Real estate business owners face unique challenges that many business owners in other industries do not experience. The real estate market climbs and falls, contractor fees and material costs rise with inflation, and high interest rates can destroy the profitability of a real estate portfolio. These added complexities mandate more complex planning for ownership and management transitions. Similar challenges are present across asset classes, but there are certain estate planning tools that can help most real estate business owners ensure their hard work creates long-term wealth and supports strong family relationships. This article focuses on selection of those tools.
Succession Planning
Many real estate business owners have basic estate plans and update them to account for changes in net worth and liquidity as they expand their portfolios. However, the basic estate plan does not contemplate the complex nature of their holdings, nor the necessary steps to transition ownership and operations to the next generation of owners and operators. Planning starts with identifying your personal goals related to the transition of your business. What you want to transfer, and when you want to transfer it, will impact the strategies you pursue and the associated tax consequences.
An initial step in developing a successful succession plan is to address succession of operations. In the context of transitioning a family real estate business to the next generation of operators, the current operators need to determine who will take over once they retire. Many business owners would like to see their children or grandchildren take over business operations, but they must often look to unrelated employees if family members lack a sufficient level of interest, experience, or subject matter knowledge to take over. Sometimes it is helpful to begin by identifying the responsibilities owners perform with respect to their real estate business. This includes identification of knowledge and roles that are critical, and ideal successors to those roles. Identifying the future operators often involves strategic conversations, targeted training, and extensive preparation to ensure a smooth transition for the successors into the key roles when the time is right; often, it helps to fill leadership roles with (or create leadership roles for) the intended future leaders. Providing a five-year period to begin training successors will allow the current operators to identify deficiencies in experience or subject matter knowledge, as well as take any steps necessary to reorganize job duties among leaders to adjust the hierarchy for the strengths of each employee and the future business plans. Different approaches are called for if the future owners will take a passive (rather than active) role with respect to ownership and operation of a real estate business. For example, when the succession plan removes operations duties from the next generation of owners, it is often helpful to create a board of owners that will oversee and direct the corporate officers on big picture matters, such as the strategic direction of the business.
A separate, but equally important, step in developing a succession plan would be to identify the future owners. While it may be ideal to pass the real estate empire to the current owners’ children, if the children lack interest or would be better suited with a financial advisor managing their investments, it could be more beneficial to structure a buyout and leave cash (or other liquid assets) to family. If an unrelated party will be taking over ownership, the timing of the announcement will depend on the identity of the acquirer; if the future leaders are acquiring the ownership interests, then it may ease the transition if the announcement is made as soon as the transition of leadership duties is underway; if the business is being acquired by an unrelated third party, the announcement can often wait until the transition of leadership duties is nearly complete.
Even while working through these and other succession planning questions, existing agreements should be reviewed and, if appropriate, renegotiated to address the succession plans. Agreements can often restrict unrelated parties from taking ownership or control upon death (e.g., buy-sell rights or change in control provisions). This review of existing agreements can also ensure that the owners’ death will not be an event of default under any loan agreements (which, if uncured, could lead to foreclosure). Many real estate investments are held through multiple entities (sometimes with outside investors) and are subject to a variety of financing arrangements. There are also often separate entities involved in the management of the properties. A careful review of entity and loan documents will identify any notice or consent requirements related to succession plans.
Reorganization of Holding Structure
A successful plan to transfer a real estate business to the next generation will rely on a variety of factors, including having the correct holding structure for assets. If real estate assets are held in an individual’s own name, transferring title to one or more entities will simplify probate, mitigate risk, and assist with the overall tax strategy. For example, title to each of the properties could be transferred to limited liability companies (LLCs) or trusts. Often the ideal holding structure will consist of one or more trusts that own membership interests (i.e., ownership interests) in holding companies, which in turn holds the membership interests in property companies, which in turn hold title to the properties.
Transferring membership interests in those limited liability companies piecemeal will allow transfer of fractional interests to family, directly or indirectly, over time. This allows valuation discounts that can help minimize the estate tax burden. Operating agreements should be prepared for each LLC (and Declarations of Trust for any trusts) and would outline rights and obligations of the members, managers, and fiduciaries. These agreements are flexible, and the terms of each can be tailored to the specific role the entity plays in the succession plan.
LLCs are recommended in most cases, because they provide liability protections but can elect for company income to be taxed separately, like a corporation, or passed through to the owners’ income tax returns, like a partnership (click here for more on entity tax classifications). In general, members of an LLC are not liable for the debts and obligations of the LLC, and judgments against it would only affect the assets owned by the LLC (protecting the other assets of each owner). In addition, LLCs that do not elect to be taxed as a corporation for federal tax purposes are automatically classified as a partnership or disregarded entity, meaning that income they receive is passed through to the members and taxed at the member’s income tax rate.
To Gift or Not to Gift
There are several tax reasons why accelerating the transfer of a business is beneficial as well. In 2024, the federal gift and estate tax exemption amount increased to $13.61 million per individual (a combined $27.22 million for a married couple), as part of the inflation adjustment. However, the federal exemption is scheduled to be cut in half in 2026, and many states have lower thresholds for estate tax liability. Additionally, the limit for a married couple applies if the spouses pass contemporaneously or do not leave assets to each other. If a surviving spouse inherits the deceased spouse’s assets, the combined assets (of both spouses) would be subject to the $13.61 million per individual limit when passing through the surviving spouse’s estate. Federal law does permit “portability,” where any unused amount of a deceased spouse’s exemption can be used by the surviving spouse’s estate, but some states’ exemptions are not portable. If the entire unified credit is used to satisfy gift taxes for transfers of $13.61 million made in 2024, there is no obligation to pay any of the taxes back in later years when the exemption drops below $13.61 million; tax-savvy planners can utilize this important timing element to minimize taxes.
