Top 8 estate planning factors for real estate

Editor: Mo Bell-Jacobs, J.D.

Estate planning for real estate requires a strategic and comprehensive approach. From tax implications to the intricacies of property management, this item is designed to help advisers understand how to craft resilient estate plans for clients with large real estate holdings. The discussion highlights eight important estate-planning factors in the real estate context.

1. Retained interest and estate inclusion challenges

Real estate investors typically value retaining some level of control over or the use of the assets they worked hard to grow, which can add complexity to transfer tax planning. Under Sec. 2036, property is sometimes unexpectedly included in a taxpayer’s gross estate if the taxpayer retains the right to enjoy or control it. This extends to what may be seen as indirect control, such as the taxpayer’s managing a family investment entity. For example, if a taxpayer has the sole ability to amend the operating agreement, dissolve the partnership, or make distribution decisions, they could be considered as having retained “strings” to the interest because they potentially control its beneficial enjoyment.

Planning tip: Retaining a life estate under Sec. 2036 in real estate or creating an appearance of continued control will inadvertently trigger issues involving ongoing use or the ability to shift beneficial enjoyment. Such scenarios should be reviewed carefully to minimize the potential for estate inclusion.

2. Valuation discounts

Valuation discounts can play a pivotal role in transfer tax planning for real estate. These discounts consider factors that contribute to lack of marketability and lack of control, including limitations relating to multiple owners, type of assets, and owner agreements that create restrictions that reduce an interest’s value. Discounting is an important consideration for lifetime gifting and interests an estate owns.

Transferring a portion of assets subject to discounting is an effective strategy for transferring assets out of a taxpayer’s estate while retaining some asset management. However, it is crucial to be aware of certain considerations that might not immediately come to mind:

• The transfer will incur upfront costs that vary based on the complexity of the type of assets or entity structure and the state of residence. Qualified business valuations and gift tax returns will also need to be done in the years in which interests are transferred. Additionally, annual administrative costs and other ongoing expenses, such as those for tax filings, are a further financial consideration.
• Operating the business formally will help ensure that the IRS upholds the structure and provides more protection from creditors.
• Upon death, assets previously gifted to an irrevocable trust, including certain real estate assets, will not result in a step-up in basis; thus, the estate and beneficiaries will be unable to step up their basis and depreciate certain real estate assets.

Planning tip: Discounting the value of applicable assets may present a strategic advantage for the taxpayer to mitigate potential gift or estate tax liabilities if formalities are followed.

3. Estate liquidity challenges

Generally, real estate investors reinvest their cash, leaving a potential liquidity issue at death. Sec. 6151 requires that estate tax be paid within nine months after the date of death. If a significant portion of a taxpayer’s assets are illiquid, alternative options are worth exploring, which include an election under Sec. 6161 or Sec. 6166 and Graegin loans, named after Estate of Graegin, T.C. Memo. 1988-477.

Sec. 6161 allows an estate’s executor to extend the time for paying estate tax for up to 10 years when reasonable cause exists. What constitutes reasonable cause may be a high bar. For example, it may take proving that liquidating assets would cause economic harm to the estate. Sec. 6166 provides relief where an estate’s value is composed at least 35% of closely held interests in an active trade or business, but only the tax related to the closely held interests qualifies for deferral. Sec. 6166 relief requires annual interest payments for the first four years and principal and interest payments for the subsequent 10 years. While offering advantages such as early repayment flexibility and using estate income for interest payments, drawbacks include variable interest rates, IRS loan terms, and potential acceleration related to business disposition or state estate tax complications.

Alternatively, Graegin loans offer an additional method for obtaining liquidity to pay the estate tax. They are typically obtained through a financial institution, family business, or irrevocable life insurance trust. If structured correctly, these loans can prevent financial loss from forced asset sales plus allow the estate to deduct the interest on the estate tax return. The deductibility of interest is subject to certain conditions such as the estate’s insufficient liquid assets, certainty of interest without the option for prepayment, and reasonable loan terms. Conditions imposed under Prop. Regs. Sec. 20.2053-3(d)(2) may make it even more difficult to deduct the interest on a Graegin loan.

