Forget Hollywood, Los Angeles is a real estate town. If we were in New York , most wealthy families’ investments would primarily consist of equity holdings. Here in Southern California real estate is king and the majority of well-off families’ investments are primarily comprised of commercial or multi-family real estate holdings. In all of California, middle class families’ primary asset and nest egg is their home. The fact of the matter is that the biggest source of value and income in Southern California is real estate and not the entertainment industry or tech. They are making more babies but not any more dirt.
Our friends at city hall and in Sacramento insist on making California the most hostile state in the country to do business – the nation’s highest state income tax, one of the highest sales taxes, CEQA, overly complex regulation and restrictions on housing and business, traffic, Los Angeles has had the worst public schools in the country for decades, poor government customer service, too much employer legal compliance and laws generated by an overly zealous plaintiffs’ bar. They chase away good jobs and the majority of film and television shoots now occur out of state. Here are just some of the major corporations that have moved their headquarters and good paying jobs outside of Los Angeles and California over the last decade – Toyota, Nissan, Occidental Petroleum, Carl’s Jr., Farmer Brothers Coffee, Numira Bio Sciences, Raytheon, Airborne Systems, H.J. Heinz, Nestle, Jacobs Engineering, Kubota Tractor and eBay. I rarely see the friends I grew up with that work in the film industry because they don’t make movies in California anymore due to the tax and regulatory environment. We are in the midst of a catastrophic homeless crisis that was directly caused by our friends in the government who have been carried away with over the top housing codes and regulations making it impossible to build new housing in adequate numbers. Instead of offering incentives to build affordable housing, our governments don’t allow affordable housing to be built. Regardless, people will unfortunately still be moving to California. Immigrants from Mexico and Central America who are suffering from lack of rule of law caused by narco terrorism will always seek opportunity here. More so, the traffic on our freeways will just keep getting worse because of one fact – weather. If you don’t believe me spend one summer or winter east of the Rockies. Our weather draws wealthy people from the eastern United States who no longer want to cope with the horrible weather in their homes states.
Celebrities like Ronald Reagan, Bob Hope, Jerry Buss, Shaquille O’Neil, Magic Johnson, Mo Vaughn, David Charvet, Vanilla Ice, Ellen DeGeneres and Arnold Schwarzenegger made much if not most of their money not in the entertainment or sports businesses but in sound real estate investments and syndications. In 1971 Schwarzenegger invested his body building winnings into a Los Angeles six unit apartment building that he purchased for $10,000 and subsequently sold for many times that amount. A few years later he purchased another apartment building in Santa Monica for $450,000 and then sold it for $2,300,000. Supposedly he made $7,000,000 from selling a Las Vegas office building which he originally purchased for under $500,000.
When advising families in Southern California on estate planning strategies, the advisor must understand the ins and outs of how real estate transactions work in order to offer accurate advice. Likewise, an attorney representing real estate operators or investors in real estate transactions must understand the tax and estate planning ramifications of the deal they are putting together. A great real estate attorney must also be a good estate planning attorney and a great estate planning attorney must also be a good real estate attorney if they are representing clients in Los Angeles.
A few examples are useful.
The choice of entity for a real estate investment is often not given very much thought. While some people are inclined to take title individually, in a trust, as a joint tenant, as a tenant-in-common or in a general partnership, solely to avoid the minimum California Franchise Tax Board $800 annual tax, this decision is a penny wise and a pound foolish. Those vesting choices provide no asset protection, the $800 annual Franchise Tax Board fee is a cheap insurance policy. A creditor with a judgment arising from a property with one of those entities can attach all of the assets of the owner – their home, their bank accounts, their car, etc. to satisfy the judgment. However, a judgment creditor can only obtain a charging order against an owner whose property vesting is in a limited partnership or limited liability company. With a charging order the creditor can only receive distributions that the limited partnership or limited liability company decides to make and the creditor cannot vote on decisions. As such, the creditor knows they will never receive anything and will be more willing to settle for pennies on the dollar. C corporations and S corporations provide similar protection, but with less tax planning opportunities. Additionally, general partners of limited partnerships should always consider using a LLC to be named as the general partner because there is no limited liability protection for individual general partners. The most effective way to provide asset protection is to silo your assets. Additionally, reporting your income from an entity with a K-1 as opposed to reporting it from no entity on Schedule C makes you 500 times less likely to get audited.
