Estate Planning Considerations for Out-of-state Property
It is not uncommon for Florida residents to own real and tangible personal property, directly or indirectly, located in one or more of the other 49 United States.1 It is somewhat less common for this property to be integrated into a comprehensive estate plan that takes into account the additional probate and state estate and inheritance tax issues that may be caused by the ownership. Although the issues raised by such ownership and the solutions available will vary greatly from situation to situation, this article briefly covers some of the more important estate planning considerations to keep in mind when dealing with ownership of non-Florida property by a Florida-based client.
Planning Concern #1: Domicile Planning
A client who reports a non-Florida “vacation home” may, in fact, be a domiciliary of another state. Domicile in another state may be less advantageous than a Florida domicile for estate or inheritance tax purposes.2 Risks of an ambiguous domicile include competing probate proceedings after death3 and state income and estate taxation claims made by the non-Florida jurisdiction.4
If domicile is not perfectly clear, steps may be taken to clarify domicile.5 Since domicile is a matter of intent, however, some ambiguity may remain in spite of the client’s best efforts. In these cases, it may be appropriate to plan flexibly to allow for the possibility that some interested party (such as a taxing authority) may successfully prove non-Florida domicile. Over time, the domicile ambiguity is often resolved, and the planning documents can then be updated.
Planning Concern #2: Avoidance of Ancillary Probate
Most clients readily understand that probate avoidance is a good thing. This is doubly true with out-of-state real and tangible personal property. The standard probate avoidance techniques — revocable trusts, joint with right of survivorship ownership, life estates — will work to avoid ancillary probate as well. In addition, any planning that converts the real and tangible personal property into an intangible asset (such as adding the property to a family limited partnership (FLP) or a limited liability company (LLC)) will also work to avoid ancillary (but not Florida) probate. Steps taken with respect to real property should also include related tangible personal property, or probate may be avoided for the real property, but still required for the tangibles. Some issues to be considered when placing property in an entity are discussed below.
Planning Concern #3: State Estate Tax
We have had a few years to get used to the “decoupling” of state estate taxes from the federal estate tax,6 but many property owners (and some estate planners) are still shocked to learn that there may be a state estate tax assessed on their out-of-state real property even if the estate escapes federal estate taxation. For example, a $2 million estate may be subject to state estate tax even if the federal exemption is $5 million, and an estate with a full marital deduction for federal purposes may nevertheless face state estate taxation. Of course, not every state assesses a state estate tax, and the exemption for state estate tax purposes is not uniform. Those states that do assess a state estate tax frequently revise their statutes. A Florida estate planner should be prepared to research sufficiently to determine the issues.
Once the issues are identified, the best course of action is generally to retain local counsel to provide state-specific advice regarding local taxation and avoidance techniques.
State Estate and Inheritance Tax — Examples
It is difficult to quickly estimate the impact of state estate tax assessed on non-Florida property. The theory is generally quite simple: The approximate tax is a fraction of the theoretical state estate tax on the entire estate calculated by dividing the value of the in-state property by the estate tax value of the entire estate. However, precise state estate tax calculation may require the preparation of a pro-forma federal estate tax return using an applicable exclusion amount that may be different than the current federal exclusion amount.The calculation would then require preparation of a state estate tax return determining the state estate tax liability created by the non-Florida real and tangible personal property. The resulting state estate tax bill may be surprisingly large — or small — depending on the value of the property taxed by the taxing state as compared to the property not taxed by the taxing state. A relatively small estate that holds only non-Florida real property may pay much more in taxes than a much larger estate that holds only a small percentage of non-Florida real property.7
Some examples of state estate taxes paid in recent years are as follows:
1) An estate of a Florida decedent who died in 2009 owning Maine real property valued at $1,260,000, all passing to a credit shelter trust, and an additional $652,336 passing to a spouse, paid over $32,000 in Maine estate taxes, notwithstanding that no federal estate tax was due.
2) A Florida decedent owned Pennsylvania real property with an appraised value of $130,000. After allowance of $4,061 in deductions, the inheritance tax liability was $5,667 (tax rate of 4.5 percent).
