Dear Friends,
It’s no secret that real estate prices have been going through the roof. Fueled partly by historically low interest rates, developers have been on a tear for the past 5 years to fulfill what, in some markets, has been an insatiable demand for homes.

If you or someone you know lives on the outskirts of a metropolitan area, you could easily find yourself in Gloria’s situation, with an aging parent who owns what once was inexpensive, “rural” property and an estate tax bill that will wipe out much of the appreciated value you stand to inherit.

This is the second of a two-part response to Gloria (you can read Part One here), who wanted advice on saving the family farm from the tax man and developers. While this can be a complicated subject, it doesn’t have to be, as demonstrated by this week’s suggestions.

Keep in mind, these estate planning techniques don’t just apply to land. They can also be used with a family business that has grown in value.

Dear Gloria,

As promised, here are some more strategies that could prevent the necessity of selling the family farm to pay the estate taxes when your mom dies.

Pittsburgh attorney Brad Franc, who specializes in business owners and wealthy clients, says a “family limited partnership” (FLP) is a way for Grandma to transfer the farm to you and her grandkids and get it out of her estate. The I.R.S. has been scrutinizing FLPs in recent years, so you’ll want to be sure you use an attorney who is experienced in this area.

But from my perspective, it’s complicated. And it’s expensive to set up. In other words, getting Grandma to buy into a “FLP” might be tough and you need to be sure it’s worth the trouble.

Franc says an alternative to a FLP would be for Grandma to segregate the farm into three parcels, with the family home in one, and the farmland divided between parcels #2 and #3. Instead of a partnership, Grandma could simply transfer Parcel #3 to you and your children as a gift, requiring that you all enter into a family “co-ownership agreement giving each of you an undivided partial interest in the farmland that requires unanimous consent on how the property is to be managed.” In addition, one of you would be unable to sell his/her fraction of it without the approval of all the others.

By including some additional provisions that would restrict the development of the property, Franc says the value of Parcel #3 would be less than what the land would bring without this agreement, which would let Grandma transfer more land than she otherwise could without incurring gift tax.

For instance, excluding the $600,000 family home, there is $2.4 million in farmland. Let’s say Grandma divides this evenly between the two parcels. Without the co-ownership agreement, Parcel #3 would be worth $1.2 million, since the land could simply be sold outright for development. However, the contract between the four owners prevents this from happening. As a result, the value of the land is reduced to take this difficulty into account. Let’s say that hypothetically it has a “discounted” value of $1,044,000.

After giving the four of you this land, Grandma will have exceeded her 2005 gift limit ($11,000 apiece) by $1,000,000 ($1,044,000-44,000). This also eliminates her lifetime excess gifting limit of $1 million. But here’s the important thing: This land and all future appreciation on it are removed from Grandma’s taxable estate.

In other words, even if the value of Parcel #3 increases to $4 million, since it now belongs to the four of you instead of Grandma, it is no longer subject to estate tax when she dies.

One more thing: when she subdivides the farmland, Grandma would enter into an agreement with you and the grandkids that she cannot do anything with Parcel #2 (which she still owns) unless the owners of Parcel #3 agree. Because of this, at Grandma’s death “the balance of the property left in the estate would also discounted” because nothing could be done with it unless the other family members agreed, according to Franc.

Each year she lives, Grandma can use her annual gifting amount to transfer another $44,000 ($11,000 x 4) worth of farmland from Parcel #2 into the parcel owned by you and the grandchildren without any gift tax consequences. Assuming your children are minors, one way to address the fact that they cannot legally own property would be to have each child’s interest in the co-ownership agreement held by a trust. This offers the added benefit of creditor protection.

Grandma “needs to feel comfortable about transferring” this property,” cautions Franc, who is a partner in the firm Houston, Harbaugh. Once the gift is made, she cannot take it back. In addition, if any of you were sued, creditors could attach your interest in the gifted property. And, of course, this can become a huge mess if your family doesn’t get along.

WARNING: Do Not Attempt This If You Have A Dysfunctional Family!

Here’s another approach. If Grandma is charitably inclined she can transfer a portion of the farmland to a charity such as the Nature Conservancy on the stipulation that it be preserved as open space in perpetuity. If she bequeaths the land at her death, her estate will get a deduction for whatever it’s worth at that time.

If Grandma is in a high tax bracket, she can also give the property while she is alive (i.e. a “gift”) and get an income tax deduction.

If she’s “land poor” and could use some extra income, she can give the property via a charitable remainder trust, a routine document that any basic estate planning attorney can set up. Basically, it’s a contract in which the charity agrees to pay Grandma income until she dies (or for a certain period of years) in exchange for receiving the property at her death. In this case, Grandma will get a tax deduction based on what the property is worth, less the income she will have received.

A note of caution: charities are always more than happy to arrange these trusts for you. Have you ever wondered why?

Turns out, if you set up your own trust, you can change the beneficiary. In other words, if you don’t like the way the organization is being run- the treasurer and the charity’s bank account both disappear (!) — you can designate that another charity receive your property.

But if you let the charity write the trust, you lose this flexibility. In other words, you’re locked into the property going only to that charity no matter what happens.

Let the donor beware,

Gail

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