Commercial real estate is often a key component of wealth, representing a major asset that owners want to pass on to their heirs. However, transferring these assets can result in significant tax bills, including capital gains tax, federal estate tax, and state taxes. Strategic estate planning can help reduce or eliminate these taxes, preserving wealth for future generations.
This detailed guide reviews tax-efficient strategies for transferring commercial real estate, including holding the property until death, refinancing, utilizing trusts, and leveraging the estate tax exemption. It also discusses additional techniques, practical examples, and important considerations for 2025, helping owners make informed decisions.
Why Estate Planning Matters for Commercial Real Estate
Commercial properties, such as office buildings, retail centers, or multifamily apartments, often appreciate significantly over time, leading to substantial capital gains and potential estate tax liabilities. Without proper planning, heirs may face taxes that force them to sell the property to cover the tax bill.
By implementing tax-efficient strategies, owners can reduce these liabilities, ensuring that more wealth is passed on to their heirs. The complexity of tax laws, along with upcoming changes such as the 2025 estate tax exemption sunset, makes professional advice essential.
Core Tax-Efficient Strategies
1. Hold Until Death: Leveraging the Stepped-Up Basis
Holding commercial real estate until death is an effective strategy to avoid capital gains taxes on appreciation through the "stepped-up basis" rule. When an owner passes away, the property's basis is adjusted to its fair market value (FMV) at the time of death, meaning heirs only pay capital gains tax on the appreciation that occurs after the inheritance.
· How It Works: Suppose a property is purchased for $1,000,000 and appreciates to $3,000,000 by the time of the owner's death. If the property was sold before the owner's death, the owner would owe capital gains tax on the $2,000,000 gain (at a rate of 15%-20%, or $300,000-$400,000, plus state taxes). However, heirs inherit the property with a $3,000,000 basis. If they sell it for $3,000,000, no capital gains tax is due.
· Benefits: This strategy is straightforward and can result in substantial tax savings, particularly for highly appreciated properties. It also makes tax reporting easier for heirs.
· Considerations: If possible, the owners need to be able to hold the property. Estate taxes may still apply if the estate exceeds the federal exemption (unified credit) of $13,999,000.
2. Refinancing: Extracting Cash Tax-Free
Refinancing allows owners to access a property's equity without selling, avoiding capital gains tax while retaining ownership for eventual transfer to heirs.
· How It Works: By taking out a new loan against the property, owners can extract cash based on the property's current value. This transaction is generally tax-free, as loan proceeds are not considered income.
· Example: A property valued at $5,000,000 with a $2,000,000 mortgage could be refinanced to extract $2,000,000 in cash (assuming a loan-to-value ratio of 80%). The owner can use this cash for investments, gifts, or personal expenses, thereby reducing the taxable estate while retaining the property.
· Benefits: Refinancing provides liquidity without triggering taxes, allowing owners to fund estate planning strategies, such as gifting or establishing trusts. It preserves the property for heirs, who may benefit from a stepped-up basis in the future.
· Considerations: Increased debt raises monthly payments, potentially straining cash flow. Heirs inherit the property with its original basis, so the step up in basis applies.
3. Utilizing Trusts: GRATs and Other Options
Trusts are versatile tools for transferring commercial real estate while minimizing gift and estate taxes. The Grantor Retained Annuity Trust (GRAT) is particularly effective for properties with high growth potential.
· How GRATs Work: The owner transfers the property to a GRAT, retaining the right to receive annuity payments for a set term (e.g., 10 years). At the term's end, the remaining property passes to heirs. The IRS taxes the "gift" based on the present value of the remainder interest, which is often minimal due to the annuity structure. If the property appreciates, the excess passes tax-free, provided the grantor survives the term of the grant.
· Example: A $5,000,000 property placed in a 10-year GRAT appreciates to $7,000,000. The $2,000,000 appreciation passes to heirs tax-free, with minimal gift tax on the initial transfer. If the grantor dies during the term, the property reverts to their estate, negating tax benefits.
· Other Trusts:
o Irrevocable Life Insurance Trusts (ILITs): Hold life insurance policies outside the taxable estate, providing liquidity for estate taxes without forcing heirs to sell assets (Charles Schwab).
o Qualified Personal Residence Trusts (QPRTs): Transfer primary or vacation homes to heirs while allowing the owner to live there for a term, reducing estate tax.
· Benefits: GRATs "freeze" the property's value for tax purposes, allowing for the transfer of appreciation tax-free. Other trusts provide flexibility for specific assets or liquidity needs.
· Considerations: Trusts require legal expertise to structure correctly. GRATs depend on the grantor's survival and low interest rates (such as the IRS 7520 rate) to enhance their effectiveness.
4. Maximizing the 2025 Estate Tax Exemption
The federal estate tax exemption allows estates to pass a specific amount tax-free. For 2025, this exemption is $13.99 million per person or $27.98 million for married couples through portability, where an unused exemption from a deceased spouse transfers to the surviving spouse.
