The passage of the Tax Cuts and Jobs Act of 2018 (the act) ushered in a new era in taxation. It fundamentally changed individual income taxation, as well as the taxation of pass-through entities and corporations. It also made significant changes to the deductibility of state income taxes at the federal level.
However, the act also made many changes that have attracted significantly less attention. These changes must be considered as well, especially in the context of arranging the lifetime structural aspects, as well as planning the estates, of real estate investors and developers. In terms of allocating wealth between assets, these changes have, arguably, tipped the scales in favor of real estate over other classes of assets.
One primary change concerns the availability of “1031 exchanges” for property held by taxpayers. Under general principles of taxation, capital gains are only recognized upon the disposition of an asset by sale. Prior to the passage of the act, in general, an exchange of business property for another of a “like-kind” (i.e., with similar attributes), rather than for another, dissimilar, asset (such as cash) could be eligible for treatment as a like-kind exchange. If so, no tax would be due on the sale and the taxpayer’s adjusted basis in the original property would transfer to the new property.
Under the act, however, like-kind exchanges are generally no longer available for personal property. The act retained all of the provisions of the code dealing with like-kind exchanges for real property (primarily found under Section 1031 of the Internal Revenue Code of 1986, as amended (the “Code”)). This presents owners of real estate with a significant and unique gain deferral opportunity relative to owners of other assets.
Many real estate owners have taken advantage of this provision as a mechanism to defer gain for decades and even eliminate gain over generations. Code Section 1014 provides that property included in the estate of a decedent receives a new basis equal to its fair market value on the date of the decedent’s death (often called a “step-up in basis”). With careful consideration of the estate and gift tax exemption, the like-kind exchange strategy can be combined with the step-up in basis under Code Section 1014 to defer tax during the life of an owner of real estate and, ultimately, completely escape the imposition of capital gains tax. The combination of these tactics creates a powerful tax elimination technique that is now unavailable to all asset classes other than real estate. This may create a strong incentive for high net worth individuals to expand their real estate portfolios to the exclusion of other types of assets.
An additional factor to be considered in planning for real estate clients is the “negative-basis” problem. Negative-basis is a colloquial term used to describe a situation in which the debt to which a property is subject exceeds a taxpayer’s adjusted basis in the property. For example, many long-term owners of real estate were able to take advantage of so-called “accelerated depreciation” under the Accelerated Cost Recovery System enacted in the 1980s, by which they were able to take significant depreciation deductions with respect to real estate.
The problem, however, is that the taxpayer’s adjusted basis would have been decreased to account for each depreciation deduction. Similarly, where a client has refinanced property in one or more “cash out” loans, significant debt may be added to the property, while basis remains the same. If, in either scenario, the debt exceeds the taxpayer’s adjusted basis in the property, there is a negative-basis problem.
The tax impact of negative-basis could be dramatic because, upon the disposition of an asset, if the asset is sold in a taxable exchange, tax would be imposed on the amount of the debt in excess of basis. Such a disposition would be regarded as similar to a “debt-relief” scenario, i.e., by disposing of the asset, the taxpayer may no longer be liable on the debt, which results in the imposition of income tax. This is sometimes also referred to as a “phantom income” issue because the disposition may result in no cash in the hands of the taxpayer, but a significant income tax being owed in the year of the disposition.
One (and perhaps currently the only) way of dealing with the negative basis problem may be to utilize Code Section 1014. If a taxpayer dies owning a negative-basis asset, the basis of the asset would be stepped-up to its date of death value under Code Section 1014, which usually results in the basis exceeding outstanding debt. In addition, under Code Section 754, the basis of a partnership’s (or limited liability company’s) business interests in the hands of the partnership (sometimes called the “inside basis”) may also be adjusted to their current values at the death of a partner. This can help to achieve basis parity and limit or prevent the imposition of capital gains tax on the partnership’s taxable disposition of the underlying asset.
While allowing assets to pass as part of a decedent’s estate may seem simple enough, the other side of the coin is that they become part of the decedent’s gross estate for estate tax purposes. This means that there is a potential for estate taxation on those assets to the extent they exceed $11.18 million (reduced by lifetime gifts) per person or twice that per couple.
