A Legacy Lives On: Best Practices in Real Estate Transition Planning
By Jeffrey Gould, CCIM, CPM, LEED AP | Principal | Lineage Asset Advisors, Daniel Lorenzen, Esq. | Partner | Venable LLP
For the past two decades, they've accumulated more real estate wealth than any other generation. And with nearly $68 trillion of total wealth expected to transfer to their heirs over the next 20 years, the U.S. is experiencing the largest wealth transfer in its history.
But many first-generation real estate owners have a different perspective on their portfolios than their heirs, and their legacies don't always endure after they are gone.
The transition of real estate assets to future generations is a complex process, requiring deep alignment and communication beyond the portfolio. Family dynamics, governance, shared asset planning, estate planning, tax planning, financial planning, and risk management - all play a role. When there is misalignment with real estate, a lack of planning can rupture a family and lead to conflict and even legal disputes. Learn how to avoid this.
Real Estate Transition Best Practices
Tailored real estate transition plans that meet a family's unique needs are most effective. These plans require participation from family stakeholders and collaboration with trusted third-party advisors. Below is a three-phase process that clients may consider when establishing and implementing a tailored real estate transition plan.
Phase 1 - Discovery Phase:
Here, the family and their advisors perform due diligence on all aspects of their existing real estate portfolio, as if they are acquiring the portfolio for the first time. For some owners, this is a process of Re-Discovery.
The Discovery Phase allows owners to reexamine existing operations and financial performance. The assessment can be used to prepare and educate family stakeholders on the performance of the portfolio and for ongoing strategic, estate, and tax planning purposes. The assessment should be simple enough that anyone can follow along and gain an understanding of the portfolio.
Here are the key elements of a robust portfolio assessment:
- Financial Performance - Analysis of how each asset in the portfolio is performing in comparison to the family's key financial metrics: value, cash flow, expenses, return on equity, and internal rate of return
- Current and Future Market Value - Analysis of the current and pro forma market values of the properties in the portfolio
- Debt Analysis - Analysis of the existing debt across the portfolio
- Tenant and Lease Analysis - Analysis of tenancy and leases across the portfolio
- Market Analysis - Analysis of the market and submarket of each property in the portfolio
- Portfolio Composition Analysis - Analysis of the real estate portfolio composition and current exposure to certain asset classes and geographies within the portfolio
- Property Condition Assessment - Assessment of the condition of each asset with an eye toward identifying and prioritizing deferred maintenance and budgeting for capital improvement projects
- Property and Asset Management Performance - Analysis of the property and asset management performance, whether the two are effectively integrated, and the efficiencies and inefficiencies of the portfolio operations
- Risk Analysis - Identification of all areas of current and future risk within the portfolio: Cash flow, debt, tenancy, market factors, taxes, regulatory environment, deferred maintenance, management, and technology
- SWOT Analysis - Analysis of the strengths, weaknesses, opportunities, and threats (SWOT) of the portfolio
- Ownership Dynamics - Interview and deeper understanding of each of the beneficiaries'/family stakeholders' interests, skill sets, and connection to the real estate portfolio and the family dynamics. Identify any challenging family dynamics that could prevent alignment
- Title - Analysis of the current ownership and title structures to ensure the assets are appropriately titled for transition to the next generation
- Recommendations - Recommendations on current and future asset and portfolio strategies
Phase 2 - Planning Phase:
During the Planning Phase, the family takes the findings uncovered during the Discovery Phase and builds a business plan with them. Also, in the Planning Phase, the family can consider methods to mitigate portfolio risks, address financing, plan for lease expirations and tenancy issues, and implement tax-advantaged strategies.
The business plan covers everything from family governance to communication and should include a shared asset plan. As the name implies, this plan outlines how individual real estate assets will be shared and establishes the structure for how the family will manage them.1
Once the family understands the performance and makeup of their real estate portfolios and has a business plan in place, the next step is to name trusts/ trustees and accomplish estate and tax planning.
Trusts and Tax Planning
Ideally, the top level of ownership for real estate assets will be one or more trusts. In almost all states, a revocable living trust is the ideal estate planning vehicle and operates as a superior form of a will. Established trusts can be used to minimize taxes or structure real estate portfolios. Trusts sometimes own real estate through family limited liability companies or partnerships, which may provide greater advantages in both managing a portfolio and making it more tax efficient.
For instance, assets may be transferred to irrevocable trusts, turning the trust itself into the owner of the assets for tax purposes. This is principally used to cease paying estate taxes on real estate assets in the trust, although there may be some income tax tradeoffs as well.
A quick note: States have different rules for when the local property tax basis for real estate is increased or decreased. Some states may impute higher property taxes to property when it is placed in an irrevocable trust, while others may not. Careful consideration should always be given to state and local taxation for real estate assets.
Trustee and Beneficiary Considerations with Real Estate
In most cases, a revocable living trust is managed by the one who contributed their property to it (that is, the “settlor”) for the remainder of that person's lifetime.
The manager of a trust is known as the trustee, and there may be one or more acting trustees at any given time. Usually, when the settlor passes away or becomes unable to act as trustee, one or more successor trustees take over while the trust continues to provide detailed instructions on distributing real estate assets.
