Do you have clients who have significant holdings in illiquid commercial real estate but little cash to fund their life insurance needs?
If so, commercial real estate can be used to pay the annual premium.
Commercial real estate (CRE) in the form of apartment rentals, storage facilities, commercial retail, office space and industrial and warehouse properties are all examples of income-producing real estate that may be used to pay premiums.
How? Clients can lend the CRE to a Grantor Trust (s)he creates under an Installment Note Sale arrangement in which there is a promise to make a balloon payment of principal at the end of the note term. At the end of the note term, the client can take the asset back as payment ‘in-kind’– or take cash or other assets as form of repayment.
Take a look…
What does this accomplish? It provides the client flexibility relative to the timing of, and comfort level with, making lifetime gifts. That is, the asset is being ‘sold’ Instead of ‘gifted outright’. The sale allows the client to buy time to decide if, and when, to make an outright gift.
That is, under the Installment Note Sale (with balloon payment) transaction, the client has flexibility to take the asset back at the end of the note term. Alternatively, the note can be forgiven, in which case the amount of forgiveness is subject to gift tax. The loan can also be refinanced– kicking the proverbial tax can down the road further.
Meanwhile, the asset gets inside the trust without gift taxes (because it’s a ‘sale’ and not a ‘gift’). The CRE asset resides in the trust as it spins off income, which is used to fund a life insurance policy on the life of the client. The life insurance policy is owned by the trust and, therefore, the proceeds, when paid, remain outside the taxable estate. The client gets the asset back, or the equivalent to its value returned, refinanced or forgiven.
What’s a Grantor Trust? The trust is a life insurance trust structured as a ‘Grantor Trust’ so that the grantor (the client) is responsible for the income taxes on trust earnings. When the client pays the trust’s income taxes, more assets remain inside the trust to do the life insurance liquidity planning.
The transaction must be structured as a fair market rate of interest using the applicable federal rate (AFR), which is generally paid annually. The difference between the AFR rate and the trust earnings is the amount that is available to pay premiums. The lower interest rates remain, the more that is available to fund premiums.
Carpe Diem. As interest rates rise, this is the last opportunity for your very wealthy clients to take advantage of this planning strategy.
Although the Installment Note Sale is a sales transaction, the sale to the trust does not trigger capital gain tax, as it otherwise would if it was a sale to a third party. The sale price may benefit from a marketability or minority interest discount, as well. The discounting will go a long way in minimizing the sale amount, or the gift amount if the repayment is forgiven.
Note that a gift of “seed” money to the trust– in the form of cash or an asset– is generally viewed as necessary when an Installment Note sale transaction is used. The “seed” ensures that the trust is a viable, independent, sufficiently funded entity capable of repaying its debt. Some practitioners believe that the ‘seed” gift should be at least 10% of the assets being sold to the trust.
Why not simply ‘lend’ the asset directly to the trust? When an asset is directly lent to the trust, there are potentially significant gift tax consequences and valuation penalties that may result because there is no promise to make a repayment. On the other hand, an Installment Note Sale (with promissory note for a balloon payment) has a long history and is generally viewed as “true debt”.
So, for your wealthy, high net worth clients with little liquid assets and significant commercial real estate holdings, an Installment Note Sale (with a promissory note of a balloon payment) may be a powerful planning strategy to create the liquidity they need.
