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Down Market Opportunities
Working Together on Passive Income and Estate Planning Goals
A family uses depressed property values to sell an interest in income-generating commercial property, using fractional interest discounting along with the applicable federal rate for an intra-family loan.
- Selling certain assets among generations, rather than gifting, can be used to preserve lifetime gift and estate tax exclusion.
- Transferring a share of an asset unlocks the possibilities of fractional interest discounting.
- Loans among family members must be documented and at market-rate interest to avoid negative tax repercussions, but this rate is much lower than commercial loan rates. Using a loan instead of a gift can be advantageous in some circumstances.
Situation
Finding the opportunity in a vacancy
Situation
Finding the opportunity in a vacancy
Katie and Ben are expecting a third baby and looking for ways to boost their income.
They have been thinking about finding a commercial real estate investment to add to their portfolio, hopeful that depressed real-estate values will offer a bargain but also worried that financing the purchase at the highest interest rates in 20 years will take a painful bite out of the asset’s cash flow.
Katie’s aunt and uncle, Gary and Susan have a variety of investment assets including a portfolio of five investment properties. One of these commercial properties is a two-tenant retail building in Austin, Texas. In late 2022, one tenant vacated while interest rates soared and market values of property plunged. They lamented the circumstances and worked with their Northern Trust real estate advisors to evaluate the costs to fill the vacancy at the property within the context of their comprehensive portfolio goals and lifestyle spending.
Discussing the sluggish market conditions at a holiday dinner, the relatives saw a potential opportunity. Gary and Susan, with no children of their own, were incredibly generous and regularly looked for ways to strategically transfer assets to younger family members. With the half-vacant property’s value likely to be close to as low as it had been since they bought it, Gary and Susan wondered if it might be an advantageous time to transfer it to their younger relatives. They set up a meeting with their advisor to get into the details and make a plan.
Solution
Shifting wealth and creating income
Solution
Shifting wealth and creating income
The property was worth $2 million in 2020 and generated $100,000 in annual net income.
But sitting 50% vacant at the end of 2022, as the economic consequences of inflation and rising interest rates were being felt, its value dropped dramatically. With the guidance of their Northern Trust commercial real estate advisors, the couples reviewed property documents and analyzed the potential transaction. They uncovered mutual benefits and the couples moved forward with plans for a transaction involving a portion of the LLC.
They had the property appraised and obtained a fractional interest discount study on the property’s ownership entity, a limited liability company. With the appropriate discounts calculated, the couples agreed to a sale of a 50% membership interest in the LLC to Katie and Ben for $562,500.
Rather than structure the transaction as a gift between the couples that would trigger tax consequences, Katie and Ben instead paid 10% in cash and borrowed the balance from Gary and Susan at the 4.25% applicable federal rate, the minimum interest rate required for personal loans by U.S. regulation, in effect in December 2022. This structure optimized the income available to both couples, kept the financing costs low and manageable for Katie and Ben and allowed Gary and Susan to shift considerable value out of their estate with no impact on their lifetime gift and estate tax exclusion.
Outcome
Cashflow projections and higher returns
Outcome
Cashflow projections and higher returns
Once a new tenant is in place, the property earns the same rent as before.
The couples split the revenue, each getting about $20,000 in the first year. Katie and Ben also pay $32,911 in loan payments to Gary and Susan, a schedule that will have the principal and interest paid off in 25 years at an interest rate that is lower than the rates on commercially available loans for income-producing properties. By the third year of the investment, the younger couple keeps about $18,000 of net cash flow after re-tenanting, and are projected to have an average annual cash on cash yield of 14% on their invested capital, achieving their goal of passive income, while Gary and Susan have moved an appreciating asset out of their estate without using up any lifetime or estate exclusion. The older couple continues to receive $84,000 annually between property income and loan payments.
The math
Two generations of a family are able to unlock higher returns, provide extra cash flow and achieve estate-planning objectives by using an intra-family loan to transfer a share of an income-generating property from the older to the younger generation.
Working as a family, two generations were able to use a real-estate market downturn and an unfortunate vacancy at a commercial investment property to advantageously shift income-producing assets. By taking strategic and unified action, the two couples achieved higher returns than if the family members had acted individually, while fulfilling other wealth and estate-planning goals. In close partnership with experienced real-estate advisors, these relatives confidently moved forward with a plan that accurately evaluated the property’s value and avoided undesirable tax consequences.
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