The Estate Planning Conundrum: Maximizing Tax Benefits for Real Estate Investors with Significant Portfolios

There are two reasons why borrowing has become the tax-preferred method of financing a sophisticated real estate investment portfolio.

First is the ability to finance improvements with debt, which offers depreciation deductions. Second is the ability to make leveraged distributions through refinancing without paying immediate tax on the proceeds. The tax basis of assets steps up to fair market value at the time of the holder’s death, eliminating the deferred gain, so the income tax deferral upon a refinancing is even more attractive for heirs.

Naturally, there are caveats. When the assets are held until death, the basis step-up is mitigated by the potential estate tax to be paid by the decedent’s estate. If the real estate is gifted while its owner is alive, the basis step-up is lost entirely; instead, gift recipients generally receive a so-called carryover basis, which is the basis the transferor had in the gifted asset. So estate planning usually balances the benefit of shifting the value growth of an asset out of the estate against the loss of the basis step-up for heirs

The holy grail of tax planning for leveraged real estate is to achieve the basis step-up while transferring the appreciation before the holder dies. It isn’t easy to achieve: income and estate tax rules don’t coordinate well when real property has liabilities that exceed the tax basis of the property, what’s known as “negative capital.” Negative capital can occur when property is refinanced after it has increased in value or when depreciation causes the tax basis to decline below the debt associated with the property.

Some transfers may trigger taxable gain, so traditional estate planning techniques, such as grantor-retained annuity trusts or gifting directly to children or grandchildren, don’t work well. The gain on such transfers may result in income tax imposed on the transferor greater than any estate tax savings. Transferring real property with negative capital to a REIT won’t work either—such transfers also generate taxable gain.

So how can you minimize the tax impact of transferring real estate with negative capital? Owners can transfer properties with negative capital to an “umbrella partnership real estate investments trust,” or UPREIT. That transfer will continue the deferral of the taxable gain associated with their negative capital. An UPREIT is a combination of a traditional REIT and a limited partnership, referred to as the operating partnership (OP), and formed by having the owners contribute their interests in the appreciated property to the partnership in exchange for limited partnership interests in the OP. In contrast to a traditional REIT, which invests in real estate assets directly, an UPREIT holds the real estate assets in the OP, and the REIT conducts most of its operations through the OP. Umbrella partnership agreements generally provide limited partners with liquidity; after an initial holding period, they may either exchange their OP interests for shares in the REIT on a one-to-one basis, or be redeemed for an equivalent amount of cash. Although this conversion of OP interests to REIT shares will be a taxable event, the OP partner has the ability to time his exchange thus allowing for more efficient income and estate tax planning. OP holders also have the ability to separately borrow against their interest in the OP, without incurring immediate taxation, based upon the market value for the interests that is established from the redemption or conversion feature.

From an estate planning perspective, UPREITs are a wonderful tool. While the holy grail of tax planning may not be obtainable, sophisticated real estate investors should consider using an UPREIT to provide liquidity and flexibility to their income and estate tax planning.

(A version of this article originally appeared in Worth magazine.)