Help your clients win when exiting their investments.
Most commercial real estate investors are clear on the
benefits of owning income property, but many underestimate the importance of
creating an end-game strategy for the timely and favorable disposition of their
assets. In fact, many investors today find that their net asset values have
grown far beyond estate tax exemptions and now are subject to substantial taxes
upon final disposition to heirs. Understanding how to manage these assets is
critical to minimizing their tax burdens.
The playing field for calculating investment taxes is
complex and uneven. In 2006, the transfer-tax exemption increases to $2 million
per person until 2009, when it is scheduled to rise to $3.5 million for the
2009 tax year only. In addition, the Tax Relief Reconciliation Act of 2001
phases out the estate transfer tax in the year 2010 before returning to the
pre-2001 structure in 2011. Additional changes in 2001 increased the lifetime gift
exemption to $1 million per person and modified the generation-skipping transfer
tax exclusion to parallel estate tax exclusions. And many professionals are
betting on still more changes to estate transfer tax laws before 2009.
Profiling Your Clients
To successfully advise clients on how to manage their exit
plans, commercial real estate professionals should first examine their clients’
investment characteristics. In my experience, most individual investors fall
into one of three distinct groups.
Ostriches. Investors in this group keep their heads down and
are not interested in going much further than having a will and perhaps a
living trust to hold their assets. There is no strategy to provide for the most
suitable market timing, deal structure, title entity, asset protection,
property management, or liquidation plan. Rather than work with a team of
professionals, decisions often are based on the client’s need to react to a
situation quickly with little investigation or due diligence. The decision to
sell is often in response to outside forces and often when the seller is in the
worst position to take advantage of the market.
Blue jays. These investors are interested in keeping -– and
spending -– all the marbles in their lifetime. Their objective is to leave
nothing to Uncle Sam or other relatives. This group is likely to cash out and
pay taxes, especially at the low federal capital gains rate of 15 percent, as
soon as the residual, after-tax cash benefit reaches a safe level for funding
their life expectancy. Depending on lifestyle choices and the remaining time to
play, a number of creative scenarios can be very useful to maximize these
investors’ cash flow and preserve their capital.
Eagles. These investors take a long-term visionary approach
and are very proactive about their investment real estate portfolio. They
generally work with a certified public accountant and attorney as well as a
real estate adviser, asset manager, and other professionals. Their goal is to
grow the asset value and cash flows while positioning the holdings to benefit
future generations of family or favorite charities. They have taken the
appropriate steps in choosing the entities and manner of taking title that provide
full advantage of the offered tax incentives. This group would be likely to use
the personal $1 million lifetime gift exemption to fund a perpetual trust
through a liquid liability company and family limited partnership. A favorite
qualifying charity ultimately would benefit from a charitable remainder unitrust
or charitable annuity trust, while the donor enjoys cash flows for life.
Matching Clients to Strategies
With the above differences in mind, commercial real estate
advisers can benefit greatly from keeping their clients abreast of market
trends and estate planning tools. The following is a general look at the kinds
of exit strategies that investors in all three of these categories may want to
Tax-friendly entities. First and foremost, advise your
clients to work with both tax law and accounting professionals to determine
their best options for holding title to their property. Some options include
family trusts, S-corporations, C-corporations, limited liability companies,
limited partnerships, real estate investment trusts, specialized trusts, and
family foundations. Choosing the right form of holding title delivers
protection of equity, tax savings, and flexibility in planning future benefits.
Tax-deferred exchanges. These tools are the most popular
form of putting off the tax man for a future day. While most Internal Revenue
Code Section 1031 exchanges are designed to defer all the gain, the exchange
also is useful in planning a graceful exit from ownership. A partial exchange
results in tax savings for the qualifying portion. The exchange of a large property
for several smaller properties allows the investor to spread his tax liability
over several tax years. Some things to watch for: Advise clients to take title
to the replacement property in the same way they held title on the relinquished
property (the time to try out the new entities is before or after the exchange).
If the relinquished property closed in the last tax year, investors should not
file a return. Instead they should file an extension until closing on the
Installment sales. Under Internal Revenue Code Section 453,
when the disposition of a property in which at least one payment is to be
received after the close of the taxable year in which the sale occurs, the
seller will recognize gain or profit as he actually receives the proceeds over
time. Typically, the cash down payment would be taxable, net of closing costs,
and the remaining installments would be taxed as they are received. This is an
effective tax management program with the added benefit of providing interest
income for the remaining balance of the contract. Due on sale and prepayment
provisions need to be addressed in advance, as the full amount of the remaining
tax of gain would be paid in the event the loan is paid off early.
