Legacy Family Planning – Passing Real Estate to the Next Generation

For many families, real estate assets represent some of their largest assets. Planning for inheritance of real estate involves many factors which must be balanced in determining a family’s estate plan, e.g., income and estate tax planning, asset protection, rights to use among different heirs, ongoing management and ongoing funding of maintenance.

Handling real estate inheritances can be challenging due to many emotional pitfalls for families, including disputes over ownership and usage as well as the ultimate sale of a family legacy asset. Proactive discussion about alternatives and priorities will minimize future family disagreements, develop a more tax efficient plan, and can create a flexible structure for management and use of the property over time.

As families consider options for managing and passing on real estate to their heirs, keep in mind a few of the following general issues and recommendations:

Transfer Highly Appreciated Real Estate by Will or Trust

As parents age, they may be tempted to “gift” a second home or their primary residence to their children prior to death. However, if you gift real estate before you die, your heirs will take the cost basis in the property rather than achieve a step-up in basis in the property at death. For real estate held for a long time, this could cause the heirs to owe a large amount of capital gains on the property’s appreciation.

In most cases, the overall tax burden to the family will be minimized if parents leave highly appreciated real estate to heirs in their will or trust at death. That way, when the heirs later sell the inherited property, they only owe capital gains taxes on the amount the real estate appreciated after the property was inherited.

For families facing a potentially taxable estate, you could sell real estate during your life to an heir under an installment note or to a trust or partnership during your life to freeze its value. The purpose of the sale is to transfer the future appreciation of the property out of your taxable estate. Common techniques involve using either an Intentionally Defective Grantor Trust (IDGT) or a “freeze” partnership. Spouses can also hold real property in a joint revocable trust and achieve a partial step-up in basis on the death of the first spouse, reducing realized capital gains if the property is later sold. These techniques involve complex requirements and may or may not be advisable given the particular facts and circumstances of each family.

For a primary residence, gifts during lifetime are commonly made using a qualified personal residence trust (QPRT). Typically, this trust is utilized to minimize estate tax for a wealthy family trying to pass on use of a cherished family residence.

How it works. A QPRT is a type of irrevocable trust that allows you to exempt the appreciation of value of your home from your personal estate. After the trust is set up, you can continue to live in your home for a specified length of time. Once that time period expires, you may live in the home but must pay rent to the trust beneficiaries. The longer the specified QPRT term, the greater the potential tax savings. However, if you fail to survive the term specified in the QPRT (i.e., 10 years), the value of the property in its entirety will be a part of your estate. It is important to select a reasonable term for the QPRT.
The value of your property placed in a QPPRT is frozen as far as estate tax purposes are concerned. Rent payments paid to the beneficiaries after the set term additionally reduce estate assets. Setting up a QRPT can be a great way to lessen your beneficiary’s estate tax burden while still enjoying the use of your home. However, QPRTs are costly to set up, can be complicated to administer, and the tax advantages are lost if you don’t outlive the set term established by the QPRT.
One potential pitfall of the QPRT is the loss of the ability to take a step-up in tax basis if your beneficiaries choose to sell the home. However, since the maximum federal rate for capital gains is significantly lower than the maximum estate tax rate, the amount of capital gains tax payable is significantly less than the amount of potential estate tax owed.

Please be sure to check local regulations since transfer taxes can apply to transfers of real property to trusts.

Use of LLCs and Family Partnerships for Asset Protection, Gifts and Flexibility

Many families own investment property, ranches and second homes in a limited liability company (LLC) or limited liability limited partnership (LLLP). Because investment property and ranches are more likely to involve liability exposure to third parties, families should segregate such assets into individual entities or hold only a few related properties together in one entity. That way, liabilities relating to one property are insulated and will not usually put other family assets at risk. Consider also how properties should be split and attempt to equalize properties in one or more entities earmarked to a specific child or family in advance.

