IRS wish list trouble for real estate families.

A "wish list" of proposed tax law changes is circulating right now in the IRS that gives new meaning to the expression "time is of the essence." On this list of about 15 items is the elimination of the interest deduction currently available to business owners who are eligible for a special estate tax deferral program. This could be particularly costly for real estate families.

This option, granted under Section 6166 of the IRS code, allows active real estate owners, whose business accounts for at least 35 percent of their total net worth, to pay off the estate tax due on their property over a 15 year period. The IRS charges a favorable interest (4 percent) on the first $153,000 of estate tax owed and a current interest rate (7 percent today) on the balance. The payment can be stretched out for 15 years, with interest only paid in the first 5 years and then interest and principal paid for the last 10 years. The program costs the family about $1.66 for every $1 of tax owed, but because the interest is deductible now, the net cost of the program is about $1.30 for every $1 of tax owed.

If the IRS is successful in eliminating the interest deduction, the need for liquidity to cover the estate tax liability will become an urgently pressing matter for real estate families. This article will examine one technique to secure life insurance that will provide the family with a tax-free pool of capital available at the date of death of the owner, so that a costly deferral is not needed by the family. This technique has the added advantage of shifting cash flow, so no gift taxes will be due on the payment of premium.

Grantor Retained Annuity Trusts (Serial GRATS)

Step 1: A series of trusts are set up to last 3, 5, 7 and 10 years respectively. The parents (owners) of the property are the grantors of these trusts and the children are the beneficiaries.

Step 2: Minority interests of a specific property or a partnership are given as gifts to these trusts. The value of each gift is calculated based on the age of the grantor, the length of each trust, the discount taken for minority interest and lack of marketability, and the prevailing IRS interest rate (Section 7520 rate). The gifts are taxable, unless they fall below $1.2 million, and the grantors have not yet used their lifetime exemptions.

Step 3: The grantors of the trust receive income each year from each trust. The trusts are designed to have sufficient income to pay the grantor his designated annual income and to have excess income to purchase insurance. The trust applies for and purchases an insurance policy on the grantors. As each trust completes according to the original number of years, the children become the owners of the property and the parents no longer receive income. The children continue to pay the insurance premium as required from cash flow from the property.

One caveat in setting up this arrangement, is that the parent(s) must survive the term of years of a trust for the program to be complete. Each trust stands alone and therefore the program will be partially complete as each term is complete, i.e. 3 years, 7 years, 10 years. If the parent dies during the eighth year for example, all the policies owned by the 3 year, 5 year and 7 year trusts could be outside the estate. The policy in the 10 year trust as well as the share of the real estate in that trust will revert back to the parent and be included in the estate.

The above method is a technique to pay large insurance premiums with no gift tax consequence. If Congress eliminates the deduction of interest payments on the 6166 deferral technique, owners will be locked into an excessive estate tax liability if they choose such a payment option. This option is often referred to as postmortem and is considered to be the plan of "no plan." Insurance will be a comfort to those families who have it.