Estate tax is not the only issue that requires liquidity after death. Marital trust planning is crucial to ensure a sufficient cash flow for the surviving spouse to maintain their accustomed lifestyle. The distributions from a marital trust to the surviving spouse may be unexpectedly reduced by depreciation expense; however, the impact varies based on state law. These types of issues may affect the operational aspects of real estate after the date of death.

Planning tip: When addressing estate liquidity concerns, consider the available options and choose the most suitable method, based on the estate’s unique circumstances and goals.

4. Basis and capital account planning

Generally, real estate that is held for a long time or is the product of multiple previous Sec. 1031 like-kind exchange transactions tends to have a low basis. Retaining these assets until death presents a unique advantage: a step-up in basis. In the case of assets held within a partnership, a step-up occurs not only for the partnership interests but also potentially in the underlying assets by the partnership’s making a Sec. 754 election.

Negative tax basis capital accounts in partnership interests owned by an irrevocable grantor trust can lead to a taxable event upon the trust’s becoming nongrantor during the grantor’s lifetime, triggering a tax liability corresponding to the negative capital accounts.

Additionally, assets owned by an irrevocable grantor trust are generally not included in the decedent’s estate and therefore do not receive a basis step-up (or step-down) at the grantor’s death. However, many irrevocable grantor trusts allow the grantor to swap assets of equal value with the trust. This is particularly valuable if the grantor has high-basis assets in their estate and the trust has substantially appreciated assets with a low basis. If the grantor swaps assets during their life, the low-basis assets held at death will receive a step-up in basis.

Planning tip: Strategically considering asset basis and tax basis capital accounts may provide opportunities for income tax savings.

5. Passive loss rules and selecting the trustee/executor with care

Many real estate investors actively participate in the activities or are considered real estate professionals for income tax purposes, resulting in preferential income tax treatment for purposes of the passive loss rules and the net investment income tax. Determining whether certain activities are active or passive becomes more complex at an individual’s death. There is no authoritative IRS guidance for how activities of a trust or estate are tested for material-participation purposes. Instead, practitioners rely heavily on two cases, Mattie K. Carter Trust, 256 F. Supp. 2d 536 (N.D. Tex. 2003), and Frank Aragona Trust, 142 T.C. 165 (2014). According to these cases, a trust or estate’s material participation depends on the fiduciaries or their agents engaging in those activities. The IRS may introduce regulations in this area, potentially altering the criteria for income tax testing.

Planning tip: If possible, appoint an executor or trustee who may qualify for material participation with respect to real estate owned in a trust or estate.

6. Multigenerational planning and GSTT

Ultra-high-net-worth families, especially those with extensive real estate holdings, should create estate plans that strategically pass down assets across multiple generations. Multigenerational planning requires incorporating the complex application of the generation-skipping transfer tax (GSTT). While many taxpayers are aware of their available $13.61 million gift and estate exemption in 2024 (indexed for inflation), each taxpayer also has the same amount of generation-skipping tax (GST) exemption. The GSTT is in addition to gift tax and estate tax. GSTT has a flat tax rate equal to the maximum estate and gift tax rate, which is 40% in 2024. Protecting legacy assets, including real estate, in trust with GST exemption allocated to it will prevent additional estate, gift, and GST taxes from being imposed on those assets for future generations.

However, the estate/gift and GST exemptions are set to be cut in half beginning Jan. 1, 2026, due to the sunsetting of a provision in the 2017 law known as the Tax Cuts and Jobs Act (TCJA), P.L. 115-97. The IRS has clarified that exemptions used in a year with a higher exemption than effective at the grantor’s death generally remain outside the taxable estate. The temporarily increased exemptions offer planning opportunities for clients that require prompt review, given the complexity and time involved in most ultra-high-net-worth planning, which often involves multiple estate planning professionals.

