Opportunities for deferring capital gains and lowering estate and
gift taxes By Reed W. Easton There have been a number of recent developments affecting the tax aspects
of investing in commercial real estate. Under IRC section 1031, investors can swap property for substantially
similar property without capital gains. The use of partnerships such as
UPREITs is one vehicle that is gaining in popularity. Some of the areas
that have been addressed in recent court cases in connection with such
swaps include-- * netting of newly acquired liabilities against old liabilities for
purposes of determining money given or received. * the time period in which the swap must be completed. * identification of replacement property. * receipt of money or other property. * what is property held for sale. Other cases dealing with discounts for minority interests and lack of
marketability lead to various gift and estate planning strategies. Among
these are the use of family limited partnerships, grantor retained annuity
trusts (GRATS), and self canceling installment notes (SCINs).
Opportunities for deferring capital gains and lowering estate and gift taxes
By Reed W. Easton
There have been a number of recent developments affecting the tax aspects of investing in commercial real estate.
Under IRC section 1031, investors can swap property for substantially similar property without capital gains. The use of partnerships such as UPREITs is one vehicle that is gaining in popularity. Some of the areas that have been addressed in recent court cases in connection with such swaps include--
* netting of newly acquired liabilities against old liabilities for purposes of determining money given or received.
* the time period in which the swap must be completed.
* identification of replacement property.
* receipt of money or other property.
* what is property held for sale.
Other cases dealing with discounts for minority interests and lack of marketability lead to various gift and estate planning strategies. Among these are the use of family limited partnerships, grantor retained annuity trusts (GRATS), and self canceling installment notes (SCINs).
Historically, commercial real estate has been a good hedge against unforeseen inflation bursts similar to that experienced in the late 1970s. Some of the well known risks of investing in commercial real estate involve fluctuations in real estate values, potential difficulties of reselling property for its appraised value, changes in occupancy rates and operating expenses, unforeseen repairs and renovations, and the possibility of environmental problems and liability.
In the 1980s institutional investors, such as pension funds, insurance companies, and savings and loan associations began to invest heavily in real estate. The tax laws prompted private individuals searching for paper losses to also invest in real estate. These investments drove up prices and encouraged widespread overbuilding. When the tax benefits were repealed in 1986, prices dropped and many lost money. In addition, an economic recession in the 1980s occurred, precipitating a dramatically reduced demand for all new space. The resulting oversupply has remained a problem for almost a decade. However, in the opinion of some analysts, the excess is being absorbed and certain markets are beginning construction again. Investments in commercial real estate, including industrial facilities, suburban office buildings, neighborhood shopping centers, and multifamily residential projects have not correlated very closely with stock market movements, making them a good diversification tool. A well-diversified portfolio of commercial real estate, selectively purchased and prudently managed, has the potential to provide long-term capital appreciation as well as a consistent stream of income.
No one can accurately predict whether the second half of the 1990s will experience a rise in commercial real estate values, but many real estate owners and developers have decided there are good arguments for investing in commercial real estate. Corporations have been increasingly attracted to real estate as an investment offering both potential appreciation and tax shelter. Corporations have a significant advantage over individuals because corporations are exempt from the passive loss rules.
Like Kind Exchanges
A significant tax break is found in IRC section 1031. It allows taxpayers to swap one property for substantially similar property without capital gains tax. The transactions are referred to as 1031 swaps or like kind exchanges. By exchanging one property for another of at least equal value, owners and developers can defer capital gains taxes that otherwise would have been due if they had sold the first property and bought the second. The main condition is that the exchange property must be "property held for investment or used in the course of a trade or business," not personal property or a family residence. Properties not covered include stock in a trade or business or other property held primarily for sale.
Any kind of commercial real estate can be swapped for any other kind, e.g., a Manhattan apartment building for a Florida store or a West Virginia coal mine for a pier in Atlantic City. In May 1991, the IRS issued regulations that cleared the way for more elaborate real estate swaps involving middlemen referred to as third-party exchanges. Today, real estate divisions of certain brokerage firms specialize in matching property swappers around the country.