In a traditional estate plan, a taxpayer might make gifts (or sales to a grantor trust) of appreciating assets in order to exclude future appreciation from his or her estate. In this manner, a taxpayer freezes the value of the asset on the date of the transfer, with subsequent appreciation accruing outside the estate. To further augment this strategy, the gift (or sale) could be made to a grantor trust, which, in simple terms, would allow the taxpayer to continue to pay income tax (if any) on income attributable to the trust’s assets. In this manner, the trust assets can continue to grow on an internally income tax-free basis, while assets that would otherwise be includible in the taxpayer’s gross estate are diminished through the continued payment of the trust’s income taxes.
Accordingly, if the transferred assets consist of real estate that produces income in the form of rents, for example, all income tax attributable to the assets would be declared on the taxpayer’s annual Form 1041, while the cash flow from the rents may be retained in the trust (which is outside the grantor’s estate). Similarly, all deductions attributable to the assets could be claimed by the taxpayer. This technique can be combined with the continued availability of like-kind exchanges under Code Section 1031 to create an extremely powerful mechanism to avoid estate tax and defer the imposition of capital gain tax for many years.
Where a taxpayer has already made significant lifetime gifts and depleted his or her lifetime exemption, a similar result can be achieved by means of a sale of real estate assets to a grantor trust. No gain is triggered in such a sale because a grantor trust is considered to be the same tax “person” as the taxpayer. Accordingly, the sale is complete for gift and estate tax purposes, but entirely disregarded for income tax purposes.
As a means of maximizing the planning techniques addressed above (depending on how real estate ventures are arranged), taxpayers may have the ability to take discounts on the value of their real estate holdings. For example, if an individual owns membership interests in a limited liability company and is not entitled to participate meaningfully in entity decision-making vis-à-vis operations and dissolution, his ownership is usually regarded as worth less than an outright interest in the underlying real property.
Appraisers will often discount the value of these interests for “lack of marketability” and “lack of control” by as much as a cumulative 30-40 percent. This can help taxpayers to maximize their gifts and to utilize as little gift tax exemption as possible. Similarly, in the context of a sale, these discounts can help diminish the value of the promissory note or other asset given in exchange for the real estate, which can diminish the value of a taxpayer’s gross estate.
Substituting Trust Assets
As a final technique to round out the overall tax planning approach, grantor trusts can include provisions allowing the taxpayer to substitute trust assets for other assets of a similar value at any time (including, for example, a promissory note). A taxpayer could exercise this power after real estate assets have had a chance to appreciate significantly. As a result, the grantor’s estate would be in the same position as prior to the substitution transaction (because the asset substitution is for assets of a similar value), but the appreciated real estate would be pulled back in the estate of the taxpayer. At the taxpayer’s death, the appreciated property would receive a step-up in basis under Code Section 1014.
This is an estate planning “home run” because: (a) the gift was made in discounted dollars, (b) the estate was frozen at the value of the gift, with subsequent appreciation accruing outside the estate, (c) the income tax on rents was paid from the taxpayer’s otherwise estate-taxable assets, which diminishes the estate tax bill, (d) the capital gain was deferred (perhaps multiple times) through the use of Code Section 1031 and (e) the capital gain was ultimately jettisoned by means of Code Section 1014 (and, potentially, Section 754).
New York’s Transfer Tax
For taxpayers living and doing business in New York City, it is also important to take into account the impact of New York State Real Estate Transfer Tax and the New York City Real Property Transfer Tax (collectively transfer tax) regimes on the initial funding of grantor trusts and subsequent asset substitutions from the grantor trust. Generally speaking, gifts of interests in real estate (i.e., where no consideration is exchanged) are exempt from transfer tax, provided, however, that there is no mortgage on the property.
If the property is subject to a mortgage and the liability is transferred with the property, the transfer is viewed as having been made in consideration for the relief of debt, which may create a situation similar to the negative basis problem discussed above. In such a case, the transfer tax may be triggered.
For sales of real estate into trusts, if the real estate is not owned by an entity, any transfer of a fractional interest could trigger a transfer tax. On the other hand, if the real estate is owned in an entity form, up to 49 percent of the membership interests in the entity can generally be disposed of in a given three-year period without being presumed subject to transfer tax. Many other nuances exist with respect to transfer tax, many of which can be dealt with in arranging the taxpayer’s ownership structure or in shaping a particular transaction.
Another factor to be considered in estate planning with real estate interests is the impact of existing mortgages or loan facilities. Frequently, one or more loans are secured by a client’s real estate portfolio. The disposition of the underlying assets or the entities that hold them (by means of conveyance to a grantor trust, for example) could result in triggering a “due on disposition” clause in the mortgage documents.
