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Death and Taxes and Liquidity

Many shopping center owners have portfolios that consist mostly of bricks and mortar. While these investments often provide a significant return, such illiquid assets can become a real burden when the shopping center owner dies.

Because the death taxes imposed on some estates can exceed half of the properties' value, shopping center owners are best served if they do some advance planning. Planning can protect your family from having to hastily liquidate the shopping center interests just to pay estate taxes on their inheritance.

How estate taxes work If you die in 1999 and your estate is worth more than $650,000 (or above $1.3 million for a couple), your heirs must pay a federal estate tax, at graduated rates from 37% to 55%, on the value of your taxable estate. Transfers of property to a spouse or charity may, however, qualify for deductions for federal estate tax purposes if properly structured. The $650,000 exemption is scheduled to increase incrementally over the next several years, until it hits $1 million in 2006.

As a result, shopping center owners, who have accumulated estates with large paper value but few liquid assets, place a significant burden on their families. With marginal tax rates as high as 55% for estates valued at more than $3 million, much of an estate's value can be sacrificed just to pay federal and state death taxes. (See Figure 1.)

Generally, the federal estate tax must be paid within nine months from the date of a death. Some estates may qualify for longer-term payments. For example, taxes may be paid over a period of up to 15 years if (a) the business being passed along was closely held, (b) the deceased owner was actively involved in the firm's management, and (c) the value of the business exceeds 35% of the total estate.

In addition to federal estate tax, many states levy inheritance and estate taxes as well. In Pennsylvania, for example, the state collects an additional 6% if the estate is transferred to parents or lineal descendants, and 15% otherwise. Transfers to spouses and charities are deductible, but in some states like Pennsylvania, there is no exemption from state inheritance tax.

Don't let your heirs get stuck If your estate does not contain enough liquidity to allow your heirs to pay the estate tax, they may be forced to liquidate the estate's assets just to pay the tax. That can create a desperate challenge for a shopping center's heirs.

In today's uncertain retail environment, the future value of a shopping center cannot be predicted with any degree of certainty. The termination of an anchor's lease, or the continued economic viability of national and local retailers, or the need for large cash infusions for tenant improvements or renovations to the center - any of these situations may affect a center's value at any point in time.

Additionally, some shopping center owners' heirs want to remain in the shopping center business; they cannot find a comparable return on their investment or they cherish the legacy the owner created.

Smart estate planning can turn a potential estate tax nightmare from a worst-case scenario to a best-case one. Using tools such as life insurance trusts and family limited partnerships, shopping center owners can both reduce estate taxes and ensure that their heirs will have the cash to pay them in the event of the shopping center owner's death. The bottom line is, plan early and update your plan regularly.

What does your family need? Shopping center owners should begin any estate plan by anticipating their family's needs and wishes. Questions to consider:

* How much annual income would your family need after your death?

* What is your family's investment/risk tolerance?

* Would they feel more comfortable with conservative investments that yield a fixed income; or riskier investments (such as shopping centers) that provide greater cash flow and may continue to grow in value?

* Who would manage your business after you're gone?

* Are your children actively involved in the business, or might they be interested in managing it in the future?

* If you have partners, do you or they want your spouse or children to become their partners?

* What taxes and administration expenses will your estate have to pay? How much in liquid assets will be available to pay them?

Once a center owner has answered these kinds of questions, it's time to decide: Should some or all of the shopping center interests be passed on to heirs, or should some liquidation plans be set in motion?

Resolve partnership issues first If a shopping center owner has partners, all of the partners should consider a written partnership agreement that addresses the purchase of a deceased partner's interest in the partnership by the surviving partners. The purchase price must be predetermined and, to the extent possible, should be funded generally by life insurance.

Upon one partner's death, the life insurance proceeds go to the deceased partner's estate and the partner's ownership interest transfers to the surviving partners. The proceeds of sale can be used to help pay death taxes, and the balance can be distributed to heirs.

Paying estate taxes with life insurance If a shopping center owner does not want to liquidate assets prior to death or leave heirs exposed to having to sell off assets to pay estate taxes, then life insurance can be a good estate planning tool. The proper life insurance policy must, however, first be determined.

To do this, all of the owner's assets, including the real estate assets, must be valued, preferably by a professional valuation consultant. Then an estate tax estimate must be determined.

Life insurance policy options should then be considered along with the history of each insurance carrier, the details of the policies and anticipated rates of return. The business value and life insurance coverage should also be reviewed periodically to make sure heirs and estate tax liabilities are adequately covered.

Transferring ownership to children or heirs Some shopping center owners start passing property or other assets on to children or other heirs while they are still alive, in an effort to involve family members in the business or just to minimize future taxes.

If this is the goal, one strategy is to put some or all of the assets in a trust rather than have them owned directly by family members. Trusts are legal entities into which you can transfer title to your property. A third party (the trustee) holds these assets for the benefit of another person or group (the beneficiaries).

There are many kinds of trusts, but one of the most useful for shopping center owners who believe their properties will increase in value over time is the grantor-retained annuity trust (GRAT). Center owners can transfer their ownership interests to the GRAT while they are alive and still retain an annuity and control of the business (as a trustee) for a stated number of years. The transfer is considered a gift to the trust and, therefore, may be subject to federal gift tax.

Another strategy for transferring ownership and limiting tax liabilities is the family limited partnership (FLP). By creating an FLP, a shopping center owner transfers shopping center interests into a partnership owned by designated family members. The shopping center owner becomes the general partner, maintaining control over the business operations but giving away limited partnership interests to members of his or her family.

Ideally, the shopping center owner winds up owning a minority interest in the partnership after transferring minority interests to various family members. Upon the general partner's death, only the retained interest in the shopping center and his other assets are subject to estate taxes.

While the transferred interests in the FLP are considered gifts and are subject to gift taxes and limitations, those shares may be valued at a discount (often 35% to 40%) because they were gifted as minority and non-controlling interests in the partnership.

The liquidation alternative Another way to make sure estate tax payment money will be available is to think about taking capital out of the shopping centers now. Refinancing is a good planning alternative when interest rates are low, especially if the asset value has increased since the last round of financing. Assuming the company has enough cash flow to pay the debt, a center owner may want to pull out some cash now and invest in other, more diversified assets that add liquidity to the estate.

Because some owners do not plan to pass the shopping center interests along to children, they consider liquidating some or all of the assets prior to their death. As with refinancing, this enables owners to get some cash to invest in other, more liquid vehicles.

A disadvantage to selling assets during lifetime is capital gains tax exposure and recapture of depreciation as ordinary income. If the properties have appreciated in value, owners may have to pay significant taxes. However, the maximum capital gains tax rate (20%) and the maximum income tax on ordinary income (39.6%) should be compared to the projected estate taxes heirs would incur later (maximum 55%) - and the less costly or more prudent route pursued.

Generally, if the real estate passes on to heirs after death, the appreciation on the real estate as of the date of death will not be subject to any capital gains taxes. The basis for the heirs' future capital gains tax is the value of the asset for federal estate tax purposes.

Whichever option is selected, the key is to begin exploring all the options early. By planning early, a shopping center owner can make sure he or she leaves his family or heirs the most with the least amount of tax, family and financial concerns.

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