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Are you thinking about creating a wealth plan for a commercial property? Real estate that is owned for business or investment purposes has certain inherent traits that create a somewhat unique planning scenario and, in some cases, may jeopardize the success of your wealth plan. However, a freeze partnership could help. In this podcast, Matthew Lee, director of wealth strategies for Wilmington Trust’s Emerald Family Office & Advisory®, offers his insights.

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To learn more about freeze partnerships, read Building Wealth: Planning with Real Estate Prior to 2026.

Hi, thank you for tuning in to today's Emerald GEM, which stands for get educated in minutes. I'm Matthew Lee, director of wealth strategies for Wilmington Trust's Emerald Family Office and Advisory, and your host for today's podcast. In today's GEM, I'm going to answer the question, what is a freeze partnership and how could that help you as a real estate investor or developer when creating a wealth plan for your properties?

Before delving into those particular questions, let me first begin by explaining why real estate that is owned for business or investment purposes is a bit different when it comes to planning and why you should be especially careful when planning with it. Despite its variety and diversity as an asset class, certain traits are common with these types of properties.

These include the following: high leverage. Leverage is often used as a tool when acquiring real estate, typically in the form of a mortgage or as a means to extract liquidity from appreciated property through a cash out refinance. Regardless of the timing and reasoning, business or investment real estate is often encumbered by some amount of debt.

Low basis. Properties that were acquired long ago and that have appreciated over time are likely to have an income tax basis that is substantially lower than their current fair market value. Generally, tax basis is equal to the acquisition cost of a property adjusted to reflect various expenses and improvements, along with certain deductions taken over time, including for depreciation.

Whether a property was acquired recently and depreciated or has been held for many years, in today's real estate market, it's common for property to have a low tax basis. Entity ownership. Often, real estate owners hold their interest through entities taxed as partnerships, whether structured as a limited partnership or a limited liability company or LLC.

While these structures can provide owners with a number of benefits, both tax and non tax, their treatment for tax purposes can be complicated and nuanced, potentially causing additional planning complexity. When high leverage, low basis, and entity ownership are taken together, it can cause a somewhat unique planning scenario known commonly as negative capital.

Put simply, negative capital accounts can occur when distributions are received which are funded by debt incurred by the partnership, and that are in excess of the tax basis. If you own negative capital real estate, it's important to plan carefully, as certain common strategies may not be viable and in some cases could jeopardize the success of your wealth plan.

For example, did you know that if you sell negative capital real estate, that could result in so called phantom gain? This could mean taxes that consume a large portion or potentially all of the net sale proceeds. How about if you gift negative capital property to a family member? What happens then? Well, there are two the tax result could be undesirable.

While a gift generally is not a taxable event for income tax purposes, that may not be so if the debt on the property exceeds its basis. If that's the case, your gift could result in gain recognition, meaning you might end up paying income tax on that gift. You might think then that it could be better to simply hold on to your real estate rather than gift it or sell it.

While many real estate families are inclined to hold onto certain legacy properties, that could raise other tax considerations. Depending on the value of the property, where it's located, and what other assets you own, if you hold onto a property until death, it could be subject to an estate tax, whether federal, state, or both.

In some cases, that tax could exceed 50 percent or more, making retaining that real estate quite costly for your family. So if selling, gifting, and holding negative capital real estate seem like less than ideal planning options, what might you consider? Enter the freeze partnership. Although it may receive less attention than other common planning techniques, like certain types of irrevocable trusts, the freeze partnership could be particularly useful when planning with negative capital real estate.

So what is it? At its most basic level, a freeze partnership is an entity, whether structured as a partnership or LLC, that is capitalized into two economic interests, a preferred interest and a common interest. Each of these has different rights and attributes and are often structured as follows. The preferred interest typically is entitled to a defined annual payment from the partnership, known as a qualified payment right.

This is determined by market appraisal, but it's frequently in the range of six to nine percent of the value of the preferred interest. The common interest receives any returns not allocated to the preferred interest, along with any growth in the value of the underlying assets. Given this division of the partnership's economics, the bulk of its current value typically is attributed to the preferred interest, with the common interest generally representing a smaller portion of the entity's overall value.

This all could be done by forming a new entity and contributing your real estate interest to it, or by recapitalizing an existing one into a preferred common structure. Either way could work. In a straightforward freeze transaction, you could retain the preferred interest and transfer, either by gift or sale, the common interest to family members or preferably to irrevocable trusts for their benefit.

Okay, that's interesting, but why would you consider doing this? Here are four reasons why this might be beneficial to you and your family. First, by gifting some or all of the common interests, you could take advantage of your available lifetime exemption from federal gift and estate tax, which is set to be substantially reduced or sunset in 2026.

This could reduce the value of the assets within your estate at death, potentially mitigating future estate tax exposure. Moreover, because the preferred interest which you would retain would only entitle you to a fixed annual payment. With any growth and earnings the benefit of the common interest holder, you could effectively freeze the value of the asset within your state.