Use of Partnerships. A new device has begun to combine this significant tax break with another significant tax break. IRC section 721 allows partners to contribute property to their own partnerships without a capital gains tax. For example, a real estate investment trust ("REIT") forms a joint venture partnership with an operating partnership. A developer can exchange his or her property with the joint venture partnership, and the REIT can contribute cash it has raised in a public offering. The new joint venture partnership can use the cash to renovate buildings or build new buildings. The result is that developers diversify their portfolios, and the additional rental income can be used to make partnership cash distributions. The joint venture partnership is termed an "UPREIT." This arrangement allows developers to acquire new properties more easily, as the UPREIT can exchange its partnership shares without tax for commercial property held by other developers who themselves want to avoid the taxes otherwise due if they sold for cash. The developer partners can borrow against their partnership shares for other ventures, and, as long as they do not convert their shares into the publicly traded shares of the REIT during their lifetime, there will be no capital gains taxes due on the real property originally contributed to the UPREIT.
Transfers Involving Liabilities. These developments justify a review of the requirements of IRC section 1031. If a property transferred involves liabilities, as most do, a recent case is of national importance to the real estate community. If a liability is assumed or the property is taken subject to a liability, the amount of the liability is considered money received by the taxpayer on the exchange. If each party assumes a liability of the other, only the net liability given or received is deemed money given or received. A question arises--if an existing mortgage is not assumable, can a taxpayer net liabilities in a situation where the taxpayer places a new mortgage on the replacement property?
Pre-1991 proposed regulations took the position that a taxpayer could not net liabilities to the extent any liabilities were incurred by the taxpayer "in anticipation" of an IRC section 1031 exchange. However, this rule was not included in the final regulations, which were silent on this issue.
Most tax practitioners therefore assumed netting of liabilities would be allowed. In 1995, the Tax Court shocked the real estate community by not allowing netting of old liabilities against new liabilities.
In Louis G. Wittig the taxpayer was in the business of purchasing, renovating, and managing apartment buildings in Albany, NY. The taxpayer became concerned that real estate in Albany had stopped appreciating in value. He entered into a nonsimultaneous third-party exchange agreement to transfer title to two apartment buildings in Albany (the "Albany Property") to a third-party buyer with the agreement the third-party buyer would transfer $405,000 to a named trustee. The trustee was to use the net funds to acquire an apartment building in Nassau County, NY (the "Nassau Property"). The Nassau Property was purchased for $850,000. The trustee transferred $188,225 as part payment of the $850,000 purchase price, and the taxpayer obtained two new mortgages totaling $687,500 to satisfy the balance of the purchase price plus certain closing costs. The trustee used the balance held in trust to pay off a mortgage balance of $124,042 on the Albany Property, pay closing costs of $3,509, and distribute $89,224 to the taxpayer. The taxpayer did not report the $120,103 in capital gain he realized from the sale of the Albany Property, claiming the transaction met the requirements of IRC section 1031. The taxpayer argued that the two new mortgages for which he became liable on the Nassau Property in the total amount of $687,500 should be taken into account and should offset the boot received (namely, the $89,224 in cash and the $124,042 mortgage liability that was paid off). The Tax Court held that a taxpayer cannot net liabilities where the taxpayer incurs new liabilities on the replacement property instead of assuming an existing mortgage or taking the replacement property subject to an existing mortgage obligation. The result was "taxable boot." The Tax Court interpreted the regulations to say that only liabilities assumed in an exchange could be netted against the liabilities from which the taxpayer was relieved. The failure of the court to permit the taxpayer to net liabilities led to the filing of a motion for reconsideration.
An amicus curiae brief was filed in support of the motion for reconsideration by the Federation of Exchange Accommodators. The brief noted that most banks do not allow mortgages to be assumed, or taken subject to, in a real estate transfer and that acquisitions are primarily financed with purchase money debt. If a like kind exchange were to be completed under the reasoning of the court, lenders would have to lend money to the seller of the replacement property, the intermediary, or the taxpayer, on an unsecured basis prior to the exchange. These types of loans would certainly increase the cost and complexity of utilizing IRC section 1031, and most lenders would not be willing or able to make such loans. Further, the issue was of national importance because many real estate exchanges have been structured in a similar manner, and the reasoning of the court would convert what were thought to be tax-free real estate transactions into taxable transactions.
