By: Randall A. Denha, J.D., LL.M.
Most owners of businesses have asset classes that require special consideration during the planning process. One of these asset classes is real estate. As with most businesses, estate planning for those in the real estate investment business presents a unique set of challenges. Lender concerns, tax considerations, asset protection and family business dynamics can all play a role and there can often be tension between these areas of concern.
Who Owns the Property?
One of the first questions to address is who owns the real property? The answer to this question will determine liability exposure and how the real property will pass upon death. When it comes to real estate title is king. If real property is held solely in a person’s individual name; that property will likely be subject to probate on death. It also means that the owner is personally liable for the debts and liabilities associated with that property. If there are two or more owners, the question becomes whether that property is held as joint tenants with rights of survivorship or tenants-in-common. In some states there are additional options for married couples, such as tenancy by the entireties or community property.
If the property is held in a joint tenancy (or in some other form that allows for rights of survivorship), then upon the death of one joint owner, the remaining joint owners will inherit the deceased owner’s share automatically and without the requirement of probate. If the property is instead held as tenants-in-common, then the deceased owner’s share will likely require a probate. While joint tenancy may appear to be an appealing way to avoid probate, it is important to understand that property owned by multiple owners is potentially at risk, in whole or in part, for the debts and liabilities of each individual owner.
Should You Use a Trust?
Holding real property in a trust is a sure fire way of avoiding probate and reducing the likelihood that a guardianship or conservatorship will be necessary in the event of incapacity. This can be crucial if a timely decision is needed on whether to sell or rent a parcel of land. But remember, unless the trust is an irrevocable trust, you will not have the asset protection that you may desire. Instead it may be advisable to hold the land in an entity, such as a limited liability company (LLC) that is in turn owned by a trust.
Why Should You Consider an Entity?
Owning your real estate investment properties in an entity or multiple entities can limit your personal vulnerability to potential lawsuits related to the property. It can also protect the property from lawsuits against individual owners of the entity. Another benefit to owning land in an entity, such as an LLC, is avoiding fractionalization of the real property upon transfer to heirs. Fractionalized real estate is vulnerable to forfeiture in the event of partition. Many states allow the owner of a fractional interest in land to sue for the partition or sale of the land without regard to how small the fractional interest may be. Giving interests in entities governed by ownership agreements can prevent the possibility of partition. Entity interests also provide a way for the owner to gift or sell an interest during the owner’s life without losing control.
In determining what type of entity to use, a careful analysis of the income tax consequences is important. A general rule is that you should never hold real estate in a corporation. The reason is that while real estate can go into a corporation tax free, it is almost impossible to get it back out without tax consequences. The preferred way of holding real estate will most often be an LLC taxed as a partnership.
The Stepped-Up Basis
As is the case in any planning, one must always be mindful of the income tax basis rules on death. Subject to certain limitations and exceptions, when an owner of assets dies, assets passing to heirs obtain a new tax basis equal to the assets’ fair market value as of the date of death. Because of the built in gain of many real estate investments, careful consideration must be given to the consequences of gifting or selling during life and gifting at death. Planning with certain entities or trusts can result in a loss of the stepped-up basis. While this may make sense in certain instances it should always be done with caution.
IRC 1031 like-kind exchange
Tax rules provide that property held for investment or used in a trade or business can be exchanged tax-free for other property of like-kind which will be held for investment or used in a trade or business. Real estate is defined very broadly for these purposes, such that basically all real estate is considered to be like kind with other real estate (e.g. you can exchange raw land for an apartment complex), so long as you meet the other tests for like-kind exchange treatment. Exchanges can be multi-party (i.e. the buyer of your property and the seller of the replacement property you desire do not have to be the same) and do not have to be simultaneous. Through the use of a Qualified Intermediary (for “delayed” or “forward” exchanges) or an Exchange Accommodation Titleholder (for “reverse” exchanges) you can have up to 180 days after you sell your property to acquire replacement property, or acquire your desired replacement property up to 180 days before you sell your property. While the section 1031 rules are complex, the basic fundamentals are pretty simple. First, both the property you are relinquishing and the replacement property you are acquiring must be used in a trade or business or held for investment. Second, in order to enjoy full tax deferral, the property(s) you are acquiring must be equal to or greater in value than that of the property you are selling.
Developer fees, management fees and commissions are important income streams and sources of current cash flow for those in the real estate business. Unfortunately, from an income tax perspective, these are typically treated as ordinary income, with no shelter other than the related operating expenses. However, since real estate professionals are generally not subject to the passive loss rules with respect to projects in which they actively participate, they may be able to shelter their fee income from tax using losses from projects in which they have an equity stake.
A wonderful benefit that real estate offers that many other assets do not, is the ability refinance the asset. The ability to refinance a property and distribute the proceeds to the developer, for personal use or to reinvest in other deals, is an often used tool for the real estate investor. Decisions as to the entities to be used, distribution provisions and mechanisms in trusts to which real estate entities are transferred, and so forth should all facilitate this.
Real estate cycles can have a significant and variable impact on the value and liquidity of properties. This is important in assessing the availability of cash when paying estate taxes, when funding working capital during a disability, or following the death of the developer. Real estate cycles need to be factored into insurance planning, because, depending upon the circumstances, the ability to liquidate assets to raise cash may become difficult and highly variable. Many real estate investors have inadequate cash reserves (because cash is often viewed as the deposit on the next deal), so “first-to-die” life insurance coverage (e.g., coverage on the wife or on the husband individually) may make more sense than survivorship coverage (which pays when the last spouse dies and an estate tax might be due since the unlimited marital deduction will no longer shelter the estate). Of course, the foregoing are all highly dependent on the particular facts and circumstances of each client.
It is helpful to consider-and, if feasible, to project-the impact of the estate plan and role of insurance. A “traditional” estate plan might fund a bypass trust and bequeath the remainder over the exemption amount (currently $5.49 million, assuming no state estate tax) to a trust. Michigan does not currently have any estate tax. If the surviving spouse lives for many years after the death of the first spouse, however, the appreciation in that QTIP will be included in the survivor’s estate. Some advisors suggest not funding a bypass trust, so that a second step-up in basis will be realized upon the surviving spouse’s death, but one should first evaluate how the different options will impact potential estate tax.