The Deal of a Lifetime – Essential Asset Protection Strategies for Real Estate Entrepreneurs

Those who have earned wealth through real estate will tell you it comes hard fought and is won deal by deal, zoning board by zoning board, tenant by tenant. Ultimately, as the net worth accumulates, it is likely to be highly concentrated in this single asset class – and you might never meet a real estate entrepreneur who would have it any other way. That said, the more concentrated the assets, the more concentrated the risk. But there are a myriad of strategies that can help protect these assets while they are being accumulated, and techniques to keep them safe and intact through the wealth transfer process.

If you are an entrepreneur whose net worth is concentrated in real estate, you have probably spent much of your life making deals and accumulating wealth based on the income and market appreciation of your properties. Like any investment class, as you know, real estate carries its own particular risks. Unlike other investment classes, however, these risks may have less to do with the market performance of the assets, and more to do with taxes, succession planning and the legal entities in which the properties reside.

If these risks go from threat to reality, they can lead to substantial erosion of net worth during your lifetime, and all too often, to asset sales under duress and a general breakdown in your best-laid plans for a smooth transition of wealth to your spouse and future generations.

The following outlines a series of strategies that can protect your assets while you’re accumulating them, as well as, through the process of passing them to the next generation. If you’ve spent your career in this space a number of these will be familiar to you; others perhaps not so much. But with the help of legal, tax and wealth advisory counsel, it is possible to have effective strategies in place at every stage; so that when the time finally arrives to pass the baton, you will be ideally positioned to turn your lifetime of deals into your family’s deal of a lifetime.

Wealth Creation

RISK:

Lack of privacy; too much wealth transparency for nosey relatives or potential litigants.

REMEDY:

Place properties in revocable trusts (or land trusts in states where they are available). The properties are titled to the trusts, not to you, so when someone gets curious enough to search public records about what you own and what they might get their hands on, the property won’t show up. All of your trusts can use the same person or entity as trustee (or multiple, as you wish) and, with you as trustee, you continue to control all aspects of the property as if you owned it directly, and the trust can be discontinued whenever you like. Note: this structure does not provide any exemption from taxation or legal liability protection.

RISK:

Liability exposure to tenants or predatory litigants.

REMEDY:

Create separate LLCs or corporations for your properties. This is more complex than multiple properties with a single LLC, but if one property becomes involved in a lawsuit the others will be out of reach.

RISK:
Your high capital gains tax obligation eventually grows to a point where it forces you to hold a property you would have otherwise decided to sell.

REMEDY:

Where there’s a realized tax liability, aside from offsetting the gain by selling other properties that might be in a loss position, there is not much you can do. Think instead about properties where this is not yet true but will be in the future – there are steps you can take now (read on) and you will thank yourself later. In the meantime, if you find yourself with current unrealized capital gains but want to exit your holding, there are a few options.

• Instead of selling the real estate directly, donate it to a charitable remainder unitrust (CRUT) and have it make the sale. The CRUT structure defers your tax on the gain, and the tax could eventually disappear altogether when the trust’s term ends. With a CRUT, the trustee, which could be you, sells the donated property without generating immediate capital gains tax (because the sale is within a tax-exempt charitable trust). The full untaxed value of the sale proceeds are then reinvested, and your trust pays you a percentage of its value each year (minimum 5%/maximum 50%) for a number of years or your life expectancy. If you work with your advisor to structure the portfolio correctly, those payments may grow over time, and a meaningful level of them will be taxable to you at the long-term capital gains rate instead of as ordinary income.
• If your motivation in selling is to fund a charity, but you hate the idea of the IRS being your major beneficiary, you can donate the property to a donor-advised fund (DAF). Your donation erases any capital gains tax obligation, and the DAF can, in turn, sell the property free of tax, creating a source of cash to fund charities at your recommendation and over your time frame. In each of the above cases there, of course, is also a significant upfront income deduction available because of the charitable gift.
• Invest in an Opportunity Zone (OZ) Fund. An OZ fund allows you to invest realized capital gains in it (if done within 180 days) and defer taxation on those gains until 12/31/26. Additionally, and powerfully, if the investment in the fund is held for at least 10 years, there is permanent exclusion of capital gains on any gains the fund itself enjoys.