State Estate and Inheritance Tax Avoidance
As noted above, even estimating the magnitude of the potential tax can be a chore and an expense that the average estate planning client does not expect and may not appreciate. However, the amount of the tax itself is only one factor in determining whether to plan to avoid the tax; the expense and complication for the estate of preparing the state estate tax return may itself be worth avoiding.
Assuming that the tax and associated costs are determined to be worth avoiding in the abstract, the property owner must consider the costs and complexity of doing so. The ease or difficulty of avoiding the state estate tax will vary widely depending on the state in question and the circumstances of the property owner. An owner of modest out-of-state real property may avoid the tax by simply gifting the property to his or her children (though that may involve further complexity to avoid federal estate tax if the owner intends to continue to use the property). More complicated planning may be expensive and time consuming.
One certain way to avoid the state estate and inheritance tax is to make a completed gift of the property during life either outright or in trust (without retaining the strings that would cause estate tax inclusion). The new $5 million federal applicable exclusion amount creates opportunities for gifting to individuals or trusts. However, gifting is not without complications. To begin with, the state in question may assess a state gift tax,8 or there may be insufficient federal or state applicable exclusion amount available for tax-free gifting. Whether gift tax is due, a federal gift tax return will likely need to be filed (and an appraisal of the property may be required for that purpose). Eventual capital gains tax liability may increase because the income tax basis of the gifted asset carries over and is not stepped up on the death of the grantor. The grantor also must avoid making use of the gifted property unless fair market rental value is paid, with the additional recordkeeping and income tax reporting that entails.9 Local law should also be reviewed if a gift is made shortly before an owner’s death to determine whether the gift will be brought back into the taxable estate for state gift tax purposes.10
Despite its potential drawbacks, a gifting strategy may work well in some circumstances. If appropriate, the property owner may want to consider leveraging the gift for estate tax purposes by use of a qualified personal residence trust. The property owner may also make fractional interest gifts in the property (or in an entity owning the property) to take advantage of valuation discounts and the gift tax annual exclusion.11
Another option for avoiding the state estate and inheritance tax is to sell the property. If the owner would like to keep the property in the family, the sale could be to a family member or to a trust. Although a sale to a third party could make the owner liable for federal (and perhaps state) capital gains taxes, a sale to a grantor trust avoids that tax (at the cost of loss of step up in basis).12 A sale to a family member could backfire if the family member unexpectedly dies before the owner, possibly accelerating the state estate or inheritance tax. Local law should also be reviewed if a gift is made shortly before an owner’s death to determine whether the gift will be brought back into the taxable estate for state gift tax purposes.13
State estate tax may be avoided if the property is placed in an entity such as a corporation or LLC.14 The state tax will be avoided only if the state treats the entity as an intangible asset (so that the situs is the domicile of the owner) rather than looking through the entity to the tangible asset (so that the situs is the location of the property). States differ on this treatment. New York, for example, determined that an S-corporation is an intangible asset as long as its purpose is the equivalent of business activity or a business is being operated, and an LLC is an intangible if it checks the box to be treated as a corporation, but not otherwise.15 Maine will look through any pass-through entity without a business purpose for funding and operation.16 Kentucky, on the other hand, may tax a partnership interest of a nonresident if the partnership conducts business activity in Kentucky on the theory that it has a business situs in that state.17 In New York, a cooperative apartment is, for now, considered to be an intangible asset.
Terms of the Will or Trust
If the state where the property is located has an inheritance tax, the tax rate may be reduced or the tax eliminated depending on who the beneficiary of the property is. Directing the property to the class of beneficiaries with the lowest possible tax may be a viable tax avoidance strategy. For example, Pennsylvania taxes a surviving spouse at 0 percent, a lineal descendant at 4.5 percent, a sibling at 12 percent, and a collateral at 15 percent.18 New Jersey charges no tax if the property passes by specific devise, right of survivorship, or gift in contemplation of death to Class A beneficiaries.19
If the client is married, the client’s will or revocable trust may be drafted in a manner that will avoid state estate tax entirely. Since a client may purchase out-of-state real property without the knowledge of the estate planner, in appropriate circumstances even, boilerplate provisions should take the possibility of state estate tax into account.
