For estate planners who practice in Maine, dealing with the family real estate often means passing on valuable shorefront property to the next generation at the least possible estate and gift tax cost. Such properties represent the living family scrapbook of births, growth, poison ivy, midnight swims, weddings, vacations, learning to fish or sail, both meaningful and mundane events. At Weiss DeRice PA, we assist clients in preserving their family's special places in ways that protect them from creditors, descendants' spouses, and taxes, while creating a sustainable framework for families to manage, use, maintain, and enjoy family real estate.
To begin, giving property to children as simple co-owners, without some sort of structure, often does no one any favors. In addition, steps may be taken to permanently reduce the value of the property. (Before considering this issue, the client should read our memorandum on the federal estate and gift tax, or otherwise be familiar with the estate and gift tax, the federal estate tax exemption, and the annual exclusion from gift tax.)
Areas of Concern
No matter how you choose to hold your family real estate, eventually you or your family will need to confront some universal questions:
- Management- who manages the property, who makes day-to-day decisions, how are decisions made?
- Usage- who gets to use the property, how often, and on what terms?
- Assessment- who pays for the property's taxes, insurance, maintenance, and agreed upon capital improvements, and what happens if someone does not contribute?
- Ownership Transfers- who will own the property in the future and how can you attempt to keep the property in the family?
Giving the Property Away During Life
Many families choose to give their real estate or interests in their real estate to the next generation during their lives. There are many ways to accomplish gifts of family real estate, including one-time gifts, annual exclusion gifts, creating Grantor Retained Interest Trusts, and creating an entity to hold the real estate (entitization) followed by gifting of ownership interests in the new entity, (a family LLC, for example). Giving real estate to the next generation for the lowest unified federal estate tax cost requires the analysis of (1) the federal estate tax exemption (which currently shelters $5,490,000 worth of property from estate tax and gift tax); (2) the annual exclusion from the federal gift tax (currently $14,000 per person, per donee, per year); and (3) the Maine estate tax exemption (also presently at $5,490,000). In some cases, families can avoid gift tax and estate taxes by gifting real estate to children immediately. In other cases, families can use gifting to minimize tax consequences and shelter the property's appreciation. At Weiss DeRice PA, we can help you determine which method of gifting family real estate is most beneficial to you and your family.
Maine's Limited Liability Company Act and Limited Partnership Act provide attractive forms of entity to use for gifting and holding family real estste. Property can be distributed to members/partners free of income taxes (in most cases) from both a limited liability company (LLC) or a limited partnership (LP) and a general partnership. With both the LP and LLC, one or more general partners or LLC managers can control the use of the property and the distribution of profits to limited partners or members. The agreement can be drafted to protect the partnership or LLC property against seizure by creditors or divorcing spouses. None of these advantages is available in the general partnership.
Like the corporation, the entire interest in partnership, limited partnership, LLC or trust can be carved up into "shares" or "units." The number of units given each year can be calculated to stay within the $14,000 per person annual gift tax exclusion, or to use up a specified portion of your $5,459,000 lifetime gift tax exemption.
Transfering the ownership of family real estate to an entity can have the desired effect of lowering the property's appraised value. Although the IRS may still contest the issue, the Tax Court has consistently held that it is appropriate to apply a "minority discount" and often also a "lack of marketability discount" to minority interests in a family entity that holds real estate. These combined discounts commonly reduce appraised values by 25 to 33%.
Your family real estate trust, LLC, or LP can be as simple or as complicated as you want to make it. We have developed model Family Real Estate Trusts, LLC Operating Agreements, and Limited Partnership Agreements which provide for a highly structured organization that can manage your property through several generations in the future, and restrict transfer (but not prevent it altogether) outside the family tree, yet allow your descendants to adapt to the changing times in which they live. These probably represent the most complicated trust, LLC, or partnership governing structure that most clients would tolerate. On the other hand, a trust, LLC, or Family LP can be fairly simple. Which form yours takes depends entirely upon the particular nature of your estate plan, your management goals for the property, how many family "partners" are likely to be involved, and over what period of time.
If you choose entitization, you can expect to follow these steps:
- decide upon the features of your family real estate trust, LLC or partnership;
- create the family trust, LLC or partnership (usually between husband and wife as co-owners, or other family members as co-owners) -- the entity should also obtain a tax I.D. number and file an annual return with the IRS;*
- obtain a real estate appraisal;
- deed your real estate into the trust, LLC, or partnership;
- make your initial gifts of trust, LLC, or partnership interests (and file any necessary Gift Tax Return when filing your Federal Income Tax Return); and
- continue your gift-giving program each year (filing any necessary Tax Returns).
