Real estate developers and investors need to address estate planning. This need is likely not urgent, as it is unlikely that a Democratic House and Republican Senate will pass any changes that make the estate tax harsher; however, if the Democratic victories of the 2018 elections are repeated in 2020, adverse changes to the estate tax could follow. A reduction in the estate tax exemption (which is scheduled to drop by 2026 even if no action is taken) might be accelerated, the harsh IRC section 2704 regulations that restricted discounts could resurface, and Obama-era “Greenbook” proposals restricting the use of grantor retained annuity trusts (GRAT), note sales, grantor trusts, and more could all appear. Given the impression that many have that the Tax Cuts and Jobs Act of 2017 (TCJA) unfairly favored the rich, the pendulum could swing the other direction.
For wealthy developers, 2019 should be the year to plan; if done in earnest, it will reduce pressure and facilitate enhanced planning. 2020 should be the year to complete funding of plans, plan implantation, and polishing the planning before possible future changes. Real estate developers face several unique considerations that affect their planning. For many, although the current exemptions are large, they will not suffice to reduce estates sufficiently. Basis considerations are also important, and changes in what might be intended for a particular property suggest flexibility in planning. Recent developments other than the TCJA will also have an important impact on planning structures. For example, the Powell and Cahill cases (detailed below) might be interpreted as suggesting different steps be taken to reduce the risk of estate inclusion. The nature of real estate development also requires more robust and tailored trusts be used in the planning. This article will provide an overview of many of these considerations.
Use Temporary Exemptions
One of the keystones of current planning advice is to use the temporary exemptions before they vanish. This has been a standard recommendation since the TCJA was passed, but that advice became sager following the IRS’s confirmation that there should be no clawback for those using the exemption before it declines (IR-2018-229). Advisors should contact developers in 2019 and encourage the use of these temporary exemptions.
With the doubling of the exemption amounts—now $11.4M in 2019 with inflation adjustments—there is plenty of planning opportunity (Revenue Procedure 2018-57). Real estate investors have an opportunity to accomplish significant tax-free gifting until the law changes. For larger developers, these exemptions can be used to leverage significant wealth transfers. This is especially important for developers who may realize significant appreciation for their holdings in coming decades. Making transfers now will enable them to remove future appreciation from transfer taxation.
Consider how a note sale to a grantor trust created by each of two spouses might shift a real estate developer’s wealth under the current law. Some commentators suggest that, although there is little basis to consider this a “requirement,” a maximum 10:1 ratio of seed gifts (or guarantees) to debt is advisable on a sale of assets to a trust. (Some believe a 9:1 ratio might be more secure.) A married couple’s unused $11.4 million exemptions thus might support a $230 million sale of assets to irrevocable trusts. If the assets involved were discounted real estate LLC interests, and assuming a 35% discount, this plan would move about $35 million of underlying value as gifts. The sale of assets other than discounted LLC assets to trusts could freeze $350 million of additional value.
This presents significant planning opportunities for real estate developers that should not be overlooked. Advisors should, however, be alert to several special considerations for real estate investors, as well as the impact of other developments on this type of planning.
The above planning approach will remove the assets from individuals’ estates, and thus those assets will not qualify for a basis adjustment—or presumably in the case of depreciable real estate, an increase in income tax basis—on death, absent further planning. There are several other planning considerations that should be discussed and baked into planning.
CPAs should have a frank discussion with real estate developer clients about the practical implications of basis issues and estate tax. If a developer has a $50 million estate, the exemption drops, and properties continue to appreciate, the estate tax could be devastating. Shifting growth out of the estate thus may be imperative to the success of the business. Real estate, unlike other assets, also can still be exchanged on a tax-deferred basis after the TCJA [Internal Revenue Code (IRC) section 1031; TCJA section 13303]. Many developers hold their properties long term and rarely if ever sell property holdings; even though basis step-up discussions are therefore de rigueur, it is not necessarily the primary planning objective for some large real estate developers. Weighing the pros and cons of basis step-up, estate tax savings, 1031 options, and more nonetheless should be a decision made, and a risk assumed, by the individual.
Substitution or swap powers present another planning option for developers. These should be included in the trusts if the trusts are structured as grantor trusts. These powers can permit the settlor to swap cash into the trust and extract property holdings of equivalent value. Those swapped-out properties included in the grantor’s estate may then qualify for a basis step-up.
