Tennessee Estate Planning Law : Tennessee Estate Planning Lawyer & Attorney : Bryan Howard : Howard & Mobley Law Firm : Nashville, Chattanooga, Memphis

A previous blog discussed the Mitchell case, in which long-term leases substantially reduced the estate tax value of certain real property. A very significant issue did not have to be decided by the Court because the IRS stipulated that the property gifted by the decedent as well as the property still owned by the decedent at the time of his death would receive fractional interest discounts.

Six days before he died, Mr. Mitchell gave a 5% interest in his beachfront property and his ranch to a trust for his sons. The IRS stipulated before trial that the 5% gift of the beachfront property would receive a 32% fractional interest discount and the 5% gift of the ranch would receive a 40% discount.

The IRS also stipulated that the 95% interests in the beachfront property and the ranch that were owned by the decedent at the time of his death would receive fractional interest discounts of 19% and 35%, respectively.  The combined fractional interest discounts saved more than $1 million of estate taxes.

Numerous court decisions have recognized significant fractional interest discounts. In my experience, discounts of 25% to 35% are typical.  These court decisions influenced the decision by the IRS to concede the discounts in the Mitchell case.

The decedent’s revocable trust devised the 95% interest to the very same trust to which he had gifted a 5% interest just 6 days before his death. Therefore, the trust for the sons received a 100% ownership of the property. However, by dividing the transfer of the property to the sons’ trust into two separate portions, Mr. Mitchell significantly reduced his estate taxes.

Mr. Mitchell's estate was fortunate to receive the discounts since he made the gift after he became very ill due to cancer. Some prior cases have disallowed otherwise valid discounts for deathbed gifts. Ideally, the gift should be made at least one year before death and certainly before a diagnosis of a terminal illness.

Whenever you plan to make a gift of real estate, you should consider giving part now and part later (or part to one donee and part to another donee). Further, if you are planning to devise real estate through your Will, you should consider giving a small percentage interest in your lifetime and the remainder through your Will.  Now is an excellent time to make a gift due to depressed real estate values and the temporary $5 million federal gift tax exemption.

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In a recent case decided by the Tax Court, Estate of James L. Mitchell v. Commissioner, T.C.M. 2011-94, the Tax Court determined that the long-term leases on a ranch and home owned by the decedent significantly reduced the values of the properties. The home was subject to a 20-year lease. The value of the home without a lease was $14 million. The court determined that the value of the property subject to the lease was $6 million. This represents a 57% discount attributable to the lease.

The ranch was subject to a 25-year lease. The value of the ranch without a lease was $13 million. The value of the ranch with the lease was $3.37. This represents a 74% discount due to the lease.

One might think that the lease payments were below market. However, evidence presented at trial indicated that the rent charged with respect to both properties reflected market value. The significant decrease in value is attributable to the way properties subject to a long-term lease are valued. Appraisers value the stream of rental income payments plus the value that you could sell the property for after the lease term is over. This stream of payments is discounted by the rate of return that an investor would require to take over the stream of payments. Often, the discounted value of the stream of payments is lower than the value that you could sell the property for if the property did not have a lease.

The properties owned by Mr. Mitchell were somewhat unusual. A more typical circumstance is real estate leased to a family business. You should consider leasing the property for a long-term. 

After a long-term lease is entered into with respect to a property, you should consider some type of gifting transaction. Rental real estate works well for a direct gift, a GRAT, or an installment sale to a grantor trust.

In summary, if you have rental real estate that you intend for you and your family to own for several years, you should consider leasing the property for a long term. The lease can significantly reduce estate taxes upon your death.
 

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I recently met with clients who own a very valuable home in Florida. We discussed the potential use of a revocable trust to avoid the need for ancillary probate in Florida following their deaths. We subsequently discussed ideas for reducing their estate taxes, including the use of a QPRT for their Florida home. My clients decided to proceed with a QPRT, but decided not to use a revocable trust since it is not needed for avoiding Florida probate.

The wife is a few years younger and has no known health concerns; therefore, she is the better candidate to establish the QPRT. She will transfer one-half of the home to a QPRT with a 10-year term and one-half of the home to a QPRT with a 13-year term.

Using two QPRTs instead of one accomplishes two purposes: First, it allows a fractional interest discount for both halves of the house. This can be as much as 25 or 30 percent. Second, the mortality risk is hedged somewhat. If the wife dies after 11 years, she will have succeeded in removing one-half of the home from her estate. We are hoping that she survives at least 13 years and removes the whole house from her estate.

The combined GRAT discount and fractional interest discount amount to about 50% of the current value of the home. This means that my clients will be making a $2.2 million gift at the current time. There are no federal gift tax concerns due to the current $5 million federal gift tax exemption. Because the gift is Florida real estate, it will not be subject to Tennessee gift taxes. Thus, this asset is an ideal way to take advantage of the current high federal gift tax exemption without having to pay Tennessee gift taxes.

It is likely that the home will appreciate between now and the date of death of my clients. Assuming the wife lives at least 13 years, none of the appreciation will ever be subject to transfer taxes.

In summary, when you own a home in another state, you might consider using a QPRT to avoid ancillary probate and to reduce estate taxes.
 

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A lot of my clients own stocks in the healthcare industry. Many stocks in that industry have been battered the last three days, primarily due to concern over Medicare cuts.

I have one of my clients trained to recognize a dip in the market as a good time to establish a GRAT. He previously established 3 GRATs with 2 year terms. We started his first GRAT in the spring of 2008. As you might imagine, this GRAT did not perform well due to the collapse of the stock market. However, his other two GRATs are performing very well and will provide a lot of tax-free funds to his children, who will use the funds to repay loans made to them by their mother.

Recognizing that the significant decline in the value of his healthcare stocks creates a gifting opportunity, he called me today to initiate a fourth GRAT. Only time will tell whether this is a temporary price decrease or a prolonged decrease in the value of the stock. If the combined appreciation and dividends from the stocks exceed 2% over the next 2 years, his children will receive all of the excess.

The great thing about a GRAT is that if the stock goes up, your children win; if the stock stays even or goes down, all of the stock and dividends will be returned to you and your children do not lose anything.
 

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