In such a case, a lender could take the position that all loans are due and payable immediately when a transfer is made. Accordingly it is sometimes necessary to deal with lenders and their counsel to structure gifts or sales. This can often be handled in the context of a broader restructuring effort or refinancing.
The following simple example will illustrate many of the concepts discussed above:
Larry Landowner is a 45 year-old real estate investor with a love for his home town, New York. He owns a portfolio of several limited partnership (LP) interests in commercial buildings, which are all subject to mortgages. There is a negative basis issue with respect to one of the buildings. The total equity value of his LP interests is $17 million, without taking any discounts into account. He also has a stock portfolio of $10 million. Larry has a wife, Laura, and two children. He has done no prior gift or estate planning. His goals are to maximize the tax efficiency of his investments and ensure that Laura and the kids are taken care of in the event of his passing.
After signing basic estate planning documents (usually consisting of a will, revocable trust, power of attorney and health care proxy) Larry creates a grantor trust. The trust provides that, during Laura’s life, Laura and all of Larry’s descendants are permissible beneficiaries who can receive distributions in the discretion of the trustees. At Laura’s death, the trust will divide into separate trusts for each child and his or her family. Laura is a trustee together with Larry’s trusted accountant. The trust includes a provision permitting Larry to substitute trust assets at any time for property of equal value.
Larry decides to make a gift to his trust. In the process of valuing his LP interests, a qualified appraiser determines that they are actually worth 35 percent less than their pre-discounted value of $17 million because Larry has no control over the underlying investments held in the entities and his interests are relatively illiquid. Therefore, for gift tax purposes, the value of his interests is $11,050,000 (65 percent of $17 million). He transfers the interests to the trust in 2018 as a gift. No gift tax is due because his gift is less than the 2018 gift tax exemption of $11.18 million. There is no transfer tax issue because Larry transfers a non-controlling interest that is less than 49 percent of each partnership.
In 2019, the LPs earn rental income and the general partners of the LPs decide to make a distribution of $500,000 in aggregate. Because the trust is a grantor trust, Larry will report the income on his personal income tax return. The trust receives the LP distribution and the trustees reinvest the proceeds into new LP interests in the name of the trust.
The general partners of the partnerships periodically exchange assets under Code Section 1031 and no gain is recognized.
This continues for 40 years. Sadly, Laura predeceases Larry with no estate of her own and her estate tax exemption is available to Larry, now 85. Larry has paid the trust’s income taxes over the last 40 years the trust assets have grown dramatically to $50 million. He decides to substitute the LP interests in the trust for a $50 million promissory note.
Six months after the substitution transaction, Larry dies peacefully in his home. The income tax bills attributable to the trust have added up over the years. Larry has paid the taxes from his stock portfolio and has also used most of the income for ordinary living expenses, so his stock portfolio and other estate-includible assets (other than the $50 million in LP interests) are only worth $15 million.
The promissory note payable given to the trust in the substitution transaction is a liability that offsets the inclusion of the LP interests in his estate, resulting in a wash. Assuming a 2 percent annual inflation rate, the estate tax exemption in 2058 would be approximately $24.7 million and Larry consumed an $11,050,000 portion of his available exemption with his gift in 2018. His estate will owe less than $2 million in Federal and state estate taxes. At some time following his death, the outstanding promissory note to the trust can be paid using the LP interests or other assets.
The LP interests can be disposed of at little or no tax cost because the 40-plus years of capital gains have been eliminated by operation of Code Section 1014. By using these strategies, Larry has reduced his estate tax bill from approximately $43 million to $2 million. In addition, he has effectively erased millions of dollars in capital gains.
Although tax planning opportunities have, in many instances, been generally restricted over time (to include the amendments introduced in the act), the act has preserved many unique estate planning opportunities for families with real estate assets. Often, because the estate plan works “in the background” and only delivers results after many years of thoughtful planning, families delay their estate planning efforts until significant wealth has accrued within the estate (or estates) of family members, at which time, planning opportunities may be significantly limited.
Owners of real estate who expect to accumulate more holdings should accustom themselves to consulting with an experienced estate planning lawyer who can help them establish the appropriate structures and make the most tax-efficient decisions as early in their lives as possible. Doing so can help to ensure that, in the long run, their family wealth is preserved for future generations to the greatest extent possible.
Philip J. Michaels is a partner at Norton Rose Fulbright. Jason A. Lederman is an associate at the firm.