A standard credit shelter/marital share formula clause may be drafted to fund a credit shelter trust with the lesser of the amount that will cause no federal estate tax and the amount that will cause no state estate tax. However, this formula may create a larger federal estate tax on the death of the second spouse. Such a formula may contemplate a later disclaimer by the surviving spouse to achieve the optimal level of federal and state taxation. It may be worthwhile to pay the state estate tax and fund the credit shelter trust with the out-of-state property, sheltering it from later state estate taxation — especially if it is expected to increase in value. Many corporate trustees are reluctant to hold real property, however.
Some states allow a “state only” QTIP election, and documents may be drafted to allow this option.20 Some states may recognize a same-sex marriage for state estate and inheritance tax purposes.
Without proper planning, non-Florida real and tangible personal property can significantly increase the cost and complexity of estate administration. Florida estate planners should make sure that their planning recommendations and drafting techniques take non-Florida real and tangible personal property into account.
1 This article considers only U.S. property and does not deal with the complexities caused by ownership of foreign assets.
2 State income taxes, while not a question of domicile, may also make a move to Florida a good idea.
3 See, e.g., Estate of Burshiem v. Burshiem, 483 N.W.2d 175 (N.D. 1992).
4 Since Florida does not currently charge a separate state estate tax, Florida has no incentive to intervene in a state estate tax claim made by
5 See Patrick J. Lannon, Domicile Planning — Don’t Take it for Granted, 80 Fla. B. J. 34 (Jan. 2006).
6 See, e.g., Robert M. Arlen and David Pratt, The New York (and Other States) Death Tax Trap, 77 Fla. B. J. 55 (Oct. 2003).
7 The results may be even more surprising if there is a large mortgage associated with the property located in the taxing state. The owner may consider his or her investment in the taxing state to be small based on a net value of the property. The value for state estate tax calculation purposes is the full value of the property, however, not the net value. As a result, a large tax may be associated with a relatively small investment.
8 See, e.g., Tenn. Code Ann. §67-8-101 (Tennessee).
9 Local law should be reviewed to determine whether the “landlord” is subject to local regulation as well.
10 See, e.g., 36 M.R.S. §§4062 and 4078 (Maine).
11 Care must be taken to ensure a present interest for gift tax purposes, especially when the property has little current use to the beneficiary. See, e.g., Hackl v. Commissioner, 335 F.3d 664, 666 (7th Cir. 2003); Fisher v. United States, 2010 U.S. Dist. LEXIS 23380 (S.D. Ind. 2010).
12 A sale to a grantor trust could be made in return for a note, assuming sufficient trust assets or income are available for note repayment.
13 See, e.g., 36 M.R.S. §4064 (Maine).
14 There are, of course, other good reasons to hold real estate in an entity, including creditor protection.
15 New York State Department of Taxation and Finance TSB-A-08(1)M. See also TSB-A-10(1)(M) (opining that interests in a multi-member LLC treated as a partnership are not treated as being located in New York where the LLC owned New York property being managed by extended family for a fee. “Assuming IRC §2036 or related economic substance doctrines do not apply, a partnership is considered to be separate from its owner.”)
16 See 36 M.R.S.A. §4064, CMR 18-125-601.
17 KRS §140.010.
18 7 2 P.S. §9101 et seq.
19 N. J.S.A. 54:34-4d. (Note that New Jersey has a state estate tax, but it does not apply to nonresidents). See also KRS §140.080 (Kentucky); Md. Code Ann. [Tax] §7-203 (Maryland).
20 See, e.g. , 36 M.R.S. §4062 (Maine).
Patrick J. Lannon practices in the areas of estate planning, estate administration, and trust administration. He is admitted to practice in Florida and New York. He earned his undergraduate degree (B.A., summa cum laude , 1991) from Columbia University, and his law degree (J.D., magna cum laude , 1996) from Harvard University. Lannon is board certified by The Florida Bar in wills, trusts, and estates and is a circuit representative and a member of the Real Property, Probate and Trust Law Section’s Trust Law, Estate and Trust Tax Planning, and Attorney Trust Officer Liaison Conference committees. He is a member of the Miami Beach Estate Planning Group and secretary of the Estate Planning Council of Greater Miami.
This column is submitted on behalf of the Real Property, Probate and Trust Law Section, George Joseph Meyer, chair, and William P. Sklar and Kristen Lynch, editors.