Estate planning with real estate: Planning opportunities existing under current federal laws

The current federal transfer tax system is designed to impose a transfer tax on wealth transfers both during life and on death. In addition, a special tax is levied on transfers that "skip" a generation (i.e., a transfer to a grandchild). Gift taxes are imposed on transfers during a person's life, estate taxes are imposed on transfers taking effect at death and the generation skipping transfer tax (GSTT) is imposed on transfers made at any time to "skip persons" (i.e., generally, a person more than one generation below the transferor). Each tax has its own rate structure and each permits certain deductions, exclusions and credits that are not uniform across each tax system. The current federal transfer tax law is set to "expire" in 2010 for one year. In 2011, the federal transfer tax laws will be reinstated as they existed in 1997 (generally resulting in greater amounts of tax). Given the expectation that a substantial portion of the nation's wealth will be transferred in the next decade, there is considerable interest in revising the transfer tax laws both now and in the future. Planning for the eventual change in the law is a topic for a separate discussion. This article focuses on planning opportunities that exist under the current federal law with the assumption that these opportunities will continue to exist in the future. The objectives and strategies discussed are applicable to annual gift programs as well as to transfers intended to take effect at a later date. In general, the objectives of transfer tax planning include: * Effecting transfers in a tax efficient manner; * Retaining control of assets during the transferor's life; * Providing protection from creditors; and * Providing liquidity to pay tax. The basic strategies for achieving these objectives include, but are certainly not limited to: * Fully utilizing exemptions and credits; * Transferring assets with appreciation potential; * Utilizing valuation discounts whenever possible, and * Accumulating assets in trusts that are exempt from the GSTT. Real estate assets present a number of planning opportunities that can be utilized to achieve the objectives outlined above. The planning opportunities exist because real estate assets generally: * Generate cash flow in the form of rental income; * Appreciate over time; * Are valued subjectively due to the lack of a defined public market, and * Are owned by closely held entities. Beyond the basic strategies, real estate assets are also well suited for more sophisticated transfer techniques that leverage the unique aspects of a real estate investment mentioned above. An excellent example of one such technique is the transfer of real estate to a grantor retained annuity trust (GRAT). The goal when planning with a GRAT is to transfer appreciating income-producing property to the GRAT with little or no value attached to the gift for gift tax purposes, thus removing the appreciation and, possibly, some amount of accumulated income from the grantor's estate with little or no current tax cost. Simply stated, a GRAT is an irrevocable trust that is established for a fixed term in which the grantor retains an income right. At the end of the trust term, any property remaining in the trust is either paid to the remainderman or is retained in the trust for his/her benefit. During the trust term, the grantor pays taxes on the trust's income and capital gains (the grantor is treated as the owner of the trust assets for income tax purposes). Payment of the tax on the trust income is not considered an additional gift, thus further reducing the value of the grantor's estate without additional transfer tax cost. For gift tax purposes, the value of the grantor's gift to the trust is equal to the value of the property contributed less the present value of the annuity to be paid to the grantor. It is possible to transfer property to a GRAT that results in a current gift of little or no value. Utilizing available valuation discounts reduces the value of the taxable gift, if any, and reduces the amount of the annuity that must be paid to the grantor which in turn decreases the rate of return on the underlying assets that is necessary to pay the annuity from current cash flow. Similar savings can be achieved with other planning techniques utilizing real estate. Qualified personal residence trusts and intentionally defective grantor trusts are some of the planning vehicles that are well suited for real estate assets. Sandy Klein is a partner at Shanholt, Glassman, Klein, Kramer & Co., New York, N.Y.