June 14, 2010
There is no argument that the markets, whether real estate, stocks, bonds, futures, commodities or grocery, have been rough over the last year or more. However, the very volatility in those markets may open up some planning opportunities that you may not be aware of.
Currently, everyone has the ability to gift up to $13,000 per year, per person without incurring gift taxes. In addition, over their lifetime each person can give an additional $1 million before paying any gift tax. In 2010, there is no estate tax on the transfer of assets. (Assuming Congress does not retroactively change the rules.) Unless the law is renewed or changed before 2011, that gift and estate exemption will become a total of $1 million on January 1, 2011.
So where are the advantages? One area, the focus of this article, is gifting. If you are considering giving some of your wealth to your loved ones during your lifetime, this is an opportunity to give away greater wealth than you could even two years ago. Why? Because prices are depressed on almost all assets and this means you can transfer a greater percentage of your property so when prices rebound, as we all hope and expect they will, the increased value will have been transferred to your loved ones.
Gifting
Assume you have a vacation home in the mountains, where your family goes to enjoy the winter weekends. You intend to pass this vacation home to your three adult children sometime during your lifetime. Further, assume that the home was worth $500,000 in 2006 and now, due to the lower real estate prices, the most you could currently sell it for is $350,000.
If you gifted it now to your three children it would only use $311,000 of your $1 million gifting credit. (Annual exclusion of $13,000 for each your three children plus $311,000 equals the $350,000 current fair market value) Slightly more complex planning could use your children’s spouses and children to increase the number of annual exclusions used and you could gift pieces of it over 2010 and 2011, doubling the utility of the annual exclusions.
Then, when the prices on real estate go up, the vacation home is out of your estate and will not be included in your estate.
Controlled Gifting
One of the designs many of my clients prefer is the ability to restrict access to gifts until the beneficiaries meet some criteria, such as age, education, work or investment goals. This is especially important when making gifts to younger beneficiaries.
An Independent Gifting Trust can allow you to make gift to even minor beneficiaries and restrict their access until the gift is needed for education, housing or they are mature enough to manage the assets on their own.
Discounted Gifting
Discounting is a valuation tool that may be used whenever you gift less than an entire asset. For example 10% ownership of a house is usually worth less than 10% of the value because the 10% owner does not have control over the property and has a harder time selling his 10% share. The difference between 10% of the building’s value and the value of owning a 10% share is called a discount.
Discounts are often generated by gifting assets in a piecemeal nature as illustrated above, or by using an entity, such as a partnership, and gifting pieces of entity’s ownership. Because an entity can restrict control to a greater degree than even a majority owner, the discount is usually larger.
Larger discounts means the gifted portion has a lesser value for so the gift uses up a smaller portion of your gifting credit or you can gift a larger portion of the property for the same credit.
Discounted gifting is most effective with property such as raw land, a building or a closely held business and less effective with stocks or bonds.
In the current environment, discounted gifting is effective even with the reduced asset prices and on larger assets can be well worth the added cost and complexity over an outright gift of property.
Estate Freezing
The term “Estate Freezing” refers to a number of techniques, the goal of which is to transfer the potential growth of an asset outside of the estate. This is often used when the asset generates income along with growth and the owner wants to retain the income stream.
As a simple illustration, assume you own a commercial building with a long-term tenant. The building generates a net income of $100,000 per year and is currently worth $1.2 million dollars. You want to keep receiving the $100,000 per year, but would like any appreciation in the building to go to your children. One technique would be to sell the building to your children in exchange for a $1.2 million promissory note, which they will pay over time. This type of sale is also known as an “installment sale.”
Because you sold the building for the fair market value of $1.2 million there is no gift tax. And because the sale is an installment sale you only have to recognize the capital gains (if any) when the payments are made. The note has to pay a minimum interest rate called the AFR (Applicable Federal Rate) appropriate for the term of the note (short, medium or long), and right now the AFR is very low, with the annual long term rate hovering around 4.4% for most of 2010. You could structure the note so the payments, over 20 years at 5.5%, would be roughly $99,000 per year, which would be paid to you by your children from the rental proceeds on the building.
You would wind up receiving your $100,000 per year, transferring the building and its future appreciation to your children, and deferring the tax on the sale.
There are several variations and options that would work with the basic estate freezing design, but the current prices make it easier to lock in the current value for the estate and the future anticipated appreciation in your children’s, grandchildren’s or other loved one’s hands.
Conclusion
While we would all prefer that the markets would have avoided the current turbulence, we should be prepared to take advantage of the present pricing opportunities, both for ourselves and our families.
This article is not legal advice. Each person or family is unique in both its goals and circumstances. You should talk with an attorney familiar with estate design and planning before attempting to implement any of the ideas expressed herein.
Michael E. Garner, Esq.