By creatively combining some tried-and-true planning tools, wealthy real estate owners have more options than they realize to reduce estate and capital gains taxes, according to one planner.
“The interplay of income and estate tax planning is magnified with real estate owners because the basis issues are really prevalent,” said Sharon Klein, managing director of family office services and wealth strategies at Wilmington Trust. “For income tax purposes, they could depreciate the property they own. That saves them income tax, but it also reduces their tax basis for capital gains tax purposes.”
Klein detailed some potential tax-saving strategies at a recent press briefing in New York, using the example of a $10 million commercial property owned by a wealthy couple in the city.
Assuming the building’s tax basis had been depreciated to zero, the couple could expect to be hit with a $10 million capital gains tax on the full value of the building if they were to sell it, Klein said.
If the owner were to die still owning the building, there would be a step up in basis to its date-of-death market value, eliminating any potential capital gains. However, the property would be part of his estate subject to estate taxes. Klein said this apparent catch-22 stems from the theory that “you shouldn’t have to pay both an estate tax and a capital gains tax. You typically pay one or the other.”
Two possible solutions exist, neither satisfactory, she said. The first to die could pass the property on to his or her spouse tax-free. The property would receive a step up in basis, allowing the surviving spouse to depreciate the building all over again. Upon the second spouse’s death, the building would get another step up, and the heirs could sell the property without realizing a capital gain. However, the building would be part of the donor’s estate and be subject to estate tax. Klein calculated that the combined top-bracket federal and New York state tax would be 49.6 percent, or a $4.96 million tax bill. “Not such a great result,” she said.
Alternatively, the owners could get the property out of their estate by transferring the building to their children. But the property would not receive a step up in basis; it would get a carryover basis—the same basis as the donor. In this case, it would be zero. At sale, the children would have to pay a capital gains tax on $10 million because with no basis, the proceeds would all be considered gain. By Klein’s calculation, the capital gains tax would be 37 percent, or $3.7 million. “Also not great,” she said.
A Third Way
Klein’s third alternative points to a way around these onerous choices. “The beauty of my third scenario is that you’re not settling for one or the other. You’re getting both,” she said.
It’s based on the premise that for estate tax purposes, a property encumbered with debt is taxed for the net value of its market value minus the amount of the debt.
In Klein’s example, the building’s owners could take out a $9 million loan on their $10 million property. At the death of the surviving spouse, the building would get a full step up in basis to $10 million, and the heirs would incur no capital gains tax upon sale. The building would be part of the decedent’s estate, but the estate would pay tax on just $1 million: $10 million date-of-death market value minus $9 million debt. At the top-bracket rate of 49.6 percent, the bill from the IRS would come to $496,000 instead of $4.96 million.
The key to this strategy is to get the $9 million out of the estate, Klein said. “Otherwise, you’re back to square one. Although you get a step up in basis, you’re not saving on estate taxes. You’re paying taxes on $1 million net equity in the building and on $9 million in your bank account.”
The final piece of the puzzle is actually a standard estate planning tool: the grantor retained annuity trust (GRAT).
The building owners would put the $9 million in a GRAT, then take back annual payments plus the interest rate in effect during the month the trust was created—in October, when Klein was speaking, it was 2.2 percent. Anything in excess of that 2.2 percent would not be part of the estate because the IRS would look at only the October rate, she said.
“The GRAT is a fantastic technique in a low-interest environment that doesn’t utilize any of your $5.34 million gift tax exclusion because you’re not making a gift,” Klein said. “You’re using the IRS’s assumptions, and taking back everything you contributed. There’s no gift. And if you’ve succeeded in beating the IRS’s interest rate assumptions, you’re getting the excess value out to family members, and it is not coming back into the estate.”
There is, she said, one final fly in the ointment with this strategy: Finding a bank that would lend $9 million on a $10 million property. A bank would more likely lend $5 million or $6 million, she said. And the smaller the loan, the more the estate would have to pay the IRS.
Wilmington Trust and its parent M&T Bank have a potential solution. “What we’re talking about internally is partnering to leverage the amount of the mortgage we would be able to give,” Klein said. If the borrowers, the $10 million building’s owners, were to put the $9 million in cash into a GRAT account opened at Wilmington Trust, M&T Bank would have both a security interest in the account at Wilmington Trust and a security interest in the building itself.
“That’s really double collateral,” she said. “Because we’re under one roof and feeling comfortable with a security interest in an account at Wilmington Trust, we could look at getting comfortable with loaning more than the market standard.”
Of course, M&T would have to be confident it had a security interest in an account that was not just going to disappear, Klein said. And the bank would still have to do an analysis of the building to make sure the property was one it wanted to make a loan on. “Our colleagues have been very receptive to it because of the double collateral,” she said.
Besides increasing the amount of the loan by opening an account at Wilmington Trust, the grantor would be able to use the annuity payments from the GRAT to supplement the repayment obligation to M&T in the event the building itself were not generating enough cash flow to do this. “The GRAT is a fantastic technique in itself,” Klein said, “but when you combine it with this technique, the annuity payment the grantor receives can be used to supplement the repayment obligation associated with the loan.”
