Many taxpayers are considering updating their estate plans to get ahead of expected tax law changes that may impact the lifetime exemption for gifting property. Currently those exemptions sit at $11.7 million per person but are scheduled to sunset on December 31, 2025, when they will revert to $5 million. However, the exemption could dip even lower — to $3.5 million per person — before the 2025 sunset date, depending on if and when the Biden administration’s tax plan comes to fruition.
As gifting strategies are often a core part of estate planning, now is the time to begin looking at potential changes to your plan. Incorporating Qualified Opportunity Zone (QOZ) investments is one such addition that could help mitigate the consequences of lower gifting exemptions.
Refresher on Qualified Opportunity Zones
The Tax Cuts and Jobs Act created QOZs, a powerful tool that incentivizes taxpayers to invest in low income communities. QOZs offer investors three significant tax benefits:
- Temporary deferral of gains;
- Basis increase, which results in a 10% decrease in the original gain if the QOZ investment is held for five years and 15% if it is held for seven years (both must be held for their respective periods prior to December 31, 2026); and
- Tax-free disposition of the investment.
The Significance of an Inclusion Event
Before we discuss how to use QOZs into your estate plan, it’s important to understand that for a QOZ investor to receive all of the tax benefits of the program, they need to avoid what are known as “inclusion events.” An inclusion event triggers the deferred gain and can result in the loss of the 10% or 15% basis increase and the tax-free disposition of the investment.
Using Qualified Opportunity Zones with Common Gifting Techniques
Incorporating QOZs into a properly structured estate plan can be worth the effort, offering significant benefits, such as:
- Minimizing burden on heirs, since there is zero tax upon sale if the investment is held for 10 years;
- Integrating easily into estate plans, whether a direct gift or a sale to an Intentionally Defective Grantor Trust; and
- Helping maximize any unused exemption, since we are in a “use it or lose it” period due to changing tax law.
Gifting, Grantor Trusts and Beneficiaries
Two common types of estate planning techniques include transferring property by means of a gift and using the unlimited marital exemption to transfer property between spouses.
For Qualified Opportunity Fund (QOF) purposes — a QOF being the investment vehicle that ultimately invests in QOZ property — gifts, including a gift to a spouse, is an inclusion event. The only type of gift that is not an inclusion event is a gift to a grantor trust.
One type of grantor trust that would be an excellent candidate to be the recipient of a QOF as a gift would be an intentionally defective grantor trust (IDGT). An IDGT is a type of trust where the grantor is treated as the owner of the trust for federal income tax purposes, but not for federal estate tax purposes. This means that all federal income tax generated by the QOF, including the deferred capital gain, are paid by the grantor, allowing the QOF owned by the trust to grow tax free while the grantor is alive. Death is not an inclusion event, so the conversion of the trust from a grantor to a non-grantor trust at the death of the grantor is also not an inclusion event.
It is important, however, that the IDGT is not converted from a grantor trust to a non-grantor trust prior to the death of the grantor, as this conversion would be an inclusion event. Conversion of an IDGT from a grantor to a non-grantor trust prior to the death typically occurs when the grantor is either unable or unwilling to pay the federal income taxes attributable to the assets owned by the IDGT. The taxpayer’s advisers should make note to analyze the effect of converting an IDGT from a grantor to a non-grantor trust during the life of the grantor as it relates to QOFs prior to making the decision to proceed with the conversion.
Another option, instead of a gift to an IDGT, is to sell assets to an IDGT in exchange for a promissory note. The sale to the IDGT is not a taxable event since the grantor is treated as the owner of the trust assets. In other words, the sale is treated for federal income tax purposes as a purchase and sale between the same taxpayer (a nontaxable event). As long as the assets in the trust grow at a higher rate of return than the interest rate on the related note, the taxpayer should be able to remove assets from their estate without consuming gift or estate tax lifetime exemption. For purchases such as the one described above, many estate tax advisers recommend a down payment of at least 10% of the sales price. A cash gift to the trust may be needed to provide the trust with sufficient funds to make the down payment, but the actual sale of the assets to the trust should not be considered a gift as long as exchange of value between the grantor and the trust are equal.
When it comes to gifting, also be mindful that while most gifts, other than to grantor trusts, are inclusion events, as mentioned above death is not. The benefits of the QOF will transfer to the ultimate beneficiary, including the decedent’s holding period. Even though transfers at death retain the original investor’s tax attributes, the QOF does not receive a step-up in basis, which runs contrary to the traditional tax treatment with most inherited property. That said, if the beneficiary inherits the QOF, and they satisfy the 10-year holding period, the beneficiary in effect could receive a step-up in basis well after the date of death. In most cases, this outcome will be more beneficial than receiving a step-up in basis at the date of death since financial assets tend to appreciate in value. The beneficiary may be responsible for the taxes associated with the deferred capital gain depending on whether the recognition of the deferred capital gain occurs before or after the date of the decedent’s death.
Recapitalizations and Discounts
Another planning strategy that can work well with QOZ interests includes recapitalizations and discounts. A typical estate planning strategy is to recapitalize an LLC into voting and nonvoting shares, in which the nonvoting shares comprise most of the outstanding units. The nonvoting shares are then gifted or sold to an IDGT. When the QOZ interest is valued by a qualified appraiser, discounts are available for lack of control and lack of marketability. Discounts can result in a decrease in the value of the gift of between 20 and 30%, thereby allowing the grantor to transfer more value out of their estate.
One critical aspect to keep in mind when incorporating QOZ investments into your estate plan is to not inadvertently trigger an inclusion event. As stated above, spousal gifts and direct gifts of a QOZ interest are inclusion events.
Also, be aware there may be a need to access a sufficient amount of cash at the time the tax on the deferred capital gain is due, regardless of whether or not the due date is accelerated as a result of an inclusion event. While the original investor is or should be planning for this event, the heir who inherits this tax liability needs to be aware of how much cash is needed to pay the tax associated with the deferred capital gain and when that payment is due.
In the current environment, it may make sense to consume as much lifetime exemption as possible now, as the $11.7 million exemption is scheduled to revert to $5 million after 2025 and may legislatively be reduced even further and/or sooner than 2026. If this happens, taxpayers may possibly forever lose the opportunity to transfer the full $11.7 million without incurring gift or estate taxes. Investments in QOFs present new and powerful estate planning opportunities to help mitigate the impending changes, but proceed with caution to avoid unintended negative consequences.
Contact Michael Boncher at firstname.lastname@example.org or Dave Sobochan at email@example.com to discuss this topic further.
Cohen & Company is not rendering legal, accounting or other professional advice. Information contained in this post is considered accurate as of the date of publishing. Any action taken based on information in this blog should be taken only after a detailed review of the specific facts, circumstances and current law.