With the current gift tax exemptions ($5.0 million for individuals and $10.0 for couples) set to expire at the end of 2012, it is imperative to find ways to grant cash and other assets to dynasty trusts now. Income producing real estate is an excellent way to do this and to get, in some instances, a multiplier effect with forethought and planning. Residences can also be used, but the process is a bit more difficult.
The value of real estate, simply put, is its appraised value minus any debt secured by it. That is, the value equals the equity. What even some sophistical people forget is that new debt does not detract from net worth because the debt creates an asset equal to the liability. So the value of the property without debt is equal to the value of the property minus the debt, plus the cash received for the mortgage. If the building is worth $10 million free and clear, it is a $10 million segment of one's net worth. Now, if a $4,500,000 mortgage is placed on the property, one's net worth is unchanged. The property now has an equity value of $5,500,000, but there is an additional cash equivalency of $5,500,000, the mortgage proceeds. Together they still equal $10,000,000, which was the value of the property without the mortgage.
Now, appraised value and net value (appraised value less mortgage) are not the same things as the valuation, which is the current worth of an asset. True, if one owns a controlling interest in an asset, that interest is worth the pro-rata share of the overall value. But what if one owns less than a controlling interest? The value is significantly reduced because of that lack of control. In the instance where the asset is an apartment building, the minority interest might be valued at 60% of what you would think if you did the simple math of percent interest times net equity. And that legal distinction makes all the difference in the (gift tax exemption) world.
Let's put those two concepts to work preserving wealth:
The income producing property has an appraised value, without debt of, say $10,000,000. It is either currently owned by an LLC or will be transferred to one. The LLC is owned by two individuals, each with a 45% interest and an entity owned by them, which has the other 10%, acts as manager. Neither then has controlling interest. Each 40% interest would seem to be worth $4,500,000 ($10,000,000 X.45), but for valuation purposes, it is discounted, say, 40% because of the difficulty in selling the interest and the lack of control. Instead of counting $4,500,000 toward the gift tax limit when that interest is granted to a dynasty trust, it is only counted as $2,700,000. Under current limits, that leaves $1,800,000 more available under the individual cap. By doing this before the end of 2012, hundreds of thousands of dollars in gift tax would be saved.
Now let's go back to the initial point about net worth not being affected by the amount mortgages on a property. Because most non-real estate professionals tend to be very conservative when it comes to financing their properties, there usually is plenty of room to increase borrowing and still stay within their comfort range, say 55% or less, loan-to-value. True, one could just diversify holdings and put the money in bonds or equities, but there are other effective ways to use the funds to preserve wealth, even though they require the actual spending of money, reducing net worth, initially. But over time, they preserve many times what they cost.
By placing a new, but still conservative, mortgage on the property, the seniors can so some current financial planning. Because of that increased debt, more of the real estate can be granted to the trust. And, over time, the mortgage is paid down by the positive cash flow of the property. The estate has been enhanced for this generation on those to come.