REMEDY:

If you don’t need all the cash from the sale of your property upfront (and could do without the full upfront taxable gain) you could structure the transaction on an installment sale basis. That way a proportionate amount of the taxable capital gain is realized with each installment payment, but not all of it, all at once.

RISK:

A sharp downturn in real estate valuations will expose your over-concentration in this single asset class. The closer you get to a liquidity event, the greater the risk that a poorly timed market downturn could materially damage your net worth, at exactly the wrong time. If it is ever your intent to monetize your holdings in the future, whether to fund your lifestyle or to cover estate tax, ignoring this risk could force property sales that are at odds with your vision and long-term strategy.

REMEDY:

Diversify your assets beyond real estate and/or beyond concentrated real estate holdings in a particular market, adding additional properties or asset classes to act as a hedge. These include:

• Leverage property(ies) for cash; reinvest away from real estate using strategies that have low correlations to real estate.
• Execute a 1031 tax-free exchange. This allows you to exchange a property for another property type that helps you diversify your holdings away from one market in which you may have a concentration into smaller multiple properties across different markets, types of real estate and cash flow streams. You can leverage your equity in the new properties as advisable to free up cash to further diversify to different asset classes beyond real estate.
• Consider a sale/lease-back, which lets you retain use of the property and use the resulting lease payments to offset other taxable income. Your sale is a taxable event, but you can minimize the impact if you time your sale to a period when you have offsetting losses elsewhere.
• Engage in an intra-family note-financed sale, by which you sell the property to a family member in exchange for a note. For income-generating properties, the note can be a source of cash flow and asset diversification for you, while also freezing the asset at its current valuation for estate planning purposes.
• Contribute your property to a tax-deferred upREIT, (Umbrella Partnership REIT) in exchange for shares in the REIT partnership. These offer up to a seven-year “lock out” before your contributed property is sold, which defers your capital gains tax. Depending on the partnership structure, the REIT shares can potentially be sold or leveraged, creating liquidity to reinvest for diversification.

RISK:

Preexisting debt with recourse obligations and personal guarantees from a bygone era in your credit history.

REMEDY:

Invite a competing lender or your advisor to reexamine your loan agreements. Where indicated and feasible, refinance as non-recourse and without personal guarantees.

RISK:

A liquidity crunch hinders your cash flow or limits your flexibility to make opportunistic buys. Resolving it with a property sale carries too much tax liability.

REMEDY:

Leverage property(ies) and extract cash for reinvestment, tax-free.

REMEDY:

Additionally, see upREIT discussion above.

 

Succession

RISK:

Family and legal chaos upon your passing – too many real estate entrepreneurs die without clear documentation of their wishes for asset disposition and transfer, or governance responsibilities for decision making.

REMEDY:

In concert with key colleagues or family members, and trusted advisors, develop and document a succession plan – ideally as part of a long-term planning process.

Like it not, plan for it or not, one day your portfolio will run without you. Forward-thinking entrepreneurs don’t wait until they are no longer around to provide advice. Instead, they develop a plan for the transition of decision making, often first involving operations and, later, deal making. This can be more challenging than running the business itself, but there are ways to make the transition easier, including establishing roles, creating a board of directors and setting a timeline for the key stages in the transition.

There is much more to do than this article can do justice to, but you and your family members will want to think through your unique issues; family dynamics; your children’s interests, skills and shortcomings, and the consequences of your decisions.

And because the proverbial beer truck can strike at any time, more immediately you will need to ensure that all of your holdings and accounts are documented, along with how to access them and who to call, in what order. Your trusted advisor can work with you on this essential step of your succession planning.

