Advanced Estate Planning Principles for Apartment Owners with Taxable Estates
By: Attorneys Kenneth Ziskin & Michael J. Wittick
While not every apartment owner has enough wealth to worry about Estate Taxes, we are not surprised to discover that many face Estate Tax exposure at a rate of 40% on the estate over the exclusion amount. Many income property owners can expect Estate Taxes of $4-10 million, or more without further planning.
Last month, Ken laid out some general estate planning principle for apartment owners who do not anticipate having an Estate Tax problem in Ken’s article 21st Century Estate Planning Principles for Apartment Owners – Focus on Income and Property Tax Savings. If you do not anticipate your estate will exceed the Estate Tax exclusion amount, good estate planning is now (after the American Taxpayer Relief Act went into effect in 2013) much more about income and property tax savings, and Estate Tax savings are irrelevant or only a minor issue.
You can learn more about these principles (which are still meaningful even for larger estates), and ways to save millions in unnecessary taxes, at one of our Estate Planning for Apartment Owners seminars.
Should You Worry About Estate Taxes?
However, if you have built, or will build, a larger estate, Estate Tax planning becomes important.
Generally, for California residents, planning to minimize or eliminate Estate Taxes begins to make sense if an apartment owner’s wealth (plus most gifts not covered by the annual exclusion) exceeds the owner’s lifetime
For an individual, the lifetime exclusion amount is $5.43 million in 2015; for a couple it is $10.86 million.
This exclusion grows by law with the rate of inflation. So, if inflation averages 2% over the next 15 years, the exemptions would grow to about $7.3 million for an individual, or $14.6 million for a couple.
On the other hand, if your property (including unspent income) grows at just 4% per year, a $10.86 million estate (with no Estate Tax exposure in 2015 for a couple) would grow to about $19.5 million, creating an Estate Tax exposure of about $2 million by 2030. Uncle Sam will appreciate collecting these taxes when you die, but your heirs will not appreciate paying them!
Bottom Line: Even if you do not have an Estate Tax problem today, if you have substantial wealth and believe it will grow faster than inflation, you should worry about Estate Tax exposure.
Principles of Estate Tax Protection Strategies
This article does not have enough words to allow us to analyze even a few of the many strategies that can be used to protect your heirs from Estate Tax exposure. In future articles, we hope to explain some of these strategies in more detail.
But, we can give you an idea of the principles that support most of these strategies:
PRINCIPLE #1 – FREEZE VALUES
This involves getting assets you expect will grow in value out of your estate before they grow further. This leverages your exclusions by using them before property has finished growing in value. If assets are going to grow at just 4% per year, they would double in about 18 years. You can leverage your Estate Tax exclusions by using them today, instead of waiting until you die.
And, sometimes you do not even need to use any of your lifetime exclusion to get assets out of your estate. Some gifts (like direct payments of tuition and medical expenses) are not treated as gifts at all.
Other gifts can use your annual exclusion without depleting your lifetime exclusion. The annual exclusion allows you to give $14,000 in present interest gifts each year per recipient without using any of your lifetime
exclusion. A married couple with 2 children and 4 grandchildren can give away $168,000 per year to their descendants using annual exclusions. Gifts can be cash, but can also, with proper valuations, consist of property.
Gifts in trust can also be structured so that your children or grandchildren will not have free access to spend, or dispose of, the gifts imprudently.
PRINCIPLE # 2 – DISCOUNT VALUES
Fractional interests in property, particularly when held in an entity such as a Family Limited Partnership or LLC, are usually worth less than a pro rata portion of the whole. For example, if your property is worth $1 million and owned in a well-drafted LLC, it is likely that a 10% interest in the LLC is only worth $60-70 thousand, even if it “represents” $100,000 in underlying value.
Combine discounting and freezing, with proper structuring, you can give 10% of that LLC to a child, and use only $60-70,000 of your annual or lifetime exclusions, even though you expect the underlying property (at 4% annual growth) to be worth about $200,000 in 18 years. That leverages your exclusions by about 300% or more!
PRINCIPLE #3 – SQUEEZE YOUR ESTATE
A great way to leverage your exclusions is to use an “Intentional Grantor Trust” (“IGT”, a special kind of trust where the property will be outside your estate for Estate Tax purposes, but any income on the property will be taxed to you.
Your payment of the income taxes on the property in an IGT “squeezes” down the value that remains in your estate for Estate Tax purposes. While payment of the income taxes on the property in the IGT has the economic effect of an additional gift to the beneficiaries of the IGT (freeing them, or the IGT, of the income tax liability), the tax law does not treat such payment as a gift.
Many advisers believe that, over time, the value of “squeezing” exceeds the value of discounting for your heirs.
Of course, this makes sense only if you have kept enough in your estate to remain concerned about estate taxes and retain enough money to pay both the income taxes and your living expenses.
PRINCIPAL #4 – THE TIME VALUE OF MONEY
In larger estates, freezing, discounting and squeezing may not provide as much Estate Tax protection as you desire.
In those cases, you can make partial outright gifts to a trust, and then, sell additional property to the trust at a low effective rate of interest. This can include sales on an installment note, “sales” in exchange for an annuity (in a Grantor Retained Annuity Trust, or “GRAT”) and sales in exchange for a Self-Cancelling Installment Note (a “SCIN”, which is a note that cancels if you die before it is paid off). If the trust is an IGT, the sale has no income tax effect as you are still deemed to own the property for income tax purposes. As a result, you generally recognize no gain on the “sale.”
This principle works when the assets in the IGT grow at a faster rate than the IRS requires on the note, or which the IRS uses to calculate the annuity. The IRS mandated minimum rate on an installment note in March, 2015 ranges from 0.4% to 2.19%; the implied rate on a GRAT is only 1.8%.