*A trust may be an income tax paying entity, while an LLC and partnership will not. An LLC or partnership's income is said to "flow through" to its members or partners and is reportable by the owners individually each year. If your entity holds only real estate, however, it is unlikely to produce income in any event.
If You Continue to Use the Real Estate -- Tax Consequences
Section 2036(A) of the Internal Revenue Code provides that property given away during your lifetime is taxed in your estate, at its value at the time of your death, if you retain the right to income from or enjoyment of the property, even though you no longer own it. This means, quite literally, if you give away your home/second home, and continue to reside in it/use it as your second home, its entire value on the date of your death may nevertheless be included in your taxable estate. Therefore, we suggest leasingthe property back from the new owners (your children, LLC, trust, or partnership) at fair market value, with a written lease. Payment should flow through a checking account to document the fact that the lease is not mere fiction. Very often this fits into a family's plans because you, and not the children, plan to continue paying the taxes, insurance, and maintenance on the property, even after title passes. We suggest paying these expenses with the rental payments, rather than paying specific items as they come due. The fair market rental value should be established by an appraiser, realtor, or leasing agent.
The Grantor Retained Interest Trust (The GRIT)
A personal residence (home or second residence) can also be given away to a Grantor Retained Interest Trust. Here, the Grantor retains the right to use and occupy the residence for a term of years, during which all taxes, insurance and upkeep are paid by the Grantor. At the end of the term, the residence belongs to the "remainder beneficiaries." (The Grantor may rent it back at fair market value.) The IRS will treat this as a gift of the actuarial value of the remainder interest to the remainder beneficiaries in the year the property is conveyed to the trust. That value depends on the term (length) of the trust. The longer the term, the lower the remainder value. Under current regulations, the remainder interest will be worth less than 50% of today's fair market value if the term is longer than 6 years. Here are two drawbacks: (1) The gift tax annual exclusion doesn't apply (you have to use up unified credit to pay gift tax), and (2) If the Grantor dies before the term is over, the entire value on the date of Grantor's death is included in the estate, as if the Grantor had done nothing at all.
Reducing the Value: Conservation Easement
The fair market value of the property can be affected by many factors, including restrictions on its use. If the value of the property is so large that none of the techniques suggested for lifetime giving are likely to be successful, and if there is no reasonable possibility that your family members will need to maximize the economic value of the property for their own needs, a properly drafted conservation easement should be considered. A conservation easement will restrict the future use of the property and, therefore, cause its fair market value to be reduced. This can generate a charitable deduction (because the easement is donated to a qualified conservation organization) for income tax purposes, and also reduce the value of the property for estate and gift tax purposes. However, such easements are permanent, and generate these tax savings because they actualy reduce the value and restrict use and development of the property.
Unless you are considering a conservation easement for ecological, rather than tax purposes, a conservation easement is only a good idea if you and your children have adequate assets. In other words, if under some circumstances you or your children might need to cash in on the value of the real estate, a conservation easement will drastically reduce that value. On the other hand, if a substantial reducation in the economic value of the property is of no concern, a properly drafted conservation easement will make it easier to pass the property to the next generation, reduce your estate taxes if you still own it at death, and generate a substantial income tax deduction while you are alive.
Reducing Municipal Real Property Taxes
The only techniques in Maine that are certain to work at reducing local real property taxes arise from tree growth or open space, or working waterfront special assessments provided by state statutes. If your property meets the requirements of the applicable statute, and your application is properly documented (tree growth, for example, requires a parcel of more than 10 acres and an extensive report by a registered professional forester), your local real estate taxes will be reduced until the use of the property is changed. If the use of the property is never changes, it is possible that these reduced assissments will apply to your property forever. However, none of these special real property assessments generate income tax or significant estate tax savings.
The conservation easement, which can generate both an income tax deduction and a reduction in federal estate tax value, should, theoretically, also permanently reduce the fair market value of the property. Some local assessors need to be convinced of the diminished value, however. The existence of a conservation easement supports "open space" property tax assessment. Obtaining such special assessment status is more certain with a "forever wild" easement than with one which permits limited development.