Reduce estate and gift taxes by selling assets? You can do it, and picking the right Estate Planning Strategy will provide more benefits for your heirs.
Now is a good time to consider an asset sale, even an unusually good time. A sale freezes the estate’s value at the current price of the assets. With a recovering economy likely to lead to higher future asset prices, this is a good time to lock in estate values. In addition, low interest rates help further reduce taxes from using one of these sale strategies.
There are three main strategies for selling assets as part of estate planning. These are private annuities, self-canceling installment notes, and fixed-payment installment sales. Each can be used to sell assets either to family members (providing the most benefits) or to third parties. Often trusts can be added to provide more benefits or wealth protection.
Usually real estate, closely-held stock, and family limited partnerships are the assets used in these transactions. When an FLP is involved, different types of assets can be put in the FLP and become part of the sale.
Many times a sale can be structured so that a gift tax valuation discount applies, providing further tax reduction. For example, an FLP usually gets valuation discounts for lack of marketability and for minority interests. Or a property can be sold in pieces. Half or less of a piece of real estate could be sold this year, and the other half next year. Selling less than a controlling interest can qualify for a minority discount.
Each strategy is extremely flexible and has many variations. A good estate planning advisor should be able to give you several options. Let’s look at typical ways these strategies can work.
Private annuities. Suppose Max Profits has a building to sell. He transfers the building to a trust (of which he is not trustee) that benefits his children. The trust gives Max a private annuity contract, promising to pay Max a fixed amount annually for life. The trustee can hold or sell the building. If it is sold, then the trustee holds and invests the cash. He makes the required annual payments to Max. The trust bought the property from Max. So, its basis in the property is its cost. That eliminates or minimizes capital gains taxes to the trust.
The initial value of the building, Max’s age, and current interest rates determine the annuity payments. This is where today’s low interest rates can add a real benefit. Those rates are used to determine the annuity payments. Low rates make it likely that the investment returns of the trust are likely to exceed annuity payments. This is especially true of real estate, but likely applies to any diversified investment portfolio.
The building is out of Max’s estate. The annuity payments are divided into three parts. Max’s basis in the annuity is the building’s value in the sale. This amount is divided by Max’s life expectancy. Each year that much of the annuity payment is a tax-free return of Max’s basis.
For example, if Max’s life expectancy is 15 years and the building’s value was $1,000,000, then for 15 years $66,667 of each annuity payment is tax free. The same calculation is done with Max’s capital gain to determine the portion of the annual payments that are capital gains. Any portion of the annuity payments above those amounts is interest income. If Max has depreciation recapture, it is recognized as payments are received. If Max lives beyond the 15 years, all of each payment is taxed as ordinary income. The annuity payments are not deductible by anyone.
When Max dies, the annuity contract becomes null and void. No more payments are due from the trust. Nothing from the trust is included in Max’s estate.
The risk is that Max lives a long time. Then, the trust overpays for the building, and extra payments are in Max’s estate.
Self-canceling installment note. The SCIN lasts for a fixed-term of years but it is canceled if the seller dies before that term.
The buyer pays a premium to justify the self-canceling feature. The SCIN can be structured with features such as interest-only payments with a final balloon payment, reducing cash flow problems for the buyer. Interest might be deductible by the buyer.
The premium for the self-canceling feature means the buyers still over pay if the seller outlives life expectancy. But it puts a cap on the potential overpayment. An advantage to the seller is that the seller has a security interest in the property. If the property declines in value or is mismanaged, the parties can in effect cancel the deal by having the seller take back the property.
The seller divides payments into three parts as with the annuity. But if the note is canceled by the seller’s death, then the estate must recognize all of the remaining capital gain in the year of the death. The 15% capital gains tax is lower than the estate tax, but still might use a fair amount of cash.
The private annuity and SCIN are especially attractive when the seller needs or wants income and has some health condition that makes it unlikely he or she will outlast the life expectancy. Then, the asset will be shifted out of the estate with the heirs having to pay only a fraction of the value back to the seller.
Fixed-payment installment note. This strategy differs from the other two in that all payments must be made. If the seller dies early, the payments go to the estate. It makes the most sense when the seller is healthy. It eliminates the risk that the buyer will over pay for the asset if the seller lives beyond life expectancy. But the value of the note is included in the seller’s estate, so only the appreciation might avoid estate taxes.
As with the SCIN, the fixed-payment note can have features such as interest-only payments.
The fixed-payment note also can be ideal when the seller has a high basis in the assets. Then, the seller is not concerned about avoiding capital gains taxes. Once again, the buyer might get to deduct the interest payments.
The fixed-payment note is popular among estate planning advisors when combined with a “defective grantor trust.” Because the grantor of the trust retains certain powers, income and gains of the trust are taxed to the grantor during his or her lifetime. (The seller of the property also is the grantor of the trust.)
The defective grantor trust provides two benefits. One is that capital gains taxes are deferred as with the other strategies. Another advantage is that the grantor is taxed on all income of the trust, though the grantor probably will not receive any of that income. This is a way of making an additional gift to the children, picking up the income taxes so the trust income can compounded or spent tax free. The income taxes of the grantor probably will be less than additional gift or estate taxes. The defective grantor trust can be a bit complicated. We discussed it in detail in the November 1999 issues. The article is available in the Grandkids’ Watch section of the web site Archive. There are some uncertainties with installment notes and the defective grantor trust, so some estate planning specialists won’t use them.
Each of these vehicles is very flexible but must be structured properly to avoid problems with the IRS. An experienced estate planning advisor is needed to determine which strategy is best for your situation. Today is the ideal time to consider these strategies. If you own valuable assets that are likely to appreciate and want income from them, have your estate planning advisor consider your options using one or more of these strategies.