 

Wealth Transfer & Tax

RISK:

The full brunt of the estate tax could hit your family, forcing property sales to cover the obligation and dramatically eroding what passes to your spouse and children.

REMEDY:

Well before your demise, use the tax law to freeze asset values where they stand today, effectively kneecapping the gains that would be subject to estate tax when you pass. One way to do this is by setting up a trust for your spouse or heirs, which will buy selected assets from you. You fund the trust with cash equal to 10% of the value of the asset, the trust then purchases the assets from you, via a note. The sale is 100% free of both capital gains tax and any recapture (because it is a grantor trust) and the property in the trust, plus its future appreciation, are out of your estate and exist for the benefit of your heirs. And unless you generously named the IRS as a beneficiary, they get nothing.

A word of caution is warranted here: the Treasury Department is not amused at being left out of so many estates and has threatened, so far unsuccessfully, to regulate this technique out of existence.

REMEDY:

Take advantage of strategies that enable a valuation discount, which will shrink the value for estate tax purposes. One common technique is to move the assets into a legal entity (a LLC or a family partnership), and then transfer those interests to your heirs or a trust for their benefit. The IRS recognizes that this hinders the marketability of the asset, and renders you a non-controlling owner. Both of these attributes are deemed to discount the value of your holding, thus eventually reducing your family’s potential estate tax liability.

RISK:

Even having deployed the strategies above, insufficient liquidity at your death could force your family to sell off properties in order to cover the estate tax, inconsistent with your intentions.

REMEDY:

Prior to death, proactively establish an irrevocable life insurance trust (ILIT) and have it purchase Private Placement Life Insurance (PPLI). The investment portfolio in the life insurance policy provides tax-free compounding over time and therefore can eventually generate tremendous liquidity. To access the funds in this trust your estate could borrow from it, employing a technique known as a Graegin loan. A Graegin loan, if properly structured, not only generates liquidity, it also allows the estate to shrink the tax it owes, dollar for dollar, by the total of the interest payments that will eventually be made.

REMEDY:

On the other hand, if this forward planning had not been done, the estate could simply approach a third party, usually a commercial lender, and negotiate a Graegin loan with them.

RISK:

Your estate plan may already include trusts that, as a price of moving assets out of the taxable estate, cause you to lose control over them.

REMEDY:

While some strategies do necessitate a loss of control, it is less so in the case of others — such as transfers to a Grantor Trust or GRAT. When there is loss of control it can be mitigated by naming a trusted friend or advisor as trustee where one is required. While they, of course, must act independently, they best understand the intent of the trust and the needs of its beneficiaries.

RISK:

A slip n’ fall lawyer and a greedy soon-to-be-ex son-in-law (who might or might not be the same person) may have designs on the empire you have worked so hard to build.

REMEDY:

While formal asset protection trusts are beyond the scope of this article, it is important to know that most trusts established for estate planning purposes have the added benefit of removing those assets from the grasp of creditors and possibly predatory in-laws!

RISK:

Over time your estate plan may fall out of date as holdings and ownerships change. Additionally, techniques and planning strategies that made sense years ago may no longer be viable, and there may be new, more effective strategies that you are not aware of.

REMEDY:

Every three to five years – and whenever there are major events and changes in your life – your estate plan should get a check-up.

About Fieldpoint Private

Fieldpoint Private is a boutique private banking firm established at the onset of the financial crisis by 31 individuals including former Chairmen and CEOs of some of the most well-known and successful financial and consumer firms in America. Their intent was not to craft a firm that would emulate the large, established institutions, but to serve as an alternative. Dedicated to meeting the comprehensive financial needs of highly successful individuals, families, businesses and institutions, Fieldpoint Private offers a powerful combination of private personal and commercial banking services directly and in partnership with our clients’ most trusted advisors. In 2021, Fieldpoint Private founded Fieldpoint Private Trust, increasing the breadth of capabilities available to serve our clients in both sole trustee and co-trustee capacity.

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