Planning tip: Now is the time to engage in estate planning conversations with clients so that they can take advantage of the increased gift/estate and GST exemptions before they sunset on Jan. 1, 2026. Real estate investors should thoughtfully contemplate the succession of their legacy for multiple generations, especially when the family is not a viable option or might not be willing to take on this responsibility.

7. Carried interest gifting valuation issues

Carried interests are commonly held assets for some real estate investors. Since they could greatly appreciate, transferring these assets outside the estate may be a highly effective strategy. Generally, real estate investors believe these assets are nominal in value, but this may not be true under the Sec. 2701 special valuation rules.

If the taxpayer owns other types of interests in the entity, Sec. 2701 may apply and essentially create a deemed gift of an equal portion of each interest even if the grantor retains other interests. Various methods such as making a gift of an equal portion of each interest (referred to as a “vertical slice”) could be used to mitigate the special valuation rules.

Planning tip: Carried interest transfer strategies are complex. Ensure your clients are working with advisers who are well versed in the valuation of these types of assets and that the appraisal is sound and adequately disclosed on a gift tax return to mitigate the risk of IRS scrutiny.

8. Periodic estate plan review

Estate plans should not be static documents created once and put away and forgotten. Regularly reviewing estate plans is vital to ensure they remain true reflections of your client’s life circumstances and evolving wishes.

Periodic estate planning review is critical for the following reasons:

• Life-changing circumstances: Life is dynamic, and events can affect estate plans, including marriage, divorce, the birth of children or grandchildren, the death of a family member, and changes in financial status. When these life-changing events happen, reviewing the estate plan will allow you to make sure it is aligned with your client’s wishes.
• Change in assets: If the value of assets increases or decreases significantly, taxpayers may need to adjust their estate plans to optimize tax savings, asset protection, or charitable giving. Also, when acquiring or selling a business or investment, taxpayers may need to update their estate plans to reflect their desired succession planning.
• Change in tax laws: Ever since the TCJA was enacted, individuals and their advisers have been busy using the temporarily doubled estate, gift, and GST exemptions that will sunset to about $7 million, indexed for inflation. The temporarily increased exemptions are a “use it or lose it” opportunity. Updating an estate plan is crucial, especially with tax laws that have changed or are expected to change.

Planning tip: An estate plan should be reviewed and updated at various times. Clients currently can take advantage of the increased gift/estate and GST exemptions with the guidance of their advisers.

Collaboration is key

Estate planning is a multifaceted endeavor that demands a comprehensive and collaborative approach, particularly when planning for real estate and its distinctive tax-related intricacies. In navigating the complexities of wealth transfer, it is paramount to involve not only the client but also a collaborative team consisting of attorneys, accountants, and financial advisers.

This collective effort ensures that every facet of the client’s financial landscape is meticulously considered, leading to the formulation of the most effective and tailored estate plan to achieve the client’s goals.

Editor Notes

Mo Bell-Jacobs, J.D., is a senior manager with RSM US LLP.

For additional information about these items, contact the author(s) of this item: Carol Warley, CPA/PFS, J.D. (Carol.Warley@rsmus.com, Incoming chair of the AICPA Trust, Estate, and Gift Tax Technical Resource Panel), Houston; Scott Filmore, J.D., LL.M. (Scott.Filmore@rsmus.com), Minneapolis; Abbie M.B. Everist, J.D., LL.M. (Abbie.Everist@rsmus.com), Sioux Falls, S.D.; Amber Waldman, CPA, M. Acc. (Amber.Waldman@rsmus.com), McLean, Va.; and Shannon Ulrich, CPA (Shannon.Ulrich@rsmus.com), Chicago.

Contributors are members of or associated with RSM US LLP.