Often time clients want to use C corporations or S corporations to hold real estate or serve as a general partner or manager of a real estate holding entity. These choices are problematic for a number of reasons:
- Grantor trusts (like a revocable trust, an irrevocable defective grantor trust or a grantor retained annuity trust) only qualify to hold S corporation stock for two years after the grantor’s death or else the S corporation will be automatically converted to a C corporation. The same consequence will immediately occur if the trust terminates for reasons other than death.
- Only qualified subchapter S corporation trusts (where all income must be distributed, there can be only one beneficiary and no generation skipping planning is available) or electing small business trusts (all income (other than capital gain) is taxed at the highest marginal rate which forces distributions) can own S corporation stock.
- S corporations can only have one class of stock. Multiple classes are allowed if the only difference is voting and nonvoting rights.
- A Section 754 step-up in basis on death election is not available to shares of either S or C corporations.
- C corporations pay double tax and there is a significant tax drag when getting cash out to make annuity payments or annual interest requirements.
- Both C and S corporations come with administrative burdens like annual board meetings, minutes and resolutions which many real estate investors never get round to doing.
As such, limited partnerships or limited liability companies are generally superior real estate holding entities when compared to corporations. However, limited liability companies have the disadvantage of being subject to the California Franchise Tax Board’s gross receipts tax.
Many beneficiaries are eager to talk their parents into exotic estate planning techniques like an irrevocable defective grantor trust or a grantor retained annuity trust which accelerate their inheritance. While the estate tax benefits of these instruments are substantial, care must be taken to avoid triggering unwanted real property tax reassessments (see my article on avoiding California real property tax assessments), losing the step-up in basis at death (see below) or triggering phantom income.
Phantom income is triggered by negative capital accounts which come from depreciation or refinancing debt on the property when the owners take nonrecourse loan proceeds as distributions. When the investor exits or sells the property, phantom gain will be realized to extent of the negative capital. If the asset is transferred at death, many believe the negative basis can be erased with a Section 754 step-up in basis election. This is a complicated subject that can be elaborated on and this brief explanation is only a greatly simplified summary.
A Section 754 step-up in basis can still be achieved on property transferred to heirs outright or by a spousal lifetime access trust, an irrevocable defective grantor trust or a grantor retained annuity trust by having the grantor purchase the real estate asset putting it back into the estate with cash on hand (or obtained through a low interest rate loan) prior to death. The real estate still gets the step-up in basis and the asset gets out of the estate or at least the amount of cash paid to bring the asset back to the estate. You don’t need a step-up in basis on cash because the basis of cash basis is 100% of its current fair market value. This way the real estate goes back into the estate from the time of the purchase until the grantor’s death when it receives a step-up in basis. The value of the real estate in the form of cash stays out of the estate for estate tax purposes.
The real estate market here in California is pretty frothy at the moment. No one knows how severe of a real estate market downturn we will see in the coming years, we only know that at some point there will be a downturn. Regardless of how drastic or long the next downturn is, over the long term California’s real estate market is going to continue to make drastic gains like it has over the last one hundred and fifty years. Over a lifetime any California real estate owned is very likely to increase value at a much higher rate than inflation and likely any other asset class. Californians, especially Southern Californians, have the bulk of their assets tied up in real estate holdings. As such, it is imperative that any estate planning or real estate investing strategies be implemented by an advisor with a thorough understanding of both practice areas to effectively plan for the tax ramifications that come along with owning and transferring real estate.
The information in this article is intended to be a general description of tax laws and is not advice as to any transactions, nor is this article advice to any person or to any client and should not be relied upon as such. If you or your client desire to receive specific legal or tax advice on a specific transaction, then please call Caldwell Law at (818) 651-6246.