McNees Insights – Estate Planning News
March 27, 2019
IN THS ISSUE: Estate Planning for Real Estate Owners | Health Care Decision-Making in PA
Estate Planning for Real Estate Owners
Estate planning for valuable, illiquid assets presents a variety of challenges. With respect to real estate, planning challenges can be compounded due to fractional ownership, outside investors, and secured debt. This article will attempt to outline these planning issues and possible solutions.
Death Tax Planning
Currently, the federal estate tax exemption amount is $11,400,000 per person and the tax rate is 40%. A husband and wife collectively can exempt $22,800,000, of property from the estate tax. Therefore, many individuals, even though very successful, do not have exposure to the federal estate tax under the current law. However, the exemption amount will revert to 2017 levels (adjusted for inflation) in 2026 under the current law. The exemption amount most likely would be about $6,000,000 per person at that time. The current law may also be amended after the 2020 election cycle depending on the make-up of the government and the political climate.
The Pennsylvania inheritance tax is determined based on the relationship of the party inheriting the property to the decedent. A spouse is taxed at 0% and children are taxed at 4.5%. Siblings are taxed at 12% and all other transferees are taxed at 15%. There is no exemption amount for the inheritance tax.
If you are a real estate developer or investor, you need to assess the value of your properties. For commercial and industrial properties, you can generally use a reasonable cap rate with typical discounts for vacancies and other factors. For residential real estate developments, the value of the land will depend in part on the health of the housing market and the stage of land development but an experienced developer generally has sense of the value of the property being developed. The value for death tax purposes is fair market value less debt.
An obvious concern for any owner of real estate is making sure debts secured by the real estate are serviced in the event of the owner’s death. This is perhaps not as great of a concern for commercial and industrial properties that are rented and cash-flowing. For real estate in the development phase, this can be of greater concern.
Many owners of real estate personally guaranty the loans made to the entity that owns the real estate. Generally speaking, the death of the party guaranteeing the debt is an event of default for the loan. Consideration must be given to dealing with secured creditors by the estate of the party guaranteeing the debt. Often, life insurance is purchased to provide liquidity for this reason. Occasionally, the bank will require the guarantor to collaterally assign the death benefit of a life insurance policy to pay all or part of the loan if there is a death. Typically, I would not recommend that the life insurance policy be owned by the entity that owns the real estate. Rather, it should be owned by the individual whose life is insured to provide maximum flexibility.
Many real estate developers and owners have partners. Often, each project may have a different set of partners. As an owner, consideration must be given to whether the owner’s interest in the project will be sold in the event of death. If so, the parties should consider (a) whether life insurance will be purchased to fund the buy-sell obligation, (b) whether there will be any amount of seller financing, (c) if there is seller financing, whether there will be any collateral securing repayment (even if the security interest is subordinate to a bank) or personal guaranty of the debt, (d) if there is seller financing, how to determine the interest rate, and (e) how to determine the sale price.
A developer and owner of real estate may consider involving children in projects for several reasons. First, involving children may acclimate them to good stewardship of wealth and the risks and rewards of being an entrepreneur. Second, including children allows the parent to shift equity growth (and thus avoid death taxes) to their children and shift income to them. Including children may complicate a project. First, the children and the parent should have a buy-sell agreement. Also, the children will need to be comfortable with the possibility of a personal guaranty of loans.
The other wrinkle to consider is the realty transfer tax. Property contributed to an entity, such as a limited partnership or limited liability company will trigger a realty transfer tax equal to 2% of the assessed value. Also, a transfer of more than 89% of equity in any three year period will trigger the realty transfer tax.
Income Tax Planning
Although paying the Pennsylvania inheritance tax is not ideal, for some individuals it may be advantageous to own depreciated real estate at death. Property transferred at death is eligible for a “step up” in cost basis to fair market value. Assume, for example, that you own a $1,000,000 building with $400,000 of remaining cost basis. If you sell the building or gift it to your children who eventually sell it, the capital gain on the sale will be $600,000 (assuming there is no 1031 exchange). The income tax due would be approximately $150,000. Although a $45,000 of inheritance tax would be due at death if the building is transferred to children, there would be a cost basis step and therefore an income tax savings of $105,000.