There is also an annual federal gift tax exemption that applies for each donor as to each donee (e.g. a father of two can apply this exemption for a gift to his son and apply it a second time for a gift to his daughter). For 2024, the annual gift tax exclusion amount is $18,000 per individual ($36,000 for a married couple). Exceeding these limits requires the filing of a federal gift tax return stating the excess amounts beyond the annual exclusion, but taxes are not owed unless the lifetime gift and estate tax exemption is exceeded (as noted above, currently $13.61 million per individual and $27.22 million per married couple). The high limits for estate and gift tax exemptions mean that many people do not currently have to pay these taxes; for small business owners, however, the value of assets can adjust with the market and could easily push an estate over state and federal limits.
Gifting is often used to reduce the size of an estate to minimize estate taxes, but potential income taxes should be considered when making gifting decisions. When a donee receives a gift, the donee generally takes the donor’s basis in the property. When inheriting property, the recipient generally receives a “stepped up” basis in property equal to the property’s fair market value on the date of death. As a result, if the recipient sells the inherited property, income taxes would only be owed on any appreciation that occurs after the date of death. For example, if a mother bought her home for $10,000 but leaves her home to her daughter through her estate, the daughter could sell it for $1,000,000 the day after her mother passes away (which is presumably the fair market value as of the date of death) and pay $0 in income taxes. Conversely, if the same mother buys a second home for $10,000 and gifts it to her son when the house is worth $1,000,000 before passing away, the son could sell it for $1,000,000 at any time after receipt but will pay income taxes on the difference between the $10,000 basis and the sale price. Depending on the asset, however, there may be additional tax mitigation strategies available through gifting. Recently, such a strategy has arisen for gifts of Qualified Small Business Stock.
Lifetime Transfers
Once the properties are transferred directly or indirectly to family, for estate and gift tax purposes, subsequent appreciation and income will not be subject to estate tax at the transferor’s level. In addition, some owners plan to make transfers when property values are relatively low to mitigate tax impacts. However, the decision whether to make lifetime transfers (and whether to transfer non-controlling (usually limited partner or non-voting membership interests) and/or controlling interests) involves both tax and non-tax considerations. For business succession purposes, owners may reorganize the business to have several classes of shares to transfer nonvoting shares to create liquidity or expedite the succession plan. However, consideration should be given to how the transfers will affect cash flows to the family both during lifetime and after death. Transferring interests to family members may entitle the family members to distributions from the business, but transfers to unrelated third parties (e.g. when the succession plan incorporates transfers of shares to unrelated employees and officers of the business) will result in less income from the business being retained by the family.
Business owners often delay putting assets in trust because of concerns that they will lose access to the assets or control over the assets. When business owners make lifetime transfers of their business interests, the transferred interests could be transferred to trusts over which they retain control, allowing the business owners to remain in control while still removing the transferred interest from their taxable estate. Further, spousal lifetime access trusts (commonly referred to as SLATs) are another tax favorable vehicle. SLATs allow taxpayers to remove assets from their estate while providing their spouse with continuing access to the assets, if needed. Revocable trusts and certain irrevocable trusts (structured as “grantor trusts”) are also used to transfer asset ownership without triggering any gift taxes or changing the calculation of income taxes on the assets. Even grantor trusts shield assets from probate court oversight, allowing for ownership and control to be transferred privately and efficiently upon death. This efficiency and lack of court supervision could be critical to preserving value of the business, due to the unpredictability of how the market could shift over months of waiting for court approvals.
Liquidity
Liquidity is another critical component of a business succession plan. Federal estate taxes are due nine months after death, leaving a relatively short time to convert assets into cash. In some circumstances, an estate may qualify for a special tax relief provision (Section 6166 of the Code) that allows for estate taxes to be paid in installments over a longer period. However, in any case, estates (and the businesses repurchasing shares from estates) must have sufficient liquidity to meet debts as they come due.
The sale or refinancing of real estate is not a reliable or desirable method of funding a business’s or an estate’s liquidity needs. The markets can be volatile. Furthermore, if the jurisdiction requires probate court approval to sell or refinance real estate, court approval could be delayed and favorable terms for the sale or refinance could expire. Failing to plan for needed liquidity could also put the property owner in a bad negotiating position (e.g., they might need to sell at a discount or accept higher interest rates on debt). If the business or its assets are already encumbered by a significant amount of debt, the ability to transfer assets or refinance the debt could be further limited. Often, advance planning to address current business debts is a critical part of a business succession plan.
Life insurance policies can provide liquidity for businesses and estates. Policies can be held by an irrevocable life insurance trust to shield the proceeds from estate taxes (because the policy is owned by the trust and not the insured, the proceeds from the policy will not pass through the estate and be subject to the federal estate tax). Alternatively, the business could hold the insurance policy, which would serve as necessary funding to keep operations for the business running smoothly. Life insurance planning has come under some recent fire, however, by the U.S. Supreme Court. There are a variety of policies and ownership structures which could be beneficial for specific liquidity needs, but each comes with a price.
Conclusion
Creating a succession plan or estate plan for your real estate portfolio starts with setting goals, talking with your family, and reviewing relevant documents. The intended goals of your succession plan will drastically change the legal agreements and business operations that you need to put in place. In all events, implementing a succession plan can protect your assets, reduce overall taxes, and help your family avoid years of stress when you are gone.
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