The IRS has recognized the right of the settlor to retain a power of substitution, but for that right not to cause estate tax inclusion (Revenue Ruling 2008-22). CPAs should be mindful, however, that the ruling was not a carte blanche grant, and real estate in particular might present a few unique considerations. The ruling provided the following:
A grantor’s retained power, exercisable in a nonfiduciary capacity, to acquire property held in trust by substituting property of equivalent value will not, by itself, cause the value of the trust corpus to be includible in the grantor’s gross estate under section 2036 or 2038, provided the trustee has a fiduciary obligation (under local law or the trust instrument) to ensure the grantor’s compliance with the terms of this power by satisfying itself that the properties acquired and substituted by the grantor are in fact of equivalent value, and further provided that the substitution power cannot be exercised in a manner that can shift benefits among the trust beneficiaries. A substitution power cannot be exercised in a manner that can shift benefits if: (a) the trustee has both the power (under local law or the trust instrument) to reinvest the trust corpus and a duty of impartiality with respect to the trust beneficiaries; or (b) the nature of the trust’s investments or the level of income produced by any or all of the trust’s investments does not impact the respective interests of the beneficiaries, such as when the trust is administered as a unitrust (under local law or the trust instrument) or when distributions from the trust are limited to discretionary distributions of principal and income.
CPAs should have a frank discussion with real estate developer clients about the practical implications of basis issues and estate tax.
There are several considerations for using swap powers with real estate developers and investors instead of the more common application with marketable securities. A swap should likely be accompanied by an appraisal of the property holdings involved to determine and corroborate that the values of the assets transferred in (usually cash) are equivalent to the assets transferred by the trust back to the settlor (perhaps real estate LLC interests). Many developers are highly leveraged, so a banking or wealth management firm relationship that can provide quick access to cash via personal lines of credit may be important to facilitate a quick exercise, particularly for someone of advanced age or in ill health. Because the assets being transferred out are hard to value, consider incorporating a defined value mechanism (see below) in the transaction documents. Perhaps most important, periodic meetings to monitor swap powers is essential.
The ‘In Conjunction With’ Issue
Several recent cases might suggest an adverse trend for planning. CPAs should give consideration when planning for real estate developers to the holdings in Estate of Powell v. Comm’r., 148 TC, (slip op. at 16) (May 18, 2017) and Estate of Cahill v. Comm’r, TC Memo. 2018-84 (June 18, 2018). In both cases, the decedent “in conjunction with” was deemed to hold powers that caused estate inclusion. Powell dealt with limited partnership interests; Cahill dealt with split-dollar insurance planning but addressed the same “in conjunction with” reasoning and applied it to a split-dollar economic benefit regime. Cahill thus might be viewed as a reinforcement of Powell.
The Cahill court quoted the Powell ruling concerning the “in conjunction with” issue: “Decedent’s ability to dissolve [her limited partnership] with the cooperation of her sons constituted a ‘right in conjunction with [others], to designate the persons who shall possess or enjoy the property [she transferred to the partnership] or the income therefrom,’ within the meaning of [IRC] section 2036(a)(2).”
How might this, applied in the extreme, affect even reasonable estate planning for a developer? Might the retention of non-manager membership interests in a real estate LLC, or limited partnerships in a real estate family limited partnership (FLP), subject the developer to a challenge that “in conjunction with” the donees of the remaining interests, the developer possessed the power to designate who could possess or enjoy the property, thereby causing estate inclusion? Might it be worthwhile, if feasible, to consider transferring all entity interests in the plan rather than retaining some? Perhaps plans should be bifurcated; instead of a developer gifting and selling a portion of 10 different real estate LLCs, she might instead gift or sell 100% of five different real estate LLCs so that she retained no interests in the transferred entities. In addition, the governing documents (partnership and operating agreements) might be revised to endeavor to deflect a Powell-type challenge.
Step Transaction Considerations
An issue that can arise on the audit of some plans is the IRS asserting a step-transaction challenge to the plan. Using this approach, the IRS might argue that various actions taken were steps of an integrated plan, and that the steps should be collapsed to properly characterize the transaction for tax purposes. In a favorable situation, the Tax Court refused to apply the step transaction doctrine because the taxpayers bore a real economic risk of a change of value of the limited partnership interests for the time period between contribution of the assets to the FLP and the later gifts of the FLP units [Holman v. Comm’r, 130 TC 170 (2008)]. When structuring transactions, if there can be independent economic events between steps, this might deflect such a challenge.