While it's true that the preferred interest would still be included in your state and potentially subject to estate taxes. That should represent only a fraction of the freeze partnership’s overall value. The bulk of the growth would occur outside of your estate and so not be subject to estate tax.

Second, by retaining the preferred interest, you might be able to reduce the potential phantom gain that previously made a sale of the property undesirable. This would be due to the so called basis step up. In short, any property that you hold at the time of your death receives a new basis equal to its fair market value at that time, effectively reducing those unrealized gains.

With a stepped up basis, your heirs could sell the interest in the partnership or, after making certain accounting adjustments, the underlying real estate without incurring the substantial gain that you might have recognized during your lifetime. Alternatively, if your heirs decided to hold rather than sell the interest, they would have a partially refreshed basis from which to depreciate, which could provide them with further tax benefits.

Third, from a cash flow standpoint, as the holder of the preferred interest, You would be entitled to receive annual distributions from the partnership in the form of qualified payments. This makes it a particularly compelling strategy if you're looking to leverage your lifetime exemption while maintaining cash security.

Last but not least, if you're looking to remain involved in the management and day to day operations of the property, a freeze partnership could also allow you to do so where other gifting strategies may limit your involvement or potentially risk adverse tax consequences. At the right time, however, the freeze partnership could serve as an effective vehicle to help transition your ownership and control to the next generation.

If this sounds like it might be a strategy worth considering, here are a few other things to keep in mind. For the freeze partnership to perform as intended, the underlying properties should have sufficient cash flow to support the qualified payment due to the preferred interest holder. Insufficient cash flow from the real estate could risk the potential estate and tax planning benefits of the structure and the strategy as a whole.

As with other planning strategies, it's also important that you analyze and understand your cash needs relative to the qualified payments due on the preferred interest. If those payments are in excess of your needs, the strategy may be less successful as a freeze technique because the surplus cash could increase your taxable estate.

It should also be mentioned that while this strategy can be effective, it's also complex. Given the strategy's highly technical nature, its success may hinge on your ongoing commitment to the structure and the skill set of your multidisciplinary advisory team, including your legal and tax partners.

Thanks again for joining us today. I hope you found our gem to be helpful. If you are interested in learning more, please also be sure to check out our article on the same topic, Building Wealth, Planning with Real Estate Prior to 2026. Please also contact your Wilmington trust advisor. If you have any questions about planning for your real estate and how a freeze partnership could help in achieving your wealth goals, we would be glad to help you.

If you have a topic that you'd like us to discuss on a future GEM, please let us know, send an email to emerald at WilmingtonTrust.com. See you next time.

 

 

DISCLOSURES:

This podcast is for general information only and is not intended as an offer or solicitation for the sale of any financial product, service, or other professional advice. The information in this podcast has been obtained from sources believed to be reliable, but its accuracy and completeness are not guaranteed.

The opinions, estimates, and projections expressed are subject to change without notice. Diversification does not ensure a profit or guarantee against a loss. There is no assurance that any investment, financial, or estate planning strategy will be successful. Past performance cannot guarantee future results.

Investing involves risk, and you may incur a profit or a loss. Investment products are not insured by the FDIC or any other governmental agency and are not deposits of, or other obligations of, or guaranteed by, Wilmington Trust, M& T Bank, or any other bank or entity, and are subject to risks, including a possible loss of the principal amount invested.

Wilmington Trust Emerald Family Office and Advisory® is a registered trademark and refers to wealth planning, family office, and advisory services provided by Wilmington Trust N. A., a member of the M& T family. Wilmington Trust Family Office is a service mark for an offering of family office and advisory services provided by Wilmington Trust N.A. Wilmington Trust is a registered service mark used in connection with various fiduciary and nonfiduciary service offered by certain subsidiaries of M& T Bank Corporation.

©2024 M& T Bank Corporation and its affiliates and subsidiaries. All rights reserved.

Wilmington Trust Emerald Family Office & Advisory® is a registered trademark and refers to wealth planning, family office and advisory services provided by Wilmington Trust, N.A., a member of the M&T family. Wilmington Family Office is a service mark for an offering of family office and advisory services provided by Wilmington Trust, N.A.

The information provided herein is for informational purposes only and is not intended as a recommendation or determination that any tax, estate planning, or investment strategy is suitable for a specific investor. Note that tax, estate planning, investing, and financial strategies require consideration for suitability of the individual, business, or investor, and there is no assurance that any strategy will be successful.

Wilmington Trust is not authorized to and does not provide legal or accounting advice. Wilmington Trust does not provide tax advice, except where we have agreed to provide tax preparation services to you. Our advice and recommendations provided to you are illustrative only and subject to the opinions and advice of your own attorney, tax advisor, or other professional advisor.

The information in this podcast has been obtained from sources believed to be reliable, but its accuracy and completeness are not guaranteed. The opinions, estimates, and projections constitute the judgment of Wilmington Trust and are subject to change without notice. 

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