In general, real estate does not present any challenges that are unique or that cannot be addressed through a thoughtful and comprehensive estate plan.
Health Care Decision-Making in Pennsylvania: Powers of Attorney, POLSTs and Living Wills
Recent inquiries from clients highlight interest and uncertainty surrounding health care decision-making documents and authority. While the term ‘Living Will’ has entered the popular vocabulary, determination of who gets to make health care decisions for a patient and under what circumstances those decisions are made are questions on the minds of many. This article is a cursory legal overview of health care decision-making and various documents and laws designed to assist persons who are unable to make such decisions for themselves.
First and foremost, each and every person has the right to make their own decisions regarding their own health care as long as they are able to effectively communicate those decisions to health care providers. Even where a person is deemed legally incapacitated, they may still be found to be legally competent to make some health care decisions under applicable law. In the absence of a patient’s competence to make health care decisions, various substitute decision-making mechanisms exist.
Health Care Power of Attorney
Since 2007, Pennsylvania law explicitly authorizes individuals to prepare and execute health care powers of attorney. A Health Care Agent is the person named in a written Health Care Power Of Attorney who is authorized to make health care decisions for the principal (the individual granting the power), including decisions about the use or withholding of life-sustaining treatment. Health Care Agents are expressly selected and appointed by the principal and need not be related to the principal in any way (though neither the principal’s attending physician nor an owner, operator or employee of a health care facility in which the principal is receiving care may serve). Ideally, every adult should have a health care power of attorney because if provides the individual with the most control over who gets to make decisions if and when they cannot.
Living Wills/Advance Directives
Essentially interchangeable terms that describe a document in which a principal (the individual giving the directive) sets forth their own guidelines for treatment, including the use or withholding of life-sustaining treatment, Living Wills/Advance Directives are important planning documents. The guidelines set forth are for the use and reference of the Heath Care Agent where there is an accompanying health care power of attorney, and for the use of health care providers.
Health Care Representative
For individuals who have not prepared and executed a Health Care Power of Attorney, Pennsylvania law provides for recognition of a Health Care Representative. A health care representative may act for a person over the age of 18 who does not have a health care power of attorney or whose agent is not reasonably available. A health care representative has essentially the same powers as a health care agent but may not direct withdrawal of life-sustaining treatment except in cases where the person has an end-stage (terminal) medical condition. A person may designate a health care representative in writing or orally to the attending physician or health care provider. In the absence of a designation, the following persons may act, in order of priority:
- a spouse (if no divorce action is pending) AND the adult children of the principal who are not children of the spouse;
- an adult child(ren);
- a parent(s);
- adult sibling(s);
- adult grandchild(ren); or
- “[a]n adult who has knowledge of the principal’s preferences and values, including, but not limited to, religious and moral beliefs, to assess how the principal would make health care decisions.”
Multiple people in the same call of relationship have to make decisions together, which disfavors on the health care representative provisions.
Physician Orders for Life-Sustaining Treatment
Over the last decade, Physician Orders for Life-Sustaining Treatment (POLSTs) have gained currency among national health care policy communities and providers. Fundamentally, a POLST differs from a Health Care Power of Attorney or Advance Directive because it formalizes a patient’s medical treatment preferences following a conversation between the patient and their doctor. Often used by attending hospitalists or geriatric specialists in health care facilities, a POLST is signed by both the patient (or their health care representative or agent) and the attending physician and sets forth actual medical orders for provision or withdrawal of treatment, specific levels of medical intervention and pain-relieving measures, and provision or withholding of nutrition. Patients with serious existing medical conditions and many patients over the age of seventy are recommended to discuss a POLST with their physicians.
Always as a last resort, courts do get involved in health care decision-making where there are not family members or other persons willing to serve as health care representative or where the agents or representatives disagree on the provision or withdrawal of care. Thoughtful planning almost always obviates the need for court involvement in these matters. Preparation and proper execution of a power of attorney and advance directive (or POLST) allows individuals to exercise the proper self-determination in their own health care decisions.
Any person without a valid living will and/or health care power of attorney should consider obtaining one. For specific questions, please contact any member of the McNees Estate Planning Group.
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