Debbie owns 100% of real estate LLC. Both she and her husband Phil want to gift interests in this LLC to their respective grantor trusts. Assume 50% of the LLC interests are valued at about $11 million. Debbie gifts 50% of her LLC interests to Phil, who the next day gifts all of those interests to his trust. If the IRS successfully asserts the step transaction doctrine, it might argue that all of the gifts made to both trusts were one integrated step, and all were transfers by Debbie. If enough time passes between Debbie’s gift to Phil and his gift to his trust, the transaction may be more secure. Also, the occurrence of independent economically significant events (e.g., a refinancing of the underlying property, distributions by the LLC, signing a lease with a new anchor tenant) may grant more independence.
Having an independent trustee in charge of administration, and especially of agreeable distributions, may enhance the planning.
In another case, the donor’s gift and sales of interests in an LLC were combined, eliminating discounts. Factors the court considered included that the transfers occurred on the same day, the taxpayer intended to transfer all interests in the transactions, and the transaction was motivated by tax benefits. The anticipated discounts were reduced [Pierre v. Comm’r, TC Memo 2010-106 (May 13, 2010)].
The step-transaction doctrine could suggest that the steps in the plan were part of an integrated transaction and the intervening steps should be collapsed to properly characterize the transaction for tax purposes.
Assume that a trust is funded in 2019 with seed gifts, and later in 2020 assets are sold to that trust. Some CPAs might view the division of those actions into separate tax years as a positive factor to deflect an IRS challenge based on the step transaction theory.
Defined Value Mechanisms
Real estate properties and entities are inherently difficult to value. Thus, CPAs should consider the use of various types of defined value mechanism that endeavor to mitigate the impact of the IRS arguing a higher value on a gift or sale. Not all such mechanisms are effective [Procter v. Comm’r, 142 F.2d 824 (4th Cir. 1944)].
Some professionals like an approach upheld in a Tax Court case premised on a transfer of a dollar value of interests rather than a percentage interest in the entity (Wandry v. Comm’r, TC Memo 2012-88). Under a Wandry transfer, a fixed dollar value of LLC interests might be transferred. If the individual intended to transfer (by gift or sale) 35% of the LLC interests, but expressed those interests in terms of a dollar value, less than the whole interest might be transferred. A concern some might raise with this approach is whether, in light of Powell, it might be desirable to ensure that the transferor has parted with all equity interests in the entity being transferred.
Can this be done with a Wandry approach? Perhaps, but not with a traditional Wandry formula, because some equity might remain. A variation on the traditional Wandry approach might be for the developer to gift (assuming a gift transfer is involved) a specified dollar interest and simultaneously sell and residual equity interests remaining in a second transaction.
A Wandry approach to the transfer of interests in a corporate general partner of a FLP might include language as follows on the stock certificate (comparable language would appear in the stock power and assignment and other transfer documents): “This Certificate represents $2 million in value of stock. All shares of stock in the corporation were transferred on Date to Name of Trust, $2 million in value of shares of stock (“Gift Shares”) transferred by gift pursuant to a Gift Assignment and any such Shares not gifted on such date, being sold pursuant to a Stock Purchase Agreement dated Date.”
Impact on Buy-Sell Agreements
CPAs should consider the succession plan for the real estate development business and holdings, the impact of the estate planning steps pursued, and effects of the TCJA, such as the increased IRC section 179 expensing of tangible property, which might affect formula buyout and other provisions in governing documents. This is particularly important for developers because the definition of property qualifying for the increased IRC section 179 expensing has been expanded to include certain components of real estate such as roofs; heating, ventilation, and air-conditioning property; fire protection and alarm systems; and security systems.
Trust Drafting Considerations
Trusts for real estate developers will often have to be structured as directed trusts. These may name an institutional general trustee but segregate investment functions, and those will be under the purview of an investment adviser or trustee (often the developer). Having an independent trustee in charge of administration, and especially of agreeable distributions, may enhance the planning.
Get Started Now
This article has highlighted only some of the myriad planning considerations affecting real estate developers. CPAs should make sure that real estate counsel is involved early in the planning process to confirm whether due-on-transfer clauses in mortgages or key leases, or other contractual considerations or real estate transfer and valuation taxes, might be implicated. Now may well be a vital window of planning opportunity, but caution and attention to detail are in order.