Multigenerational Wealth

3 Ways to Transfer Real Estate to Future Generations

Multigenerational wealth — an aspiration for most high-net-worth individuals — requires sensitivity to a variety of complex financial planning issues. Owning a special residence, vacation home or investment property can represent a pinnacle of achievement, but transferring that property to the next generation has tax and estate implications for you and your family.

There’s no one vehicle that can address every possible concern about intergenerational wealth transfer, capital gains, property taxes, gift taxes and estate taxes, said Peter J. Zarifes, Managing Director and Director of Wealth Management for Whittier Trust Company in Los Angeles.

“We start by talking with every family about their goals and objectives,” said Zarifes. “We need to get an understanding of their entire balance sheet, which is sort of like a crossword puzzle. We’re not honing in on just one asset but looking at the total picture to come up with an optimized solution for the family.”

Most any effective solution will take into account the necessity of transferring real estate to the next generation. Here are three ways to do it.

1. Gift your property now or through your estate

If your goal is to preserve a family home, be it a primary residence or a vacation property, an outright lifetime gift means the beneficiaries have the ultimate say in what happens to the property, said Zarifes.

“The bad side of this is that they’ll inherit the cost basis of the property, so if they were to sell it, there would presumably be a heavy capital gains tax,” he said.

At least in California, however, the property tax will stay at the parents’ rate rather than undergo reassessment, thus resulting in lower taxes.

The decision to gift outright should be made in conjunction with a tax expert who can analyze the implications based on the original purchase price of the property as well as the family’s other assets and objectives. The gift would generally be coupled with a lease, under which the parents would retain broad control as well as responsibility to continue to pay for property taxes and other expenses of homeownership — thus providing further cash flow to the children.

“Sometimes the goal is to remove the asset from the parents’ balance sheet to reduce their taxable estate,” said Zarifes. “Right now, the lifetime gift and estate tax exemption is $22.8 million for a married couple, so we need to look at whether they’ve used that up and would need to pay a gift tax or not.”

The parents can also hold on to the property until they pass away. The heirs then inherit the property with a stepped-up tax basis equal to the market value of the property at the time of the death, not the original purchase price.

“If the heirs decide to sell immediately, they won’t pay any capital gains tax,” said Zarifes. “If they sell later on, they still have a much higher tax basis than they would have if they had received the property prior to the parents’ death.”

2. Use more complex estate planning for tax efficiency

Possible ways to mitigate tax implications include:

Fractional Interest Transfers

Moving an investment property or properties to a family limited partnership (FLP) or an LLC can reduce your taxes, said Zarifes.

For example, based upon a supporting valuation, a parent can contribute property to an LLC and then either sell or give the LLC membership interests to the kids. This sale or gift is subject to marketability and minority interest discounts that could reduce the value of the transfer significantly.

Qualified Personal Residence Trust (QPRT)

A QPRT is a split-interest trust where the parents are typically the initial beneficiaries for a period of years (such as five years). Then the children become the beneficiaries. This type of trust also allows parents to effectively discount the value of their residence for transfer purposes — with the value transferred being deemed only that “remainder” interest, said Robert W. Renken, Senior Vice President and Deputy General Counsel for Whittier Trust.

If the parents survive the term of the trust, the asset is no longer considered part of their taxable estate. “While the estate tax savings can be compelling, the parents need to be very comfortable with no longer owning their home and having to pay rent to the trust for their children,” said Renken. “So this needs to be thoughtfully analyzed not just for tax efficiency but also for the emotional impact inorder for this vehicle to be effective.”

Intra-family Sale

Parents can also choose to sell property to family members with an intra-family loan using the IRS’s “applicable federal rate,” or AFR, which, Renken noted, is a below-market interest rate.

“If you’re selling an investment property to the kids, they can use the income from the property to pay back the loan from the parents,” said Renken. “The property has been moved out of the parents’ taxable estate and, ideally, increases in value in the hands of the children.”

Philanthropic Funds

Families can also place their investment real estate assets into three different types of vehicles that offer tax benefits while fulfilling the family’s charitable interests, said Zarifes.

A charitable remainder trust (CRT) provides an annuity for beneficiaries for a period of years or a lifetime, with remaining funds designated to charity. A charitable lead trust (CLT) provides the annuity to the charity first, with the remainder going to beneficiaries. A donor-advised fund provides a dollar-for-dollar tax benefit while otherwise purely benefiting your family’s chosen charities.

It’s a modeling exercise to determine which structure works for you, said Zarifes.

A CRT or CLT will allow you to convert a real estate asset into marketable securities that generate an annuity and provide a philanthropic benefit, he added. Additionally, due to the charitable involvement, there’s an ability to defer any capital gains resulting from the sale.

3. Convert a Property to an Investment

If the ultimate goal is to exchange a residential property for an income-producing investment property, then the family needs to convert that residence to an investment and not a place for personal use, Renken explained.

If done effectively, a so-called 1031 exchange allows the family to sell an investment asset and purchase another while deferring the capital gains taxes.

For example, if a family compound in Palm Springs would otherwise go unused, it may be best to convert it to a rental property in order to exchange it in the future for an apartment building; doing this will defer the capital gain tax liability and maximize the income potential.

Before executing a 1031 exchange, Renken said, the family dynamic should be openly discussed.

Whether the issue is divvying up the use of a beach house, navigating the financial problems that emerge when some family members want to keep a property and some prefer to sell, or just managing maintenance expenses among siblings, it’s easy to see how conflicts can arise.

“If you want more control over the situation, then gifting it in an irrevocable trust ensures that the parents’ wishes are going to be fully executed,” said Zarifes. “The trust document will dictate what happens to the asset.”

“Sometimes everyone agrees to maintain and fund a family vacation home through a trust, but years later, some people aren’t using the property or there’s deferred maintenance that will be very expensive,” said Renken. “Then you need to plan a new transition, because family dynamics evolve.”

In any case, it’s always essential to look at real estate as well as other significant holdings in the context of the overall balance sheet and family dynamics to find the optimal solution, Zarifes explained. “It’s really a complex matrix for wealthy families,” he said.

Real estate is typically a key element of a family’s wealth, and each of these planning techniques has the potential to enhance multigenerational wealth if woven into a comprehensive long-term plan that incorporates the family’s goals and objectives. A wealth manager in tune with your family dynamics can help solve the puzzle in a way that’s most beneficial for everyone’s bottom line.

This is not a thorough discussion of the options presented, and a tax professional should be consulted before implementing any strategy. Written in partnership with Forbes BrandVoice.