For those real estate investors whose share ownership with other family members, proposed Treasury Regulations under Internal Revenue Code Section 2704 may affect the ability to make discounted gifts of interests in these entities to other family members for gift tax or estate tax purposes.
On Dec. 1, 2016, the Internal Revenue Service conducted a hearing after a public comment period regarding the proposed regulations; however, the new regulations have not been finalized. Furthermore, the new Trump administration has indicated an intent to repeal the estate tax; while no details have emerged regarding the mechanics of such a repeal, doing so would likely invalidate the new regulations (even if they are finalized). Even if finalized, it is also possible that the final regulations would be watered down from their present form. Regardless, it is important to anticipate what effect, if any, the changes to valuation will have.
Background. Traditionally, estate planning for real estate ownership has taken advantage of the availability of discounts for lack of control and lack of marketability. By making gifts of interests in a real estate holding entity to other family members over time, the value of the donor’s estate could be reduced for estate tax purposes, with the corresponding gift tax being reduced or eliminated by the available discounts. Gifts could also be accelerated later in life, especially in the years leading up to death, in situations where the donor no longer depended on the income stream from the real estate. Ultimately, by shifting ownership and control of the real estate to family members prior to death, the donor could once again use these discounts for estate tax purposes at his or her death.
Effect. Generally, the new regulations apply to business entities in which the majority of ownership consists of family members. Under the proposed regulations, family members will, in most cases, be treated as one unified owner for purposes of determining control of a business entity. The effect is that any gift tax or estate tax discounts for lack of control will largely be eliminated. Additionally, the IRS has proposed to, in effect, ignore any transfers of an interest in such a business entity to a family member within three years of death, which would in turn cause the gifted interests to be included in the donor’s estate for estate tax purposes.
Who is affected? Generally, the new regulations will only affect certain real estate investors whose net worth could subject them to estate tax liability, and who have transferred (or plan to transfer) ownership of any property to children or other family members during life. For 2017, the estate tax generally only applies to those individuals whose net worth exceeds the estate tax applicable exclusion amount of $5.49 million ($10.98 million for married couples with the proper planning in place). The regulations only specify ownership of interests in a business entity (such as a corporation, partnership or limited liability company) – it is unclear whether the regulations would apply to co-ownership of real estate as tenants-in-common (unless the tenancy in common is treated like a partnership for income tax purposes).
What should be done. For those investors who are affected, the uncertainty of the future poses a problem; it is more important than ever to contact your legal and tax advisers to implement both short-term and long-term strategies. It may be advisable to reevaluate any current gifting or lifetime transfer strategies where family members are involved. An aggressive approach would involve accelerating gifts before the regulations can be enacted, while a more conservative approach may call for curtailing the reliance on the affected valuation discounts in any gifting program. Changes in ownership structure may also be advisable, especially for family partnerships and family limited liability companies with significant real estate holdings. For example, given that tenancy in common may escape coverage under the proposed regulations, such an ownership form may reduce the effect of the loss of discounts. Finally, it is important to keep informed of tax law changes coming from Congress, as sweeping reform (beyond the valuation issue) could be on the horizon.