Feature
by John O'Grady
The greatest measure of a life is the impact it had on others and the legacy it leaves. Planning your legacy means rigorously exploring basic questions that have been of interest to most people for some time. Like it or not, the control of your buildings will someday pass to others. This may occur when you die, retire or become incapable of managing your own affairs. You can let the default provisions of the law determine who will take control or you can decide for yourself through proper estate planning.
Who Gets the Building?
In many cultures the oldest son inherits the farm—or the apartment building. In modern San Francisco the property is often divided equally among the children. Ideally, each child will get a separate building and everyone will live happily ever after. Alternatively, one child can inherit the buildings and then other children can receive life insurance payouts of equal value.
Every unresolved sibling concern seems to come to light when the parents die and the siblings often direct their anger at each other, regardless of whether they own a building together. Co-ownership of apartment buildings after the death of the parents is often like putting fuel on the fires of this sibling rivalry.
In addition, you may need to watch someone performing the responsibilities of managing a building before you can decide whether that person will do a good job at it. A poor manager can ruin an otherwise successful building.
Consider the following questions. Do you want your building to be owned and managed by one or more of your heirs upon your death? What is the nature and extent of any current involvement of family members in the management of the building? Do you have any plans to involve family members in the management and how will those plans be implemented? What is your realistic estimate of the ability, or lack of ability, of various family members to manage the building successfully? What are the family dynamics, including sibling rivalries, and the potential impacts of those dynamics on the continuing success of the building? What is the current and anticipated involvement of the spouses of your family members and the potential impact of the divorce of a family member on the building?
Some of the most difficult questions relate to your willingness to let go of the control of the building during your lifetime, the impact of your withdrawal on the continuing success of the building, the likelihood that you will intervene in the management of the building after your withdrawal, and the impact of that intervention, including conflict between family members managing the building.
In addition, it is important to elicit the views of the various family members regarding the interest and willingness of each to take an active role in the management of the building and to identify those management activities for which he or she is best suited. Some family members may be better suited than others to manage the building and some family members may be wholly unsuited for the task. You may want to consider planning for this in considering which assets to leave to which children.
Family meetings can serve as a vehicle to assure a sense of ownership and involvement in the activities of the building, especially for family members receiving inactive interests in the building. Family meetings can also go a long way toward developing cooperation and team spirit among the family members.
Avoiding Estate Taxes and Creditors
Current federal law provides that, without estate tax planning, up to 45% of the value of your assets in excess of $2 million will go to the U.S. Treasury upon your death (a properly drafted bypass trust can be used to entitle your loved ones to a $2 million exemption). There is uncertainty about the future of the estate tax and many tax specialists anticipate that the exemption amount will eventually increase from $2 million to perhaps $4 million.
You want to see your buildings stay in the family for some time after your death rather than have your family sell them to pay the estate tax. There are several steps you can take to make this a reality. In fact, the estate tax can often be eliminated entirely with a multifaceted plan. Transferring the property to family members during your lifetime, directly or through a grantor trust, is one way to keep your building in the family and avoid the estate tax. There can be some tax costs associated with these lifetime transfers, and they must be carefully planned, but they are a great way to keep the government from taxing the future appreciation of the buildings upon your death.
Setting up a life insurance trust now can also provide the family with the liquidity with which to pay the taxes and keep the buildings in the family. Note, though, that half the life insurance proceeds will have to go to the government in the form of an additional estate tax if the life insurance is not owned by the right kind of trust. Consider transferring ownership of your life insurance policies to a life insurance trust.
Protecting the building from tenants and other potential creditors with liability insurance is another aspect of planning to keep the building in the family. Liability insurance can become very expensive, though, and insurance companies limit the amount of insurance you can buy. You can also own each building in a separate limited liability company to limit your liability to creditors.
Divorce and Remarriage
Whatever is left after the government gets its share, and creditors are paid off, can be divided up among your loved ones. That assumes that your marriage or domestic partnership ends in death and not in divorce. In the event of divorce, your spouse may have a “right of contribution” for the value of the services provided in managing the building during the course of your marriage or domestic partnership, even if the building is your separate property. This is because these managerial services are “community” in nature. You can provide clear agreement on these questions in a properly drafted prenuptial or postnuptial agreement.
