Almost all estate planning clients own real estate in one form or another – a residence, a vacation home, or rental property. Real estate presents unique challenges in estate planning because debt is often associated with the property and because it may be difficult (or not desirable) to sell the property.
The most common property ownership is a client’s residence. A residence is often sold as part of the administration of an estate and the net sale proceeds are then distributed as part of the residue of the estate. The residence, however, may be given to a particular beneficiary, and, if that is the desire the Last Will and Testament should clearly provide for this disposition. If there is a mortgage, the beneficiary’s receipt of the residence can be conditioned on the assumption of the mortgage or the Last Will and Testament can state that the beneficiary must pay off the mortgage.
Clients sometimes will jointly or solely title real estate with a child to “avoid probate.” Although titling the property this way may simplify or avoid an estate settlement, the sale of the property likely will have adverse income tax consequences. Most homeowners take for granted that a primary residence can be sold without the recognition of a capital gain provided the capital gain is less than $250,000 for one resident or $500,000 for joint residents. This exclusion, however, only applies to a property that is a primary residence of the seller for two of the last five years. For example, if a house is purchased for $100,000 and later is sold for $300,000, then the $200,000 capital gain does not result in any capital gains tax. However, if the residence was gifted to a child during the parent’s lifetime, the child will not satisfy this rule if the child’s primary residence is elsewhere. The tax due would be $47,600 (20% for the capital gain and 3.8% for the net investment income tax, if it applies).
Vacation properties present special planning challenges. There is often a desire to keep a vacation property within a family but this may not be practical. Joint ownership among heirs can create a variety of issues. How are the costs of ownership to be divided? What happens if an owner fails to contribute his or her share of the costs? How is the use of the property determined? Should the property be rented to third parties? What happens if an owner wants out of the arrangement? What if an owner goes through a divorce or bankruptcy? It is important that a client have realistic expectations. Although a trust can own a vacation property instead of individual heirs, these issues must still be addressed and ultimately resolved by a trustee.
One advantage of a vacation property is that a property located outside of Pennsylvania generally can avoid a state-level inheritance tax or estate tax upon the death of an owner. Pennsylvania taxes all transfers of property at death (transfers to spouses are taxed at 0% and transfers to children are taxed at 4.5%) with no amount of property transferred being exempt. Pennsylvania’s inheritance tax, however, does not apply to property located in another state. New Jersey does not tax transfers at death to children. Delaware has a tax but provides for an exemption of over $5,000,000. Therefore, ownership of real estate in these jurisdictions is a way to avoid Pennsylvania inheritance tax.
A client with investment properties (whether residential, commercial, or industrial) has a variety of issues to consider in his or her estate plan. These issues generally consist of (1) planning for payment of estate tax and inheritance tax, (2) planning for the transfer of ownership of the investment, and (3) dealing with debt.
As with a family-owned business, real estate presents the problem of being valuable but not liquid. A client with a significant portfolio of investment properties will need to plan carefully to create liquidity in the estate in order to pay the inheritance tax and the estate tax, if applicable. Many clients will address this issue through the ownership of life insurance. Life insurance is not subject to the Pennsylvania inheritance tax and life insurance ownership can be structured so the death benefit is not subject to federal estate tax (generally speaking, the life insurance is owned by an Irrevocable Trust). If there is sufficient equity in the properties, then consideration can be given to borrowing against the equity.
A client will need to give consideration to how a real estate investment will be disposed of at death. There is sometimes a desire to continue ownership for the benefit of a surviving spouse so the surviving spouse can continue to benefit from the cash flow of the investments. If there is bank debt, however, the transfer to a surviving spouse or to a trust for the surviving spouse’s benefit often will require the consent of the lender. If the investment is owned with other investors, then any agreement governing the transfer of ownership (a “buy-sell” agreement) must allow for such a transfer.
Often, the buy-sell agreement requires the sale of the investment in the event of death. Careful attention needs to be given to the terms of a required sale. Is a down-payment required? Is seller-financing required? If there is seller-financing, then is the debt secured or unsecured? How long is the financing term and how frequently will payments be made (monthly, yearly, etc.)? What happens if the other investors cash out of the investment (that is, will the surviving spouse be paid in full if there is such an event)?
Another key consideration with buy-sell agreements or retaining the real estate investment in-kind is the payment of death taxes. Generally speaking, if there is a transfer to a surviving spouse (or in trust for the surviving spouse’s benefit) there is no federal estate tax or Pennsylvania inheritance tax due. If taxable heirs (children) are to receive the real estate investment in-kind or are to receive installment payments under a buy-sell agreement, then your estate’s liquidity must be analyzed to ensure that the death taxes can be paid at that time. For example, if the real estate or buy-sell payments have a $2,000,000 value, this value could trigger $90,000 of inheritance tax and $800,000 of federal estate tax. From the buyer’s perspective, will there be sufficient cash flow to meet the payment obligations? For example, cash flow from a residential development project may be years away or unpredictable.
Real estate is and will continue to be a valuable asset for most clients. Residential real estate, vacation properties, and investment real estate all provide clients with potential for capital appreciation and, in the case of rented vacation properties and investment properties, the potential for income. Clients should give considerable thought to the disposition of these assets in the event of death to make sure that taxes are minimized and the client’s intent is carried out.