Judge Steven J. Swift of the Tax Court withdrew his memorandum opinion after considering the motion. In withdrawing its opinion, the Tax Court relied on a number of prior cases and an IRS letter ruling for the proposition that netting old liabilities against new liabilities is allowable. In one case, the assumed debt was allowed although it was obtained by the other party at the request of the taxpayer. In another case, the Tax Court stated the regulations refer only to assuming a liability, not assuming a preexisting liability. In that case, a taxpayer conveyed property subject to a liability and received cash equal to his net investment. A portion of the cash was used as a down payment on new property, and the balance was financed by the seller. The court held that since the parties had intended the transaction to qualify as a like kind exchange, gain had to be recognized only to the extent of the cash retained by the taxpayer.
After withdrawal of the opinion, the IRS and the taxpayer resolved the case as recommended in the motion. The taxpayer was allowed to offset the boot arising from the relief of liabilities on the relinquished property with the new mortgage incurred on the replacement property.
In light of the concern expressed by the real estate community and since the withdrawn case has no value as precedent, the IRS should provide guidance on the issue of netting liabilities for taxpayers to have a sense of certainty as to the outcome. Until such time, taxpayers should continue the practice of netting newly acquired liabilities against assumed liabilities on the basis of the judicial authority and letter ruling discussed in the withdrawal of the memorandum opinion.
Time Period. As indicated above, a nonsimultaneous exchange or "deferred exchange" can qualify for IRC section 1031 treatment, if the exchange is completed within a specified time period. The property to be received in the exchange must be identified within 45 days after the date of the transfer of the property relinquished in the exchange. The replacement property must be received within the earlier of 180 days after the date the taxpayer transfers the property relinquished in the exchange and the due date for filing a return (including extensions) for the year in which the transfer of the relinquished property occurs. During the 45-day identification period, the taxpayer may identify a total of three properties, or an undetermined amount of properties, provided such properties do not exceed 200% of the fair market value of the property transferred (determined without regard to liabilities).
In Orville E. Christensen the taxpayer transferred property on December 22, 1988, to an intermediary who, in turn, transferred the property to the buyers. On February 3, 1989, the taxpayer notified the intermediary of nineteen properties that taxpayer desired to acquire as part of a projected IRC section 1031 exchange. The replacement properties were acquired between April 25, 1989, and June 20, 1989. The 1988 return for the taxpayer was filed on April 17, 1989, since April 15 fell on a Saturday. The 180th day was June 20, 1989; however, since the taxpayer filed his 1988 return by the normal due date, the replacement property had to have been received no later than April 17, 1989. Accordingly the Tax Court held that since the due date of the return was earlier than the June 20th date, the transaction failed to qualify as a like kind exchange. As a planning consideration, the accountant for the taxpayer could have sought an automatic four-month extension, and the full 180 days to receive the replacement property would have been available. The taxpayer also could have considered changing the closing date to January 1, 1989.
Similarly, in Raymond St. Laurent, taxpayer sold an apartment complex in Auburn, Maine on November 4, 1988. The purchase price was paid by the buyer to an escrow agent. On December 16, 1988, the taxpayer identified twenty properties. One of these properties was a 40-unit trailer park in Turner, Maine and another was a vacant lot in Lewiston, Maine. Taxpayer closed on the trailer park on March 22, 1989, and the vacant lot on May 17, 1989. Taxpayer timely filed a Federal income tax return on April 15, 1989. He did not request an extension of time to file such a return. The exchange of the apartment complex for the trailer park was held to qualify as a like kind exchange. The exchange of the apartment complex for the vacant lot was not held to be a like kind exchange because the vacant lot was transferred after the due date of the tax return and 194 days after the taxpayer had transferred the apartment complex.
