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.