Bear in mind that GRATs do not work well if you die before the end of the term of the annuity payments, and SCINS do not work well if you outlive the note. However, with careful structuring, you can hedge a SCIN with a GRAT and your heirs will get Estate Tax savings regardless of how long you live. This enables you to balance a “bet to die” strategy with a “bet to live” strategy.
PRINCIPLE #5 – SPLIT INTEREST CHARITABLE TRUSTS
While clients usually assume that charitable trusts work only for those who want to give their property away, they can be used to enhance the amount you can ultimately spend and/or pass to your heirs.
The Capital Gains Bypass Trust (“CGBT” – see Ken’s article in the October, 2014 issue of Apartment Management Magazine and affiliated publications) can enable you to sell your highly appreciated property and reinvest the proceeds to produce income for you and/or your designated beneficiaries without reduction from capital gains taxes. Plus, you can get a current income tax deduction as well.
Although the remainder in the CGBT will go to charity after you, or your designated heirs, are gone, the income stream (enhanced by NOT paying capital gains taxes) can, in some cases, produce more wealth for you and your heirs than you would have been able to produce/retain after a taxable sale. Furthermore, if you structure it correctly, your children or grandchildren can earn a sense of significance and self-esteem from managing the charitable portion, which can be “priceless.”
Finally, some of the excess cash flow from a CGBT can often be reinvested free of income taxes in life insurance, the proceeds of which can pass to your heirs free of both income and estate taxes.[We DO NOT share in insurance commissions. That allows us to be objective regarding the advantages of life insurance. While we do not believe that all insurance makes sense, the income tax-free buildup in value often
produces a rate of return comparable to a 7-10%, or greater, income taxable return over a client’s life expectancy.]
A Charitable Lead Trust (“CLT”) works in the opposite way from a CGBT. The CLT pays a fixed amount or percent of income each year to charity, but the remainder to your heirs. The IRS usually treats the value of the remainder for your heirs as a gift when you establish the CLT. It calculates such value by considering the term of the CLT, the amount of payments and an assumption that the CLT will earn at the AFR rate, currently only 1.8% per annum. Any growth in value above that AFR rate passes to your heirs free of estate taxes.
Don’t Try Any Advanced Planning without Expert Help
As you would expect, the advanced strategies that use these principles have a lot of technical requirements. You should not attempt to implement one of them without expert assistance. Work with a lawyer who cares about making these strategies meet YOUR goals, who will spend time helping you understand and plan for them, and who has the knowledge to help you implement them in an IRS compliant manner
Science fiction writer Robert Heinlein, in The Moon Is a Harsh Mistress, reminded us all that “There Ain’t No Such Thing As A Free Lunch.” The same thing applies to most advanced Estate Tax Protection strategies.
Many of the strategies may have other “costs”, including legal fees, possible loss of (or reduced) step-ups in basis, and possible adverse property tax consequences. Still, for many clients and property owners, with careful structuring, you can enhance the overall wealth of your heirs by employing strategies that combine one or more of the advanced Estate Tax Protection Principles.
For very large estates, the best results can be produced when you both reduce estate taxes and get a full step-up in basis for your heirs. There is one strategy that can do this by creating the right kind of illiquidity to utilize a special estate tax deduction. This is a very advanced strategy (with solid support in IRS and court decisions) that will usually make sense only in estates which total at least $15 million for a single person, or $20 million for a couple, and which include significant amounts of highly appreciated assets.
Using the latter strategy can be a “home run”, but whether it makes sense for particular client depends on a more factors than can be explained here. Accordingly, we do not, advocate this strategy generally, but will evaluate it for clients who want to engage in planning before hiring an attorney to implement an advanced estate plan.
PLANNING WELL – The Solution to the “No Free Lunch” Problem
My motto for years has been “IF YOU FAIL TO PLAN (WELL), PLAN TO FAIL.” PLANNING WELL takes time working with an experienced estate planning lawyer who will help you analyze your estate and your goals, will work to develop a plan that meets your goals and work to optimize all of the tax consequences based on your assumptions.
If you have a multi-million dollar estate, your family cannot afford to let you pass it without good planning. The failure to do good planning can cost your heirs millions of dollars, often up to 1000 times the cost of good planning!
You will be hard pressed to find another investment that can produce as high an after tax return for your family as really good PLANNING. Find a lawyer who cares about doing good planning to meet your goals, and you can achieve great results for your family.
Kenneth Ziskin, an estate planning attorney, focuses on integrated estate planning for apartment owners throughout California to save income, property, gift and estate Taxes. He holds the, which also gave him a Client Choice Award in 2014.
Ken works in Orange County with Attorney Michael J. Wittick, who is a Certified Specialist in Estate Planning, Trust and Probate Law. Ken and Michael both hold the coveted AV Preeminent peer reviewed rating for Ethical Standards and Legal Ability from Martindale-Hubbell, and a perfect 10 out of 10 rating on legal website AVVO. In San Diego, Ken works with Attorney John Demas, while in Northern California he works with San Jose Attorney Robert J. Bergman.
Ken is presenting upcoming seminars on Estate Planning for Apartment Owners in Los Angeles on June 30, in Orange County (with Michael J. Wittick) on July 21 and in Van Nuys on July 23, 2015. For reservations, call (818) 613-8442 or email [email protected]
This article is intended to assist readers to get a general understanding of some estate planning concepts relevant for income property owners. To keep it concise, it does not discuss all of the exceptions, qualifications and other concepts that might affect their utility in your situation. You can only rely on counsel you specifically retain, and not on these materials, in connection with your planning.