Blended families made up of people with previous marriages or domestic partnerships have some of the trickiest estate planning concerns. Who will inherit premarital assets? Will it be the kids from the prior marriage, the current spouse, kids from the current marriage or all of them together? A more complete analysis of these questions is beyond the scope of this brief article.
Ownership Agreements
When more than one person is expected to inherit the building, you can use an ownership agreement to address how they are going to own the property together. These agreements can be used to address questions such as how to compensate the one owner responsible for overseeing the management of the building. A right of first refusal can be used to discourage or prevent one co-owner from selling, exchanging or otherwise transferring an interest in the building. The right-of-first-refusal price can be set so low, and the terms of purchase so favorable that, as a practical matter, no sale is likely to occur. Such rights of first refusal can be a powerful mechanism to prevent outsiders from acquiring interests in the building. You may also require that a certain number or percentage of individuals have to consent to the sale of the building. For example, if you leave the building to all of your children, you can require a unanimous or a super-majority vote of the children. These agreements are most effective when signed with your leadership before your death.
Keeping Your Buildings in Trust
Perhaps the most effective way to prevent the sale of your building is to provide that the building will remain in trust for a specified number of years after your death before it can be sold or distributed to your beneficiaries. The trust document can give the trustee greater discretion to retain the building than is allowed by the default provision of the law. The trustee’s potential liability for retaining assets is minimized when the trust document specifies the particular building or buildings to be retained and sets out the reasons for retention. For example, the trust document can specify that you (the settler or creator of the trust) want to pass the buildings to succeeding generations because you believe that the portfolio you have built will protect the beneficiaries better than any investments the trustee could make.
California law severely limits a trustee’s ability to operate a business or even lease property as a lessor in the absence of an express provision in the trust document. The drafting attorney should include specifically tailored provisions allowing the trustee to own and operate rental properties where appropriate.
One advantage of this approach is that the creditors of your beneficiaries cannot go after the interests of the beneficiaries in the trust or in the building. Even the former spouses of your kids cannot interfere with the trust. The trust document can also be drafted to prohibit the sale of the beneficiaries’ interests in the trust.
One of the most important decisions you will make is who will serve as trustee of your trust. The trustee becomes the legal owner of the property. The trustee holds the authority, usually at the exclusion of the beneficiaries for whom they act, to implement and administer the trust according to its terms and to decide when and if the property will be purchased, sold, exchanged, abandoned, or invested for high income, low income or no income at all. The trustee also carries out the “who gets what” provisions, which, in many trusts, may include deciding when to make distributions and how much to distribute. The trustee is a fiduciary and must act in the best interests of the beneficiaries.
Most people decide to act as their own trustees while they are alive to maintain control over their assets. They also may amend or revoke their trusts to remove any third party trustee with whom they are unhappy. Their choices of successor trustees usually become irrevocable, however, after their death.
Who to choose as trustee depends upon the terms of the trust and the purpose for which it is created. The tax consequences of choosing a particular trustee must be given careful consideration.
Regardless of your age and health, now is the time to plan for your successor. Perhaps nothing will be more important for the continued financial success of your buildings than having that plan in place. With proper planning, you can minimize the amount of your estate that will go to the government and maximize the amount that will go to your loved ones. A little planning goes a long way in taking care of your loved ones. Your investment in the time and money it takes to do the planning can save your family big dollars and big headaches after you are gone.
The opinions expressed in this article are those of the author and do not necessarily reflect the viewpoint of SFAA or SF Apartment Magazine. The information contained in this article is general in nature. Consult the advice of an attorney for any specific problem. John O’Grady has been an estate planner for 20 years and counsels apartment building owners, business owners and others to develop estate plans to meet even the most specific objectives. He is with the O’Grady Law Group, APC, and can be reached at 415-986-8500. Copyright © 2007 by SF Apartment Magazine. All rights reserved.