by Neil F. Axler and Craig Stephanson
Same Old Story: Now Is The Time for Planning with Real Estate Agents
As we enter the 2024 new year, there are several financial, legislative, economic and political undercurrents that are lining up for a perfect storm of opportunity for families with real estate wealth and their estate advisors. All of these happenings are occurring as certain tax cuts are expected to sunset soon and the U.S. faces increasing political uncertainties. However, wherever there is a changing tax landscape and uncertainty, there are opportunities that abound, especially now for real estate owners looking to take advantage of wealth planning, succession planning and the associated gifting strategies.
TCJA
Understanding and taking advantage of these opportunities first starts with a quick refresher on the Tax Cuts and Jobs Act (“TCJA”) and its legislative sunset provisions. The TCJA significantly increased the lifetime exemption and the generation-skipping transfer (the “GST”) tax exemption, each of which now stands at $13.61 million per person. What this means to individuals with significant wealth is that a married couple can give away (and thus remove assets from their taxable estates) $27.22 million without incurring any gift or estate tax. These high exemption levels have meant that fewer estates have been subject to federal estate taxes and fewer taxpayers have paid federal gift taxes. This may soon change because the TCJA did not make these increased exemptions permanent. Rather, without further legislative action, they are set to revert or “sunset” back to pre-TCJA levels at the end of 2025, that is, $5 million, adjusted for inflation (which many predict will put it around $7 million). Additionally, at the end of 2025, the current 40% maximum gift and estate tax rate of 40% will increase to 45%. Now is the time to prepare for the sunset and take advantage of the very high lifetime and GST tax exemptions before they are significantly reduced.
In conjunction with this tax planning opportunity, there are a set of unique occurrences in the U.S. real estate markets that are further enhancing the need for wealthy real estate owners and investors to act soon. Real estate values are in a state of flux right now, with changes likely in the coming year.
Commercial Real Estate
The high interest rate environment will continue to negatively impact commercial real estate. However, real estate investors are beginning to be more confident that the Federal Reserve will be more accommodating in 2024, which could positively impact values. According to Capital Economics, Commercial Real Estate (“CRE”) had a $590 billion wipeout in 2023 and is projected to lose another $480 billion in 2024. This instability makes real estate underwriting difficult and valuations can differ significantly over time. It is imperative to understand the strengths and weaknesses of different property types.
Core and non-core office markets are continuing to lose value. Since the pandemic, landlords have struggled to keep tenants due to the genie being let out of the bottle - workers can be very productive at home and Wi-Fi works very well. The labor market is still tight for junior professionals and many companies have to accommodate work-from-home (“WFH”) for their existing workforce and for optimal recruitment initiatives. The health of the office sector is a tale of two cities – Ultra Class A properties versus everything else. The modern Class A properties with premier technology and amenity space are doing quite well, while all others are suffering. Keys for many office buildings nationally are “going back to the banks” and other buildings are suffering with low occupancy, exceptionally low rents and short lease terms. Office buildings that have vacancies are suffering from the exuberant amount of capital needed to attract tenants – significant tenant improvement allowances, extremely competitive leasing commissions and free rent.
The current interest rate environment is also creating opportunities for real estate owners and investors. Interest rates are near their highest levels in decades. With debt rates so high, required equity returns are low, thus driving down the values of most all income producing real estate properties. While certain market segments and property types are still supported by low capital rates, imagine what is going to happen when interest rates go down? Naturally, as rates go down, real estate values will go up. It is widely anticipated that during 2024, the Federal Reserve will start to lower interest rates. In fact, just this past December the Federal Reserve held its key interest rate steady for the third straight time and set the table for multiple cuts to come in 2024 and beyond. It appears from indications that the Federal Reserve is set to decrease rates potentially three to four times in the coming year.
Opportunity
Now is the perfect opportunity to gift real estate, permanently remove these assets from your estate and pass the future anticipated appreciation on these real estate assets gift and estate tax-free to the next generation of family members:
Real estate valuations are low and expected to increase as mortgage interest rates begin to gradually drop;
Landlords and tenants are sorting through the post-pandemic real estate markets; and
The lifetime and GST tax exemptions are high but anticipated to revert back to pre-TCJA levels.
But wait, there is more! What if you could further supercharge this gifting strategy? Through the leveraging of valuation discounts, you can. By using valuation discounts, these gifts of real estate can be effectively valued even lower, thus using up less lifetime and GST tax exemptions, passing on even more future asset appreciation to the next generation and beyond, and eliminating the family’s current estate tax burden.
