While the much-publicized downturn in real property values has been a cause for concern among investors, the current valuation of and market conditions surrounding these properties lend themselves to a variety of estate planning opportunities.
For entities holding commercial, income-producing properties, one such opportunity involves the use of a Grantor Retained Annuity Trust (GRAT). Through a GRAT, a grantor transfers property to the trust and retains an annuity interest in the form of a fixed annual payment from the trust. At the end of the term, any remaining value in the trust passes to the trust’s remainder beneficiaries. The amount of a gift, if any, is computed at the time of formation of the trust and is equivalent to the estimated remainder interest at this time.
For example, let’s assume that assets valued at $20.0 million are transferred to a GRAT and the grantor takes back a five-year annuity payment with an interest rate (as specified in Internal Revenue Code §7520) of 3.0 percent. The payment schedule is modeled out below.
In this case, the annual annuity payment is set such that the remainder interest is $0. Therefore, there is no gift at the time of formation. This is referred to as a “zeroed-out” GRAT. In the event that the assets transferred to the GRAT appreciate at a rate higher than the specified interest rate, this amount leaves the grantor’s estate upon termination of the GRAT.
As displayed above, two key variables in the calculation are: (1) the prevailing interest rate; and (2) the value of the assets transferred. Given the current low interest rate environment, the amount of interest required to zero out the GRAT through the annuity payment is relatively low. In addition, this sets a low “hurdle rate” in terms of asset appreciation to result in a reduction of grantor’s estate upon termination of the GRAT. Further, values of commercial properties are generally significantly reduced from levels of recent years. Assuming a cyclical market, in which commercial property values will return to previous levels, there is greater potential to transfer value (through appreciated asset value) out of the grantor’s estate.
Therefore, given the current economic environment (low interest rates and decreased real property valuations), the GRAT can be an inviting estate planning strategy for commercial property owners.
For non-income producing property, other techniques may be employed. For example, such assets may be transferred to an entity such as a Family Limited Partnership (FLP). Once the transfer has been completed, the persons who form the FLP no longer own the contributed property. Rather, they own partnership interests in the FLP that owns the property.
An FLP is governed by the general partners, with the limited partners having few, if any, management rights. As such, a limited partnership interest in an FLP is commonly viewed as a “non-controlling” interest for valuation purposes and subject to a discount for lack of control (DLOC).
In addition, these partnership interests are illiquid – that is, there is no secondary market on which to trade the interests. As such, a limited partnership interest in an FLP is commonly viewed as a “non-marketable” interest for valuation purposes and also subject to a discount for lack of marketability (DLOM).
In aggregate, the DLOC and DLOM can be substantial and allow for greater flexibility when making gifts of limited partnership interests. For example, let’s assume that an FLP is formed with a 1 percent general partnership interest and a 99 percent limited partnership interest. Further assume that the general partnership interest is owned by the parents and the limited partnership interests are gifted to their children. If the value of the contributed assets is $11.0 million, the pro rata value attributable to the limited partnership interest is $10.89 million. After application of a DLOC and DLOM at an aggregate 40 percent (for discussion purposes), the value of the limited partnership interest is $6.53 million which is below the 2009 unified gift and estate tax credit of $7.00 million.
The valuation process involved with the strategies outlined above can be complicated and require a thorough understanding of the issues. In addition, considerable thought must be given to the development and support of any applicable DLOC and DLOM that are utilized in the process.
David R. Bogus is a Principal in Ellin & Tucker, Chartered’s Forensic and Valuation Services Group. He is also an Accredited Senior Appraiser of the American Society of Appraisers. Michael B. Lawrence is an Analyst in Ellin & Tucker’s Forensic and Valuation Services Group. He holds a Bachelor of Science degree in Economics and Finance from the CalhounHonorsCollege.*Dollar Amounts given in millions.