Identification of Replacement Property. In St. Laurent, the IRS also argued that the identification of the replacement properties did not satisfy the requirements of IRC section 1031(a)(3)(A) because the taxpayer had identified twenty properties as replacement properties and the particular replacement properties to be received were not to be determined by contingencies beyond the control of the parties to the exchange. The Tax Court found no such limitations and held taxpayer had complied with the literal language of IRC section 1031(a)(3). The identification of too many properties may take the taxpayer out of IRC section 1031 treatment (i.e., taxpayer is treated as if no replacement property has been identified). However, St. Laurent, supra, makes it clear there is no magic number of properties that can be identified or any requirement that the particular replacement properties to be received be determined by contingencies beyond the control of the parties to the exchange.
Receipt of Money or Other Property. The IRS and courts have held a deferred like kind exchange qualifies a taxpayer for nonrecognition even though the taxpayer receives title to the replacement property directly from a person not a party to the exchange. The buyer has not been required to ever possess title to the replacement property, with the result the additional state transfer taxes such a conveyance to the buyer would entail can be avoided. However, the regulations provide that the party transferring the relinquished property in a deferred exchange not receive money or other property, and control of the taxpayer over the escrow account be expressly limited.
In Michael Hillyer, shareholders of an S corporation were denied like kind exchange treatment. The S corporation sold the real estate for cash and then deposited the cash proceeds with the bank escrow agent pending designation of like kind property to be acquired. The only requirement was that the S corporation indicate the desired replacement properties in 45 days. No affirmative acts were required of the buyer except to cooperate prior to settlement of the original property in the acquisition of desired replacement properties. None were asked and none were performed. Within 45 days of the deposit, the S corporation designated three properties, and within 180 days after the sale, two properties were acquired. The Tax Court held that since the S corporation actually received the sales proceeds and thereafter transferred them to the bank, the escrow agreement was a "facade" insufficient to provide for like kind exchange treatment.
Thus, although the taxpayer may receive title to replacement property directly from other than the buyer, the taxpayer may not receive money or other property directly from the buyer if a deferred like kind exchange is to qualify for nonrecognition.
Property Held for Sale. In Loren F. Paullus the issue was whether a country club was a real estate developer. The Tax Court held the country club might exclude the gain it realized on a real property exchange, finding for the country club that the property exchanged had been primarily held for investment, not in the ordinary course of a trade or business. The country club, as well as other real estate, was contributed to a corporation that acquired, developed, and sold hundreds of real estate lots over a 17-year period. The corporation ultimately decided to remove itself from the real estate business to focus on the country club. The corporation thereupon exchanged its remaining residential lots for property it intended to develop into a golf course and resort facility. The corporation had held the residential lots for four years and had engaged in relatively few purchases and sales. However, the corporation maintained a sales office and a list of 97 individuals interested in buying lots. The Tax Court noted the golf operating revenue was approximately twice the revenue from the real estate transactions and zoning the property as residential was necessary to maximize possible loans from third parties. The fact the corporation in the course of negotiations had offered to subdivide the property was not held to be significant.
This decision can be seen as opening up to more taxpayers the benefits of nonrecognition treatment. Proper planning including properly documented minutes of board of directors meetings can change the characterization of the property to be exchanged. The consistent reporting of the business activity as other than real estate development was found to be probative evidence of primary involvement in other than the development of residential lots, even though there were active sales for more than 17 years. Can there be a better case of form over substance?
Discounts. Once an individual, owner, or developer has accumulated real estate, the next step is to preserve it for his or her family. A discount for minority interest and lack of marketability are usually available in connection with the transfer of a noncontrolling interest in a closely-held business, a general or limited partnership, and a limited liability company ("LLC"). The IRS has abandoned its attempt to aggregate among family members. A minority discount is available when family members together own a controlling interest in a business.
A number of cases have come down recently dealing with discounts for minority interest and lack of marketability leading to various gift and estate planning strategies.
In Estate of James Barudin, a general partnership interest in a partnership in the business of leasing commercial real estate in New York City was allowed a 19% minority interest discount and a 26% lack of marketability discount.