Instead of gifting fee simple title in the real estate, real estate that is owned through partnerships or limited liability companies can be fractionalized and gifted at lower values by utilizing valuation discounts. These fractional, minority interests lack control over the underlying real estate and lack marketability as they are private, subject to transfer restrictions hard to value equity securities for which no sales market or exchange exists. These lack of control and lack of marketability valuation discounts can legally reduce the value of the fractional interest below its proportionate value of the real estate by meaningful amounts. Up front planning is needed in these situations to supercharge the benefits. Working with qualified real estate appraisers for the real estate and qualified business valuation professionals for the valuation discount analyses can unlock these immensely powerful tools.
Even after the opportunities presented by sunsetting tax provisions, currently low real estate values and the changing interest rate environment, there are still more happenings creating opportunities for real estate owners in the area of estate and gift tax planning:
1. 2024 is an election year with potentially huge ramifications. With Congress unable to agree on anything and political parties so diametrically opposed on just about every economic, social and political issue, the U.S. is facing a cripplingly uncertain future.
a. With every election cycle and change in administration comes potential legislative changes that can impact tax strategies. For years, there have been discussions of eliminating valuation discount strategies in family entities. Investors in real estate (especially those minority partners or members in entities where they cannot control the underlying property) do not like uncertainty.
b. Investors prefer reliability, assurance, predictability and consistency in their investments. Such uncertainty in real estate values, changing interest rates and uncertain tax and fiscal policies are risks that can impact the fair market value of these types of investments and thus tend to increase valuation discounts.
2. Another unique opportunity exists for the above gifting strategy as a result of the evolving IRS budget. It has long been known that the resources of the IRS are, at best, strained. However, in August of 2022, the Inflation Reduction Act (“IRA”) passed. Part of this legislation included a line item in the Federal budget of $80 billion to help improve and better fund the IRS (however, the IRS funding was later reduced by $1.4 billion by the debt ceiling and budget cuts package passed by Congress in 2023 and a separate agreement took an additional $20 billion from the IRS over the next two years). Additional funds will be provided for new computer technology and attracting and retaining a much improved, skilled workforce. These new initiatives will likely focus on the detection of noncompliance and enforcement of tax laws, especially for high-income individuals. It is widely anticipated that gifting strategies for high-net-worth real estate owners such as those discussed here will likely be scrutinized more in the future. However, while some changes started in the 2023 fiscal year, which started on October 1, 2023, the Federal government and the IRS are not known for speed and efficiency. It will take considerable time before this funding fully takes effect. Herein lies the opportunity. The old adage “make hay while the sun shines” comes to mind. Initiate now and make these gifts of real estate interests in 2024 and 2025 before the IRS is fully staffed and operating under its new, more robust system.
In conclusion, now is the time to act and make transfers of real estate interests to take advantage of the benefits of tax-free gifting while
The lifetime and GST tax exemptions remain high for a limited period;
Valuation discounts are still permissible;
Real estate values are low but likely to increase as interest rates drop;
Our future political and legislative landscape is uncertain; and
The IRS is still only in its ramp up/planning stage of its enforcement growth period.
It is also important to remember and learn from our past. We were in an analogous situation in 2012. The Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 established a high exemption for gift, estate and GST tax and a low maximum tax rate. Those provisions were set to sunset (just like TCJA is) on December 31, 2012, when the then lifetime and GST tax exemptions were due to decrease significantly and the maximum tax rate was scheduled to increase substantially. Business valuation professionals, real estate appraisers and estate planning attorneys were busy, over-loaded with transfer planning, and working around the clock in December of 2012 to meet the needs of clients looking to take advantage of the same gifting strategies discussed here. There undoubtedly will be a surge in demand for real estate and business valuation services in 2024 and 2025. Accordingly, it is important to do your planning now and get into the queue sooner, rather than later. These types of opportunities present themselves only so often and now is the time to act.
Neil Axler, MRICS is a Managing Director with B. Riley Advisory Services, based in New York City. Drawing on nearly three decades of expertise in valuation consulting, encompassing individual assets and portfolios of income producing commercial, industrial and residential properties, Neil currently leads the national real estate appraisal practice of B. Riley. Neil’s real estate appraisal assignments have included major office buildings, multi-family residential, regional shopping centers, industrial facilities, warehouses, hotels, subdivision land, data centers, special-use and complex mixed-use valuations. Neil has extensive real estate valuation experience with trust and estate and litigation matters for high net-worth families.
Craig Stephanson, CVA, began his career in public accounting in 1981 at Arthur Andersen & Co. providing auditing and income tax planning services for public and private companies. He later served as Chief Financial Officer for several private real estate development and investment companies before joining Valuation Services, Inc. to provide valuation support services. Craig is now a Managing Director at Valuation Services, Inc. and is a leading expert on the formation and valuation of family limited partnerships. He specializes in the valuation of real estate partnerships for estate planning and administration, succession planning, divorce proceedings, partner disputes and litigation support.