Because of the significant responsibilities being shouldered, careful consideration should be given to trustee selection. Each significant point of contact a trustee may have should be considered, and the rights and responsibilities of the trustee should be spelled out in the trust documents or the family partnership's organizing documents. In many cases, a third-party trustee may be involved in managing assets, or management may be outsourced to a third party. This can affect day-to-day management, especially when the settlor wishes to retain some control.
Hiring third-party property managers may allow for continuous control and management of properties held in a trust. Where this is not enough, however, real property may be held in an entity, such as an LLC, and the ownership of that entity will be placed into the trust.
Though it is possible for the settlor to be appointed as the manager of an LLC owned by a trust and therefore manage the real property investments directly, there may be tax implications.
More complex trusts may separate the roles of a trustee, investment advisor, and distribution advisor. This could add flexibility. For instance, one person may direct the investments in a trust, while another decides when and how to distribute the net cash flow of the trust to beneficiaries.
Estate Tax Planning Considerations with Real Estate
Assets can be placed in an irrevocable trust for the benefit of future descendants, charities, or other beneficiaries. With a well-designed trust plan, the assets in the trust will not be subject to estate taxes upon the settlor's date of death.
Estate taxes are currently assessed at a 40% rate on all assets more than the base exemption amount of $12,920,000 (a number that is indexed for inflation and is scheduled to be cut in half under current federal law starting in 2026, with the rate increasing to 45%). The base exemption value may be transferred to trusts during the settlor's lifetime without incurring a 40% gift tax.
Even if the value of the trust grows to a much larger value, no estate taxes will be due in the future. This is a great strategy when a settlor's asset value is likely to be more than the exemption amount, and the settlor has property with the potential to appreciate in value.
However, assets transferred to an irrevocable trust are no longer considered to be owned by the settlor, so they do not receive a step-up in income tax basis. This impacts the capital gains taxation on the future sale of properties, as well as the basis for taking depreciation deductions against investment property. In most states, a 40% estate tax is higher than the marginal state and federal income tax rate, but the tax benefits of these estate planning techniques should be weighed carefully to ensure efficient planning.
Phase 3 - Implementation Phase:
Here, we arrive at the culmination of the Discovery and Planning Phases. The Implementation Phase requires ongoing management, communication, and adaptability. Once the plans are in place and the stakeholders are aligned, the next focus is on bringing everything to life.
Proactive implementation can take a variety of different forms depending on the makeup of the real estate portfolio and the family dynamics. Below are examples of key areas in the implementation phase.
- Property and Asset Management Integration - It is incumbent upon the family stakeholders to have the right next-generation management team and infrastructure in place as part of their transition plan and to ensure that these teams are fully integrated to achieve operational efficiencies, cost savings, and increased/ preserved revenue. This plan might include hiring multiple third-party property managers that manage different assets in different locales with oversight from a family asset manager. Or bringing management back in-house with a qualified family-run management team. Technology and integration of technology can also be a critical aspect of this operational integration. The key to implementing the right management plan is family alignment and oversight.
- Portfolio Diversification - Multigenerational real estate families that own portfolios concentrated in a certain type of property or geography may consider diversifying their portfolio to avoid concentration risk. Different property types and geographies may have higher risks and more volatile return scenarios, and diversification can help mitigate risks and stabilize returns.
- Capital Improvement Projects - Prioritizing, budgeting, and implementing capital improvement projects to cure deferred maintenance within a real estate portfolio should be planned, outlined, and communicated. Deferred maintenance issues that are inherited by the next generation can be one of the leading reasons for family conflict and liquidation.
- Selecting The Right Fiduciary - By avoiding common mistakes when selecting a fiduciary, real estate families can select a fiduciary who is the best fit for their needs and create a trusted partnership that supports their long-term goals and protects their assets for future generations.
- Title Considerations with Real Estate - It is imperative that multigenerational real estate families establish clear ownership structures that take into account the needs and goals of all family members and ensure the parties have a clear understanding of their rights and responsibilities. Succession planning strategies should address estate taxes, probate, and the transfer of ownership to future generations. It's important to regularly review and update title documents to ensure that they are accurate and up to date and to address any potential legal or regulatory issues that could have future impact.
- Hold Versus Sell Decisions - Families that are analyzing hold versus sell decisions with their real estate should follow best practices. These could include having professionals conduct a thorough analysis of the market conditions, property values, and potential risks and rewards associated with the decision. The tax implications of holding or selling the property and establishing clear communication channels with all stakeholders involved in the decision are key.
Real estate transition planning is crucial for any family that owns property, as it can help ensure the long-term success of the real estate portfolio and the preservation of the family's legacy.
Without proper planning, real estate assets can become a source of conflict and confusion, leading to costly legal battles, family disputes, and even the dissolution of a business. Failing to plan for the transition of real estate assets can leave the assets vulnerable to many management risks and external risks.
But by investing in the proper planning, family real estate owners can create a roadmap for the future that ensures the proper management and protection of their real estate assets and paves the way for continued success and growth for generations to come.