In Bernard Mandelbaum, three brothers owned a privately held, family-owned corporation operating numerous women's apparel retail stores. The corporation had two retail divisions: Mandee Shops and Annie Sez with headquarters in Totowa, NJ. Beginning in 1976, the three brothers made annual gifts of their stock to their children and for gift tax purposes claimed a 50% combined minority and marketability discount. The Tax Court concluded a 30% discount for lack of marketability should be allowed. The Third Circuit Court of Appeals affirmed the decision without opinion.
In Estate of McCormick, a decedent owned general partnership interests in two general partnerships. The first was formed to own real property and engage in the contracting business involving the building of roads, public utilities, and other structures. The second was formed for the purposes of purchasing, owning, developing, and selling real estate. The Tax Court was asked to decide the value of the percentage interests for estate and gift tax purposes; the decedent having made certain gifts prior to death. The Tax Court determined minority interest discounts ranging from 24% to 34% and marketability discounts ranging from 20% to 22% in valuing the minority general partnership interests.
Life Expectancy. Final regulations were issued under IRC section 7520 on December 12, 1995. The regulations determine when the fair market value of an interest in property is to be valued using IRC section 7520 actuarial factors. The regulations provide for exceptions to the standard valuation tables used for valuing annuities, interest for life or a term of years, and remainder or reversionary interests. One test addresses the mortality component of the transferred interest. If an individual is terminally ill, the normal actuarial life expectancy may not be used. "Terminal illness" is defined as an incurable illness or other deteriorating physical condition that would substantially reduce a person's life expectancy to the extent there is at least a 50% probability the individual will not survive for more than one year from the valuation date. However, if the individual survives for 18 months or longer after the valuation date, he or she will be presumed to have not been terminally ill, unless the contrary is established by clear and convincing evidence.
In Estate of Gordon M. McLendon, a decedent transferred his general partnership interests in two partnerships to family members in exchange for a private annuity approximately six months prior to his death. Decedent was 65 years old when the private annuity agreement was executed, giving him an actuarial life expectancy of 15 years. The courts ultimately decided the actuarial tables could not be used in valuing the private annuity.
Assignee Interests. After the decedent was diagnosed but before the exchange, the decedent amended the two partnership agreements. The amendments provided in pertinent part that no partner could, except with the consent of the other partners, assign, mortgage, grant a security interest in, or sell his share of the partnerships. Upon death of a partner, the remaining partners might either purchase a proportionate share of the deceased partner's interest for an amount equal to his capital account, terminate and liquidate the partnerships, or continue the partnerships with the successor in interest of a deceased partner. The Court of Appeals, reversing the Tax Court, held that as the partnership interests were transferred without the consent of the other partners, the interests so transferred were "assignee" interests, not actual partnership interests, and were entitled to a valuation discount.
While McLendon, supra, predates IRC sections 2703 and 2704(b) dealing with disregarding restrictions on liquidation for estate and gift tax valuation purposes, most commentators believe that even if the restrictions in a partnership agreement are ignored, a discount for an assignee interest should be sustained, which therefore justifies a lack of marketability discount. A buyer will pay less if his rights are limited to an assignee.
Family Limited Partnerships ("FLPS") have recently become a popular estate planning technique. Although the FLP is not a new concept, current cases have provided a new level of comfort. Further, when combined with other estate planning strategies such as a grantor retained annuity trust ("GRAT") or a self-canceling installment note ("SCIN"), FLPS improve a client's ability to retain control and cash flow from family-held real estate while effectively transferring the value of that real estate to the next generation at little or no transfer tax cost. An illustration will help with an understanding of the potential benefits.
Assume an unmarried taxpayer, age 91, owns individually $1,000,000 worth of unencumbered real property. He has two children, five grandchildren and three great-grandchildren. Assume further that the Federal estate tax applicable to the estate of the taxpayer is a flat 55% and the unified credit and annual exclusions were otherwise used and thus not available here.
Scenario One: If a taxpayer retains the real property in his individual name, rather than transferring such real property into a FLP, $1,000,000 in value will be included in his estate. After paying Federal estate taxes, only $450,000 will actually pass to his heirs.
