A lot of my clients are more property rich than they are cash rich, meaning the bulk of their wealth is in the land and properties they own. It’s not uncommon for me to run into clients who inherited property that’s been in their families for generations. Unfortunately, estate tax can be a big burden when it comes to keeping these properties in the family.
For example, I once had single client who, at the time of our consult, had an estate valued at $22 million. Of that $22 million, about $20 million was property and intangible assets, like drilling rights. After his exemption of $11.7 million, he would have had to pay estate taxes on the remaining $10.3 million at a rate of 40%. The issue he ran into was that he didn’t have $4.12 million in cash to satisfy the tax bill. In order to pay the estate tax bill, his heirs would have had to sell the property, possibly at less than market value in a fire sale type situation.
No one wants to have to give up a property holding that’s been in their family for generations simply because they don’t have a liquid enough estate to pay those taxes. When I have a cash-poor, property-rich client, I use irrevocable life insurance trusts (ILIT) to reduce the taxable estate while funding the payoff of these taxes with life insurance.
How the IRS Determines the Value of Property in Your Estate
To understand how much property can cost you when it comes to estate taxes, you need to understand how the IRS determines the value of your property. It uses something called fair market value, which the IRS defines as: “The price at which property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or to sell and both having reasonable knowledge of the relevant facts.”
In the past, some have tried to get around this by “gifting” these assets to relatives or selling them for a nominal amount. That doesn’t work because gift tax and estate tax are combined. If you give away a property for less than it is worth, then that sale is considered a gift with the value being added to your taxable estate.
At the same time, the IRS doesn’t get all the say in determining how much a property is worth. The executor of an estate can dispute an estate valuation, though this can be a long, complex process. When the executor of the estate believes a valuation to be incorrect, he or she can require the IRS to furnish proof of its value assessment to include:
- The basis for the IRS’s conflicting valuation.
- Any computations used in arriving at the IRS value.
- A copy of any expert appraisal made for the IRS.
This can be burdensome and problematic. If you underestimate the value of an asset, there could be additional penalties enforced. This is why some choose to save themselves some trouble by creating an alternative source of funding to pay taxes.
Reducing Your Taxable Estate and Paying Tax Bills with Life Insurance
The first step to any plan of action for using life insurance as a tool is creating an ILIT. An ILIT is a separate entity from you with its own tax ID number.
The tricky thing about the trust is that, like any other entity, it must file a tax return if it earns money. Trusts are also subject to the three-year rule for transfers. This rule establishes that certain transfers out of your name will be considered part of your taxable estate if you die within three years of the transfer. For these reasons, simply transferring the property to the trust is not the ideal option.
Instead, what you could do is create a fund to pay the future taxes on the property without that fund being considered part of your estate. The ILIT itself will likely not have to pay or file any taxes as long as the trust doesn’t make more than $600 in annual interest income.
Consider my client in the beginning who had $20 million in property, meaning he could expect a tax bill of almost half of that amount upon his death. Rather than his beneficiaries liquidating the property to pay the tax, he was able to set up a separate ILIT. That ILIT then funded the estimated tax on the property with life insurance. On the death of the property owner, the life insurance proceeds won’t be considered part of his estate, nor will the beneficiary have to pay taxes on them. When the insured dies, the policy pays out its face value without having to go through probate. This gives the beneficiaries an immediate source of funding to pay the tax on the property.
The IRS demands to be paid in cash, which is why many of our clients with a lot of property holdings need to give their heirs a source of funding to pay that bill. Life insurance and ILITs can be the ideal way to provide this funding while keeping the amounts out of your estate. Contact a Howard Kaye advisor at 800-DIE-RICH for more information about managing estate taxes and property holdings.
