Estate Planning Considerations for Real Property Owners - Part 2 - Transition Planning for the Property Rich & Cash Poor

By Kell Rabern - CPA - Hutchinson & Walter

Many real estate investors in the Puget Sound have experienced significant appreciation in their properties. However, rapid appreciation can leave investors property rich and cash poor – creating a dilemma when it comes to estate taxes. With recent increases in real estate values, a plausible hypothetical “Before and After” scenario may look like this:

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While it is true that estate tax exclusions increase annually, the rate of increase rarely keeps up with strong real estate markets. The increases in this year’s exclusion limits compared to real estate values can be seen below:

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Continuing our earlier scenario, let’s assume one spouse passed away in 2017. If the surviving spouse also passes away in 2017, they would first receive the Washington State exclusion of $2,129,000 leaving a remaining taxable estate of $2,471,000. The remaining estate would be taxed at a rate between 10% and 20% - creating a tax liability of $310,650. Were the estate worth more than the Federal exclusion, the excess value of the estate would be taxed at a rate ranging from 18% to 40%. The total maximum is 52%, after a deduction on the Federal return for state tax.

Federal law allows a Deceased Spouse Unused Exclusion (“DSUE”) – meaning that the second spouse to pass away can use the unused Federal exclusion allocated to the first spouse, in addition to their own. The “DSUE” effectively doubles the Federal exclusion amount. Unfortunately, Washington State does not have a DSUE concept.

You Can Run, But You Can't Hide

Tom Stewart was a Washington business man who owned Food Services of America. He moved from Vashon Island after Washington State changed its estate tax laws, passing away in Arizona.  

Real estate is not something you can take with you. The property he owned within the state remained taxable by the state. Washington has what is referred to as “tax apportionment” for decedents who own property in the state.

Entity Shares

What about owning shares of an entity, which owns real estate? Can you leave the state with the shares?

Washington State says, “Real property owned by a limited liability company (LLC) operating for a true business purpose is considered an intangible asset and is allocated to the decedent’s state of domicile” (Washington State Dept. of Revenue – “Estate tax apportionment for out of state property”). Thus, the answer is “Yes”, you can leave Washington with LLC shares and avoid tax apportionment.

Reducing Tax Burden Without Relocating

Ownership of minority shares of non-public entities (DSTs, TICs etc.) can receive a “discount for lack of marketability” (DLOM) for estate tax purposes. DLOMs are alive and well, for now, and can contribute significantly to reduce the values of estates that own real estate when structured appropriately. For example, you want to give a $3 million property to three children, as undivided interests (Tenant-In-Common or “TIC”) or as shares of an LLC. Assuming the TIC shares get a 35% valuation discount, compare as follows:

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Annual exclusions do not count against your lifetime exclusion, but the taxable amount does.  

Washington does not have DSUE, but it does have GABE, Gift Add-Back Exclusion. Gifts are not taxed and do not add back later.

What About Trusts?

Trusts, such as a Delaware Statutory Trust (DST), may own real estate. A trust is an entity with “beneficial owners”, treated as owning undivided fractional interests in the property. This is the reason DSTs are used to complete Section 1031 exchanges. Trust assets remain tangible property when an owner dies. Trusts, like LLCs and other entities, are great for transitioning wealth in a tax-efficient way.  

All in all, estate taxes can be significant if a strategy is not developed to properly address them when individuals own significant amounts of real estate.  

*Note, Kell Rabern and Hutchinson & Walter are not affiliated with Real Estate Transition Solutions, LLC beyond collaborating to serve to educate the investment real estate industry.