Scenario Two: If the taxpayer transferred the real property to a FLP and received in return a one percent general partner interest and a 99% limited partner interest, if nothing else were done, the value of the limited partner interest would on death, for estate tax purposes, be discounted for lack of marketability. As seen from the foregoing case law, the discount for lack of marketability can range up to 30%. Further, the 99% limited partner interest might be gifted any time to relatives using the unified credit plus the annual gift tax exclusion (i.e., $10,000 per donee per year times 10 donees). If he transferred only 75 percent of the limited partner interest during his lifetime, the savings would still be substantial. For gift tax and subsequent estate tax purposes, both a discount for lack of marketability and a minority interest discount would be available. These discounts combined may equal 45% based on the foregoing case law. Based on a gift of only 75%, the value of the real property net of estate and gift taxes that would pass to the children, grandchildren, and great-grandchildren would be $697,500. The 75% percent limited partner interest would be valued at $412,500 (55% of $750,000) for tax purposes. If subject to a transfer tax of 55%, or $226,875, the net value to the children, grandchildren, and great-grandchildren would be $523,125 ($750,000 less $226,875). The 25% limited partner interest that passes to the children, grandchildren, and great-grandchildren at death would be valued at $137,500 (55% of $250,000) for tax purposes subject to an estate tax of 55% or $75,625. The net value to the children, grandchildren, and great-grandchildren would be $174,375 ($250,000 less $75,625).
As a direct result of the foregoing, the designated beneficiaries would get $247,500 more of the value net of taxes (i.e., $697,500 less $450,000). Further, the taxpayer might retain control and cash flow for any specified period, yet the eventual transfer to his relatives would have reduced transfer tax consequences.
This scenario only works if a minority interest is gifted during the person's life and a minority interest is left at death. If nothing were given away, the estate would receive a majority interest and the minority interest discount would be lost.
Using a GRAT or SCIN. As indicated above, the use of minority interest discount and the discount for lack of marketability might be combined with the benefits of a GRAT or SCIN. Another illustration may help.
Assume the same facts as above unless otherwise indicated.
Scenario Three: Taxpayer is age 65 and healthy. As in scenario two, he contributes the real property to a FLP. However, instead of gifting the limited partner interest to the children, grandchildren, and great-grandchildren, the 99% limited partner interest is transferred to a GRAT with a term of 15 years. Under the terms of the GRAT, the taxpayer is paid $80,000 per year, the net cash flow from the real property. At the end of the term, assuming the taxpayer survives, the limited partner interest goes to the children, grandchildren, and great-grandchildren. If we assume the gift to the GRAT is valued at $300,000, less a discount as it is in a limited partnership, and if we further assume a 30% discount for lack of marketability, there is a zero amount of current gift. The $700,000 value going in to the GRAT after discount for lack of marketability is reduced by $700,000, the value of the retained interest of taxpayer upon the transfer to the GRAT. Assuming the taxpayer survives 15 years and is willing at age 80 to lose the cash flow from the property, the eventual transfer to the relatives can have no gift and little, if any, estate tax consequences. The designated beneficiaries get $302,500 more ($1,000,000 less $697,500) or the complete value of the real property, free of taxes.
Scenario Four: The taxpayer is 65 years old, has a fatal ailment, and is not going to live to his actuarial life expectancy. However, there is at least a 50% probability he will survive for more than one year and, in fact, survives for more than 18 months. Rather than use a GRAT, the taxpayer might sell the 99% limited partner interest for $700,000 to the children using a SCIN. The taxpayer retains a one percent general partner interest, and the adult children buy the 99% limited partner interest with a note payable over 15 years, the actuarial life expectancy of the taxpayer. Pursuant to the note, if the taxpayer dies, the unpaid balance is canceled. There is no estate inclusion since the taxpayer has no interest in the note after his death. There are income tax consequences either on the initial fiduciary income tax return or the final income tax return of the taxpayer, depending upon conflicting authority. At worst, taxpayer benefits by 15% (i.e., 55% estate tax exclusion over 40% income tax inclusion) after a 30% discount. *
Reed W. Easton, JD, LLM, CPA, is an associate professor in the department of accounting and taxation at Seton Hall University.
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