In addition to shielding other assets from liabilities associated with the property, holding real property in an entity provides families with additional planning options for gifting interests to children, often at a discount to fair market value, and often in a non-voting capacity. The LLC or LLLP can be structured so that parents can give away economic rights to the property but meanwhile maintaining management control over use and sale of the property.

Because the IRS generally allows taxpayers to discount non-controlling interests in privately held entities holding real property or privately held businesses, families can leverage the amount of gift meanwhile using less of their overall estate tax exemption. Small gifts can be made annually utilizing the annual gift tax exemption (currently $19,000 per person, $38,000 per couple). Larger gifts require filing a gift tax return and should be supported by a third-party appraisal of the property. The same discounting technique is not allowed for LLCs or LLLPs that hold liquid family assets such as publicly traded stocks or cash.

Particularly in the case of a second home or ranch, LLCs and LLLPs can be structured in a way to plan for multi-generational ownership and use. The organizational agreements can address important items such as management rights and usage rules, as well as restrictions on transfers outside of the family (such as to a child’s spouse) during life and at death. An operating agreement can provide heirs with the option to buy each other or spouse’s interests under a pre-determined formula and paid in installments. An operating agreement can also compensate a child who acts as manager overseeing the properties. These issues get more complicated the longer a property is held as ownership gets disbursed over multiple generations.

Other considerations: Transferring property to an LLC or LLLP can trigger transfer taxes, particularly in the case of vacation homes, so it is important to check the local regulations. Transferring property subject to a mortgage to an LLC or LLLP may also trigger due on sale provisions.
Placing real property in an LLC or LLLP may also be advised if you own property outside of Colorado to avoid the costs of onerous probate procedures or to maintain the privacy of the underlying owners.
While owning property in an entity is a good idea for investment property, ranches or second homes, be careful placing a primary residence in an LLC or LLLP. Ownership of personal residences in an entity with multiple owners could prevent the individual owners from utilizing the $250,000 per person exclusion from capital gains on the sale of a primary residence. There may be options for utilizing ownership in one or more single member LLCs which are disregarded for tax purposes.

Strategies for Successive Marriages and Blended Families

For tax planning for a personal residence in a successive marriage, a blended family must balance providing for the new spouse or partner while preserving assets for children from previous relationships. The best strategy depends on your family dynamics, financial situation and ultimate goals. Trusts are often the best tool for managing these competing interests by minimizing estate, gift and capital gains taxes and preventing future legal disputes among family members.

A QTIP trust is an effective tool for blended families because it lets you provide for your surviving spouse or partner a place to live while securing a future inheritance for your children.

How it works: Focusing on real estate still, you place the home in an irrevocable trust, naming your spouse as the lifetime beneficiary and your children as the final beneficiaries. The surviving spouse or partner receives the income from the trust but cannot sell or transfer the property. When the surviving spouse or partner dies, the home goes to your children as designated in the trust.
It is important that the surviving spouse or partner be left with adequate liquid assets to maintain the home and pay insurance and taxes.
Once the surviving spouse or partner passes away, the home is often sold by the trustee and the proceeds split among some or all the children.

Plan Ahead – Liquidity for Upkeep, Taxes and Insurance

Especially in families where heirs have differing financial means and objectives, an inherited property can become a financial burden and cause friction among siblings. To address this, the property could be owned in a trust or entity which is endowed by a life insurance policy or liquid assets sufficient to cover ongoing maintenance, insurance and taxes. However, should the funds run out the trust or operating agreement should require heirs make future contributions to maintain the property as a condition to continued use and a mechanism for forcing ultimate sale should the heirs no longer be able or want to cover the ongoing cost to keep the property.

Conclusion

While real estate can be a powerful tool for generating and preserving generational wealth, it also presents unique planning challenges. Unlike stocks or cash, real estate is relatively illiquid, requires upkeep, and can be difficult to divide equitably among multiple heirs. Families that engage in advanced planning may minimize future family disagreements, ease the transfer process and reduce overall taxes.

Please reach out to your attorneys at Hackstaff Snow Atkinson & Griess, LLC to discuss how best to protect, manage and pass on your family legacy real estate.