All-inclusive trust deeds. This tool can be particularly
beneficial with an installment sale in cases where the existing junior loan
carries a lower interest rate than the negotiated rate on the all-inclusive
trust deed. The seller then has the arbitrage on the collected rate on the full
amount of the combined loans and the lower rate paid on the underlying loans. Existing
lenders can be an obstacle.
Lease options. Under the lease option, the title to a
property remains with the taxpayer and a contract to sell is contained in an
option. The owner of the option leases the property with the lease payment equal
to the amount of interest on an installment sale. The lease deposit equals the
down payment under an installment sale. The expected benefits to the buyer and
seller are that the property taxes would not change; capital gain has not been
triggered; the buyer has full use of the property, its management, and cash
flow; the seller has lease income, assumes no management, and can plan ahead
for the most beneficial year to exercise the option. The Internal Revenue Service,
lenders, and the county tax collector all are likely to challenge this device
as a hidden sale, so professional counsel is a must.
Exchange for NNN and sell cash flows. This strategy is to complete
a 1031 exchange into a quality net-leased investment and borrow against the
cash flows at a reasonable discount. The benefits are tax-free cash today.
Family limited partnerships. The formation of a family
limited partnership provides a convenient way of passing along equity interests
to family members at bargain prices. Control of the property remains with the
grantor or general partner and the limited partnership interests are discounted
up to 40 percent due to the lack of market liquidity. These can be used with
lifetime gift exemptions and generation-skipping plans.
Charitable remainder unitrust. This structure is especially
useful when property is fully depreciated. The transfer of ownership to a
qualified charity results in no capital gains tax upon sale and cash flow for
the life of the donors. The charity receives the remainder of the asset.
Retained life estate. The donor receives a significant tax
write-off in the year of transfer and use of the property for life.
Family foundation. This structure provides involvement in funding
activities and specific needs, while providing tax benefits and control.
Private annuity trust. Private annuities can provide
significant benefit in transferring ownership of assets from one generation to
the next. Many rules apply to their application to investment real estate and
they are fairly rigid structures that are not easily adaptable after
implementation. Many similarities exist between private annuities and
installment sales. However, if carefully crafted, private annuities can avoid
triggering a taxable event if the related-party obligor decides to sell the
Reverse exchange. This is another planning tool that allows
the replacement property to be acquired prior to closing on the relinquished
property. Recent tax rulings have blessed this strategy, but it is best to work
with an experienced accommodator. In some circumstances related entities can be
useful in completing a qualified exchange.
Exchange with tenants in common. Often this is an exchange
in which management-weary owners acquire a tenancy in common in a larger
property with professional management. This also is a strategy in which related
entities (for example, a family trust and a corporation) each can acquire a
portion of the equity in a replacement property, limiting the percentage of
ownership in the trust subject to the old basis and “bookmarking” with the
corporation a portion of the equity for future exchanges. Related-party rules
apply in this scenario, requiring that the related entity must not dispose of
the property for 24 months.
Umbrella partnership real estate investment trusts. An
UPREIT is an exchange in which equity in a property or portfolio of properties
is relinquished for shares in a real estate investment trust. This usually
applies to larger and newer properties that would fit a REIT acquisition
profile. Limitations apply to the sale of the newly acquired stock.
Corporate conversion to REIT. In June 2001 the IRS issued
Revenue Ruling 2001-29 in which corporate-owned real estate can be transferred
tax free to a corporate shareholder’s stand-alone business subsidiary. The
subsidiary then can elect to be treated as a REIT and lease the property back
to the corporation in an arm’s-length transaction.
Offshore trusts. Offshore enterprise zones can offer special
benefits under some circumstances. Consult a very specialized tax attorney or
CPA to navigate these safe havens.
Redevelopment area joint venture. Owners of property in a
redevelopment area may find benefits in structuring a joint venture with a reliable
development firm. Care should be taken to preserve long-term capital gains
Combine IRC 1031 and 121. This new IRS Revenue Procedure went
into effect Feb. 14, 2005. When a seller has owned and lived in a home for two
of the past five years, it is eligible for the capital gain exclusion under IRC
121, even if it is presently being used as a rental. For a married couple this
could result in an exclusion of $500,000 in tax-free cash and a deferral of the
balance of the gain under IRC 1031.
While this is not an all-inclusive list of strategies,
qualified professionals in each specialty, practice, and worldwide location can
be reached for further information through the CCIM Partners program at www.ccim.com/partners. Qualified
charitable contributions as well as questions for more information can be
directed to the Education Foundation of the CCIM Institute at www.ccim.com/education/education_foundation/default.html.