Estate planning is crucial in real estate wealth. We all know that real estate investments involve the rolling of equity from project to project to continue growth. Such being the case, it’s imperative to do proper estate planning to avoid having to liquidate real estate assets to pay inheritance tax.
The current lifetime exemption a person may give away during life or at death without owing federal estate tax is $13,990,000 per person ($27,980,000 for married couples). This amount is set to increase in 2026 to $15,000,000 per person ($30,000,000 for married couples).
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Three Key Concepts For Estate Planning With Real Estate
Utilizing Discount Valuations
Using the right entity structure to hold real estate can allow a donor to gift interests in the entity at a discounted value, such as discounts for minority interest and lack of control. These discounts commonly range from 20% to 35% each. These discounts reduce the value of a gift, which in turn reduces the amount taken from a donor’s lifetime exemption. This can be a substantial gift transfer savings when considering the estate and gift tax rate is at 40%.
Gifting To Generational Trusts
Utilizing generational trusts, otherwise known as Dynasty Trusts, permits a donor to create a trust from their generational skipping transfer (GST) lifetime exemption to escape all their future descendants’ estates for as long as the assets stay in trust. This means all future appreciation of the assets will be protected from estate tax as each generation passes, leaving the assets to grow without being subjected to estate tax.
Utilizing Substitution Powers
One risk of funding trusts is the loss of “step-up” basis. Assets held by a taxpayer at their death receive a step-up to FMV at the date of death. Assets transferred to irrevocable trusts that are considered completed gifts take on a carryover of the original cost basis (purchase amount) from the taxpayer.
For those with taxable estates beyond their lifetime exemption, a workaround for the uncertainty of which real estate asset may recognize greater appreciation is a trust clause referred to as “substitution powers.”
Substitution Powers In Action
If a trust is holding a highly appreciated asset, a donor can “substitute” a lower appreciating asset of equal fair market value (FMV) to optimize which asset receives a step-up at the date of death. For example, the donor personally holds real estate with a $100,000 gain (asset A). A Trust funded in a prior year holds real estate with $1,000,000 gain (asset B). Both assets have a fair market value of $2,000,000. The donor may “substitute” the two assets, bringing asset B with a $1,000,000 gain back into their estate, and the trust then holding asset A with the $100,000 gain. Upon the donor’s death, asset B gets a step up to FMV, avoiding the $1,000,000 gain from being recognized. The shift of the assets results in a savings of income taxes on $900,000 of appreciation.
Contact GBQ to learn more. Our tax and advisory professionals can help you effectively unlock generational wealth through smart planning strategies.
By Julie Drumm, CPA, Tax & Advisory
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