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Real estate investors, with all of their optimism about the growth in real estate values, are constantly asking about the ever-changing landscape of federal and state estate taxes, about planning for liquidity at their deaths, about how their choice of entity affects their exposure to taxes, and about how gifts to trusts and charities can benefit them, their families, and their communities. Here is the deal. STATUS OF ESTATE TAXES Currently, the federal estate tax applies to estates exceeding $1.5 million, except for the unlimited amounts that can pass to a surviving spouse or to charity. The $1.5 million exemption is scheduled to rise to $2 million next year, and to $3.5 million in 2009. Where the tax applies, the rate is high, roughly a flat 45 percent. As has been well reported and mocked, the tax is scheduled to be repealed altogether for estates of folks who die in the year 2010, but then — because congressional anti-deficit budget rules did not permit such tax reduction to extend beyond the year 2010 — the tax is scheduled to come back in the year 2011 with refreshed vigor, offering an exemption of only $1 million and tax rates that reach 50 percent. Most states have responded to another change — under which the federal tax is no longer shared with the states — by beefing up their own death taxes, with rates as high as 10 percent to 16 percent for moderate and large estates. The state taxes, however, are deductible in computing the federal tax. Congress seems to be considering everything from doing nothing and letting the exemption rise and fall (and the top tax rate fall and rise) as scheduled, to repealing the tax permanently, to settling on a moderate-to-large rise in the exemption with the possible complement of a sharp cut in the top rate (maybe to as low as 15 percent). In short, estate planners say: Stay tuned, stay healthy, and continue to plan in case the bus hits you before tax relief does. LIQUIDITY NEEDS AT DEATH Estates often need cash to pay funeral expenses and to care for the deceased’s dependents. In some families, in which a business is passing to the children who work in the business, cash is needed to bring the other children to a similar level. If estate tax is due, it is due in cash, generally nine months from the date of death. Of course, life insurance is a classic part of a liquidity plan. Insurance policy flavors of the month are confusing, and a knowledgeable insurance adviser is key, but at least one feature will be familiar to real estate investors: how much interest-rate risk to take in terms of the growth of the cash reserves in the policy. Investors might want to consider guaranteed “no lapse” policies in which the carrier takes on the interest-rate risk. Ownership of the life insurance policy should be in an irrevocable trust so that the death benefit is not subject to the estate tax. If you are in business with partners, a buy-sell agreement is usually important if you think the business will tank when you are not there to run it. Agreements often require that partners buy life insurance to provide liquidity for some or all of the purchase price. Keep in mind, though, that tax authorities won’t be bound by agreements between family members that attempt to save estate taxes by setting an artificially low value for real estate and business interests. Federal tax law offers a deferral of time to pay estate taxes (up to 14 years, with interest at attractive rates) for certain closely held businesses, including real estate companies that actively manage properties. The deceased and his or her family members must generally have owned at least 20 percent of the business, and the deceased’s interests in closely held businesses must comprise at least 35 percent of his or her estate. ENTITY, VALUATION, AND CONTROL Tax and creditor-protection concerns often lead a real estate investor to own assets in a limited liability company that elects to be taxed as a partnership. Limited liability companies also provide opportunities for members to claim valuation discounts for gift and estate tax purposes. For example, where a gift or estate consists of noncontrolling interests in an LLC that is not publicly traded, where 100 percent of the LLC assets are appraised at $1 million, LLC membership interests deserve valuation discounts for lack of control and lack of marketability as high as 40 percent. In other words, a 50 percent membership interest in the LLC might only be worth $300,000. Sometimes parents owning real estate want to transfer LLC membership interests to children and claim valuation discounts while retaining control as the manager. Unfortunately, retaining control could mean that the interests the parents give away could be included in their taxable estate. Too often, estate planners tout the ability to retain control of a gift without paying heed to the law or to the fact that taxpayers are losing on this issue in some court cases. ESTATE-FREEZE GIFTS There are a few gift-giving strategies where the donor retains the current value of the property plus a moderate return, while giving away the future appreciation of the property above that return. The result is that the gift is valued at zero and has no gift-tax consequences. A Grantor Retained Annuity Trust (GRAT) is popular because it is blessed by statute and is not controversial with the Internal Revenue Service. When a donor transfers assets to a GRAT, a fixed annuity will be paid back to the donor over a period of years. After that, any assets remaining in the trust go to the children. The annuity can be paid with income generated by the real estate investment, or by a piece of the investment itself (which may require another appraisal and may require valuation discounts). The only taxable part of the gift is the present value of what the children are predicted to receive, computed using a discount factor — really an interest-rate assumption — published by the IRS for the month in which the gift is made. If the size of the retained annuity payment can be set large enough so that the present value of the annuity represents 100 percent of what the donor transfers (over the period of years selected and using the IRS discount factor), then the value of the gift to the children is zero. If the asset in fact outperforms the IRS discount rate, then there will be some assets remaining in the trust for the children when the retained annuity terminates. A second estate-freeze technique, quite popular but with some risk of IRS challenge, is to establish a trust for the benefit of children (perhaps funded using part of the parent’s exemption from gift and estate taxes), and then to sell real estate interests to the trust in return for an interest-bearing installment note. By selling rather than giving away the real estate interests, there is little exposure to gift tax if the note bears adequate interest. After the sale, appreciation in the real estate interests belongs to the trusts, with the parent’s estate retaining only the principal of the note and the required interest payments. To avoid realization of gain on the sale, the trust for the children is structured as a so-called grantor trust. To avoid arguments that the note represents an equity interest in the property sold (which would lead to estate-tax inclusion of the property), the trust should be sufficiently capitalized before the property is sold to it. Unlike a GRAT that lacks liquidity to make annuity payments, installment sales do not risk the need for annual revaluation of real estate interests. CHARITABLE GIFTS Donors of real estate interests to charity want a deduction for the fair market value of their gift. However, while a fair-market-value deduction is available for gifts of any kind of asset to a public charity (if held by the donor one year), a gift of such appreciated property to a private family foundation is generally deductible at fair market value only if the gift is of publicly traded stock; gifts to a private family foundation of real estate and partnership interests provide a deduction only for the donor’s basis in the property. So estate planners like to identify public charity alternatives to a private family foundation — such as a donor-advised fund at a local community foundation. Even when giving to a public charity, a donor should expect that the value of gifts of interests in an LLC will have to suffer the standard valuation discounts — although it is possible to create an exit strategy for the charity that can help diminish the discount for lack of marketability. In short, proper planning can help the real estate investor overcome the estate illiquidity and charitable income tax deduction challenges of real estate, leaving time to focus on estate and gift tax valuation opportunities.
Robert P. Goldman is a tax and estate planning partner in the Boston and Washington, D.C., offices of Goulston & Storrs.

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