· How It Works: An estate valued at $15,000,000 incurs estate tax only on $1,010,000 ($15,000,000 - $13,990,000) at rates up to 40%. Lifetime gifts using the exemption can further reduce the size of the taxable estate.
· Example: A couple with a $20,000,000 estate can pass it tax-free in 2025, as it's below their $27.98 million combined exemption. If one spouse dies, portability preserves the unused exemption for the survivor.
· Benefits: The high exemption allows significant tax-free transfers, but it's set to drop to ~$7 million (inflation-adjusted) after 2025 unless extended.
· Considerations: State estate taxes, such as New York's $7.16 million exemption with a "cliff" that taxes the entire estate if exceeded by 5%, require additional planning.
Additional Strategies for Tax Efficiency
Lifetime Gifting
Making gifts during one's lifetime reduces the taxable estate. In 2025, the annual gift tax exclusion is $19,000 per recipient, allowing tax-free gifts to be made without utilizing the lifetime exemption. Larger gifts can use the $13.99 million exemption, removing future appreciation from the estate.
· Example: A couple gifts $38,000 annually to each of their three children ($114,000 total) without using their exemption, thereby reducing their estate over time.
Education Gifting
· The owner can give the gift of education by prepaying a complete college degree at an accredited university for their heirs. The education gift reduces the estate without triggering tax implications.
Charitable Planning
Donating property to charity provides income tax deductions and removes it from the taxable estate. Charitable remainder trusts (CRTs) allow owners to receive income during their lifetime, with the remainder passing to charity, reducing estate taxes.
Family Limited Partnerships (FLPs)
FLPs transfer ownership interests to heirs at discounted values for tax purposes while the owner retains control. Discounts of 20%-40% are common due to a lack of marketability and control (Husch Blackwell).
Installment Sales to Grantor Trusts
Selling property to a grantor trust for installment notes defers capital gains tax and transfers wealth to heirs. The trust's appreciation passes tax-free, similar to a Grantor Retained Annuity Trust (GRAT).
Key Considerations
· State Taxes: States like New York impose estate taxes with lower exemptions ($7.16 million in 2025) and unique rules, requiring tailored planning.
· Generation-Skipping Transfer Tax (GSTT): Transfers to grandchildren or beyond may trigger the GSTT, with an exemption of $13.99 million as of 2025.
· Income Tax Implications: Strategies such as refinancing or installment sales may have income tax consequences, necessitating coordination with estate tax planning.
· Health and Longevity: GRATs and similar trusts depend on the owner surviving the term. Health should guide strategy selection.
· 2025 Exemption Sunset: The $13.99 million exemption may drop significantly in 2026, making 2025 a critical year for large transfers.
Practical Example
An owner holds a $5,000,000 property (basis $1,000,000) and implements multiple strategies:
· Hold Until Death: Heirs inherit at $5,000,000, avoiding $800,000 in capital gains tax (20% of $4,000,000).
· Refinancing: Extracts $2,000,000 tax-free, funding lifetime gifts of $114,000 annually to three children.
· GRAT: Transfers $3,000,000 of the property to a 10-year GRAT. If it appreciates to $4,500,000, $1,500,000 passes tax-free.
· Exemption: The estate, valued at $10,000,000 (including other assets), is below the $13.99 million exemption, avoiding federal estate tax.
Total Savings: Over $1,000,000 in combined capital gains and estate taxes, with additional state tax savings.
Case Study: Office Building Owner
A couple owns a $10,000,000 office building (basis $2,000,000) and other assets totaling $15,000,000. They:
· Hold the property until death, saving $1,600,000 in capital gains tax (20% of $8,000,000).
· Refinance for $4,000,000, funding a $2,000,000 ILIT to cover potential state estate taxes.
· Place $5,000,000 in a GRAT, transferring $2,000,000 appreciation tax-free.
· Give the maximum annual gift of $19,000 every year to their children or grandchildren.
· Prepay tuition expenses at the University of their choice.
· Use their $27.98 million exemption to pass the estate tax-free.
Outcome: The heirs receive the property and assets with minimal tax liability, preserving nearly the entire estate.
Conclusion
Passing commercial real estate to heirs requires strategic planning to address capital gains, estate, and state taxes. Holding assets until death leverages the stepped-up basis; refinancing offers tax-free liquidity; trusts, such as GRATs, transfer appreciation; and the 2025 $13.99 million exemption allows for substantial tax-free transfers. Additional strategies, such as lifetime gifting and Family Limited Partnerships (FLPs), enhance flexibility. With the exemption set to decrease in 2026, 2025 is a crucial year to act. Consulting estate planning attorneys and tax advisors ensures a customized plan that maximizes savings and aligns with your legacy goals.