Estate Planning for Real Estate
Almost all estate planning clients own real estate in one form or another – a residence, a vacation home, investment or rental properties.
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. Your residence, however, may be given to a particular beneficiary and if that is your desire your Last Will and Testament or Living Trust should clearly provide for sale. If there is a mortgage, you can condition the beneficiary’s receipt of the residence on the assumption of the mortgage or provide in your Last Will and Testament or Living Trust for the pay off of 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 know 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 you purchased your house for $100,000 and sell it 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 substantial.
Vacation properties present special planning challenges. There is often a desire to keep a vacation property within a family. However that 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?
- What if an owner has creditor issues or liens against them?
- Should the property be rented to third parties?
- What happens if an owners wants out of the arrangement?
- What if an owner goes through a divorce or bankruptcy?It is important that a client has 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.
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. Generally, Life insurance is not subject to income tax and 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)?
Types of Estate Planning Strategies/Why its necessary to implement Estate Planning for Real Estate Owners
An Estate Plan is a tailor-made, legally binding series of documents that outlines your last wishes for yourself and your assets after death. An Estate Plan ensures that your properties and possessions are safe during life and that they get to where you intend them to after death.
A complete Estate Plan includes four key elements: a Last Will and Testament, Living Will, Power of Attorney, and Revocable Living Trust. By planning what will happen to your Estate after you’re gone and putting your wishes in the correct document, you can protect your assets while saving your Beneficiaries a considerable amount of money.
Many real estate owners will accumulate one-of-a-kind properties. A Trust-Based Estate Plan is a comprehensive way to protect your assets in life and after death. For real estate owners, a Trust can also provide legal protections for the Trustees. With proper Estate Planning, you can maintain your real estate assets for future generations.
You can place just about anything in a Trust for safekeeping. Typically, when you fund a Trust with real estate, you are transferring the ownership of that property from yourself to your Trust. That is what keeps it safe for your Beneficiaries after death. But for a piece of real estate that you own and are currently living in, a Qualified Personal Residence Trust (QPRT) can keep you in your home.
A Qualified Personal Residence Trust allows for a piece of property to be removed from an Estate and put into a Trust for safekeeping. At the same time, it grants the original owner the right to live in the residence for an agreed-upon length of time. After that time, which may be after the original owner’s death, the property then passes to the Beneficiary or Beneficiaries.
Important to many real estate owners are the tax protections that come with Estate Planning. Typically, the more valuable an Estate is, the more likely it is that a financial adviser or lawyer will recommend setting up a Trust.
Trusts are taxed differently than Wills, based on a variety of different factors. For instance, a Beneficiary of a Trust receives a tax deduction, making them responsible for paying income tax on the taxable amount of the Trust only.
When naming Beneficiaries to your Estate Plan, it’s important to consider how they will be affected by the inheritance. Not everyone is in a financial position to pay the fees and taxes associated with a large inheritance. When that inheritance is real estate, the taxes can multiply with no end in sight.
Federal Estate taxes are due nine months after a Decedent’s death. That doesn’t leave much time for a Beneficiary to raise the cash needed to pay what can be a sizable tax payment. In some cases, an Estate may qualify for a tax relief provision that allows up to 14 years for a Beneficiary to pay off the Federal Estate taxes in installments. This provision, however, is only available to real estate investors with specific operations. It’s wise not to count on this provision as a way for your Heirs to stay up-to-date on their tax payments.
Putting your Estate into a Trust also allows your Beneficiaries to avoid Probate after your death, which we will discuss in more detail below.
Probate Court is the process of settling your Estate in court. It can also come with its own set of hefty fees, long waits, and red tape. If there is no Executor named in an Estate Plan, it can sometimes take the Probate Court weeks or even months to appoint an Executor and get the process started. And that wait may cost you.
When a Will gets stuck in the Probate process, the Estate is responsible for paying the fees and taxes related to it. Depending on the size of the Estate, Probate could end up eating into an inheritance. It may even require you to sell off assets to pay off the debts of the Estate.
To avoid Probate, real estate owners may put their properties into a Trust. They may also set up Joint Tenancy or Transfer on Death Deeds in states that permit it, which would transfer ownership of a property to the co-owner (or owners) immediately after death.
By avoiding Probate, your assets, including all your real estate properties and investments, would pass seamlessly and immediately to your Beneficiaries, no waiting or red tape, fees, and minimizing federal and state taxes.
Creating Your Estate Plan
A comprehensive Estate Plan allows real estate owners to pass their legacy onto their families without compromise. Trust & Will is here to help real estate owners of all sizes make sense of their Estate Plan and keep their most valuable assets safe.
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.