Your Estate Plan: Could This Happen To You?

The combination of reduced asset values and the increase in the estate tax exemption between 2008 and 2009 has created a situation in which the “Law of Unintended Consequences” may cause devestating consequences for the surviving spouse.

Assume that in 2008, a married couple had a net worth of $10M and instituted a very common estate plan, wherein at the death of the first spouse the then applicable estate tax exemption amount ($2M in 2008) is allocated to the children or a trust established for their benefit (the “Bypass Trust” as it is sometimes called). Under this estate plan, the balance of the estate is allocated to a trust for the surviving spouse. At that time, the net result of such a plan is as follows: If the husband had died in 2008, the children (or their trust) would have received $2M and the wife (or her trust) would have received $8M, which would have achieved the result the couple desired (see left side of the illustration below).

BUT, WHAT IF NEITHER SPOUSE DIED IN 2008…

Assume that in 2009, due to the economic downturn, the estate assets decreased to $6M, while the estate tax exemption amount increased to $3.5M. If the couple did not visit their estate planning attorney to review their plan in light of these changes, then their plan will very likely lead to unintended consequences. Note the result if the husband dies in 2009 (or later) without the plan having been updated:

With a $6M estate, the estate tax exemption amount of $3.5M passes to the children (or their trust, i.e. the Bypass Trust), while the balance of $2.5M passes to the wife (or her trust). As is reflected in the right side of the illustration, the wife’s share has been reduced from $8M to $2.5M, due to lower asset values and the increase in the estate tax exemption amount.

This result could not be what this family intended, but this is exactly what would happen if the estate planning documents are not reviewed and amended to reflect the changes in asset values and the estate tax exemption amount.

Client-Alert---Your-Estate-Plan---Could-This-Happen-To-You-2

LESSON LEARNED

It is important to have your estate planning documents reviewed by your attorney every year to ensure you avoid potential unintended consequences like those described above.

If you would like to make an appointment and have our firm review your estate planning documents, please contact me at your convenience.

About the Author: Jeffrey M. Verdon is an estate/income tax planning and asset protection planning attorney with offices in Irvine, CA and Las Vegas, NV. He can be contacted at (702) 341-6009 Ext 1, or via email at jeff@jmvlaw.com.

Mortgage Over Basis Problems? Not Anymore… How To Deal With Phantom Income

If you (or your clients) have owned real estate for a long period of time, you are most likely faced with mortgage liabilities in excess of your adjusted tax basis in the real estate.1 Excessive depreciation deductions and mortgage refinancing have created what is commonly referred to as “phantom gain,” which is the excess of the mortgage liability over adjusted basis (also known as a “negative capital account”).2

If the value of the property has declined to a point where the mortgage is more than the property is worth and the property is potentially facing foreclosure, the real estate owner will soon learn that he/she will have to report and pay state and Federal income taxes on the entire phantom gain if a foreclosure sale occurs, even though there is no equity in the property.

For those who have this “phantom gain” exposure, but are not facing foreclosure, if they intend to sell the property for a small profit, the resulting state and Federal income taxes on that phantom gain may far exceed any cash netted from that sale.

EXAMPLE

A partnership owns a residential rental building. A 40% Partner’s allocable share of the building is as follows:

Adjusted Basis: $2,500,000

Mortgage: 7,500,000

Gross Value: 10,500,000

Equity: 3,000,000

The partnership decides to sell the building and distribute the cash to the partners. The 40% Partner will receive a distribution of $3,000,000 in cash.

The total gain allocated to the 40% Partner upon a sale of the building for its gross value would be $8,000,000 (Gross Value minus Adjusted Basis). The minimum gain (i.e. the “phantom gain,” as measured by the liability on the asset minus the adjusted basis) would be $5,000,000. Thus, Federal and state income taxes will have to be paid on the $5,000,000 tax gain.

Likewise, if the 40% Partner sells the partnership interest for its value, receiving $3,000,000 in cash, the entire $8,000,000 gain is reported immediately. The 40% Partner’s amount realized includes the mortgage encumbering the real estate, even though the Partner is not personally liable on the mortgage. The “phantom gain” is therefore $5,000,000.

If the $8,000,000 gain is taxable at a combined effective tax rate of approximately 35% (taking into account the 35% rate for the Section 1245 depreciation recapture, the 25% rate for Section 1250 depreciation, the 15% rate for the remainder of the capital gain, as well as the 10.5% California state income tax rate), the total income taxes on the $8,000,000 gain would be $2,800,000, leaving the Partner with only $200,000 after the payment of all Federal and state income taxes.

SOLUTION

There is a technique approved by the IRS that can be used if the real estate is already owned by an entity treated as a partnership for Federal income tax purposes. If a foreclosure is anticipated, and the foreclosure proceedings have not yet begun, this technique can be used to shift the reporting of the phantom gain to a charitable remainder trust. Since the charitable remainder trust is tax-exempt, there will not be any income taxes on that gain. Alternatively, if a voluntary sale of the real estate is anticipated in the future, this technique can be used to defer the reporting of the phantom gain for up to 20 years. 3

The technique is designed to eliminate the excess of mortgage over basis by what is commonly referred to as borrowing basis from other assets. If the taxpayer has assets that he/she intends to hold for a long period, or assets that have significantly declined in value, the income tax basis in these assets can be shifted to the partnership that holds the phantom gain real estate. Using the situation described in the above example, the 40% Partner needs to borrow $5,000,000 of basis from other assets. The other assets are not limited to other real estate. Any kind of assets will suffice, even personal assets. For example, if the partner invested in the stock market and owns a portfolio of stocks with a tax cost of $5,000,000 and a value of only $1,000,000, these loss assets are ideal assets to use for the borrowing basis technique. In fact, any assets with a tax basis can be used, including personal assets such as a residence, an art collection or a life insurance policy.

If you or your client is facing this situation and would like to discuss the strategy to resolve this issue, please contact the author at (702) 341-6009 x1 or e-mail jeff@jmvlaw.com.

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1Taxpayers who have exchanged their real estate interests for interests in a REIT typically have this same exposure.

2Low adjusted basis can occur if the buildings have been fully depreciated, if accelerated depreciation deductions were generated from a cost segregation study, a refinancing occurred or a tax-free like-kind exchange took place.

3The technique can also be used for tax-free like-kind exchanges under § 1031 if the amount of mortgage financing for the property acquired is not sufficient.