the trust grantor may need to lend or gift additional funds.
Estate Inclusion Risks
Complications arise with respect to transferring real estate when the individual who transfers the property intends to retain some use of the property. This is common when the transferred property is a vacation or primary residence.
If an individual who transfers property to a trust wishes to continue to use the property, take care to mitigate the estate tax inclusion risk posed by the individual’s ongoing beneficial enjoyment of the property.7 Due to the estate inclusion risk, properties that the individual plans to continue to use may not be ideal assets for planning. If planning with such property is unavoidable, consider limiting the inclusion risk by either: (1) transferring the property to a trust that includes the trust grantor’s spouse as a beneficiary; or (2) implementing a lease agreement between the trust grantor and the trust that owns the property. The first approach could entitle the spouse to rent-free use of the property (depending on the terms of the trust) and give the trust grantor rent-free use of the property during the spouse’s life.8 The second approach of leasing the transferred property presents additional tax planning opportunities. While a client may initially scoff at renting their own residence, paying rent to the trust provides the trust with the capital needed to maintain the property and, to the extent the fair market rent exceeds the property’s expenses, the excess rental income represents an additional tax-free transfer from the trust grantor to the trust.
It’s important that the lease is commercially reasonable and that the rent is set at FMV. To support this argument, an appraiser or real estate broker should provide a letter confirming the fair market rent for a property of similar size and location. The lease as well as the rent amount should be updated on a regular basis.
Income Tax Considerations
If you work with clients who own commercial real estate, be sensitive to the potential income tax implications of transferring the property. Two situations present specific challenges: (1) if the client has a very low basis in the property (or a negative capital account in the entity that holds the real estate); and (2) if the property is a qualified opportunity zone (QOZ) investment.
As mentioned above, lifetime transfers of real estate remove both the property as well as all future appreciation from the transferor’s estate. One tradeoff, however, is that the property won’t receive a step-up in basis at the time of the transferor’s death. When the asset has a very low basis (common for depreciated real estate investments), it’s important to compare the potential estate tax exposure if the property were to remain in the individual’s estate against the income tax exposure if the property is expected to be sold following a transfer to a trust or following the individual’s death. This analysis may suggest that the individual should choose other assets to plan with.
If the real estate is held through a partnership and the partner has a negative capital account, the income tax consequences on a transfer of the partnership interest can be significant. A negative capital account may occur when depreciation deductions and partnership distributions exceed a partner’s capital contributions, particularly when the partnership refinances appreciated property and distributes the financing proceeds. In that situation, if the partnership interest is transferred to another taxpayer (such as a non-grantor trust or family member), the partner is treated as having been relieved of indebtedness, which is an income tax realization event. If the interest is gifted or sold to a grantor trust, there’s no immediate gain recognition on transfer; however, there’s a question as to whether there’s a gain recognition event on the death of the partner when the grantor trust becomes a non-grantor trust.9 While a detailed analysis of the tax treatment of this scenario is beyond the scope of this article, beware that the ultimate income tax consequences of transferring a partnership interest when the partner has a negative capital account can be surprising and severe.
By contrast, if the negative capital account property were included in the grantor’s estate, the estate and its beneficiaries would receive a stepped-up basis in the partnership interest, and the partnership could make an IRC Section 754 election to step up the inside basis to FMV, wiping out the negative capital account as well. This would allow for the sale of the asset immediately thereafter without income tax consequences to the estate and/or beneficiaries. A comparison of the potential income tax consequences against the estate-planning benefits of a lifetime transfer is therefore instrumental in providing guidance to the client.
QOZ funds are partnerships or corporations formed to invest in real property located in these designated opportunity zones. Broadly speaking, investors may defer the payment of capital gains taxes by reinvesting proceeds from the sale of capital assets in a QOZ fund, and any further gain on the QOZ fund investment may escape tax entirely.10
Don’t jeopardize the tax treatment of a client’s QOZ fund investments when considering an estate-planning transaction. In December 2019, the Internal Revenue Service issued final regulations clarifying the tax treatment of transfers of QOZ fund interests. In general, these regulations provide that a gift of QOZ fund interests is an inclusion event causing the grantor to realize all deferred gain. There is, however, an important exception for a transfer to a grantor trust. It doesn’t matter whether the transfer of the QOZ fund interest is structured as a gift, sale or exercise of a grantor trust substitution power, so long as the transfer is between the investor and the investor’s grantor trust. QOZ fund property may be an attractive asset for estate-planning transfers because of its unique tax treatment, but don’t lose this valuable tax benefit through a transfer to a non-grantor trust (or a grantor trust whose grantor status is subsequently “turned off”) or through a direct transfer to a family member, including the client’s spouse.
Although estate planning with real estate can be more complex than planning with liquid assets, the upside can be considerable and well worth any additional headache. However, it may not be the best approach for every parcel of real estate or for every client.
Endnotes
1. As of Jan. 1, 2023, each individual can transfer $12.92 million during life or at death free of wealth transfer tax. The current exemption amount is set to sunset by the end of 2025, at which point it reverts to $5 million, indexed for inflation.
2. N.Y. Tax Law Sections 1402 and 1402-a. Note that if the property is located in New York City, an additional transfer tax is imposed.
3. The transfer shouldn’t be structured as a sale of an ownership interest in the property directly, as such a transfer would be subject to the transfer tax. Structuring the sale as involving only an entity interest essentially shields the transfer from transfer tax, provided the interest transferred isn’t a “controlling interest.”
4. For example, New York with respect to controlling interest transfers.
5. CA Revenue and Taxation Code Section 64(c) and (d).
6. CA Revenue and Taxation Code Section 51.
7. See Internal Revenue Code Section 2036.
8. See Estate of Gutchess v. Commissioner, 46 T.C. 554 (1966); Private Letter Ruling 9735035 (June 2, 1997). Note that once the beneficiary spouse dies, the grantor spouse must rent the property from the trust for any use of the property to avoid estate inclusion.
9. Treasury Regulations Section 1.1001-2(c), Example 5.
10. IRC Section 1400Z-2.