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by Larry Weiss and Patrick Carney

Cash is the grease that keeps the financial markets in motion. Unfortunately, as we have seen in the headlines every day, cash is suddenly in short supply. For the first time, we have seen major banks suspend jumbo reverse mortgages and cut off home equity lines of credit.

Those with significant real-estate holdings are facing stricter lending guidelines, and cash is still needed to diversify risk and fund life insurance for estate tax planning. Managing debt, interest costs and FICO scores have also been at the core of real-estate mortgage planning.

Now, more than ever, property owners are finding themselves with fewer options and some difficult decisions. No one wants to feel forced to sell in a down market and, as a result, we are continuously searching for more alternatives. Besides not getting top dollar for your property, you may face capital gains taxes as high as 25% (a 15% federal tax plus California’s 9.3% tax), in addition to higher taxation on depreciation recapture on the property sale.

Creating good liquidity solutions requires good planning. Many people need cash to cover living expenses, consolidate debts, fund education and vacations, or for estate planning.

Responding to this need in the market and the lack of alternative solutions, a group of CPAs and CFPs began brainstorming. Over a two-year period, they developed an option program whereby a property owner could receive a lump-sum cash payment in exchange for sharing in the future appreciation of the property.

For example, an owner of a $10-million office building could receive a cash advance of $1 million. In exchange, the property owner gives up 50% of the future appreciation of the building. In theory, once the property has appreciated to $12 million, the investors have $1 million of equity (50% of the $2 million of appreciation) and the property owner has an additional $1 million of equity.
You could say that the investors have hit their break even point. Additional appreciation would then begin to provide profits to the investors.

Because this program was structured as an option agreement, there is the possibility that the property owner could pass away in an early year of the program before the property has had a chance to appreciate. In this situation, the investors would lose the entire $1-million investment, and it would be free money to the estate.

To avoid such a loss, the investors decided to purchase life insurance policies on the property owners to hedge the contracts. This option program has now been formalized and is funded by KBC Bank of Belgium with assets of $450 billion and offices in Europe, New York City and San Diego.

Fully developed, the program is now available for use with residential, commercial and investment properties. The residential and investment programs require a minimum value of $500,000, while the commercial program requires a minimum fair market value of $5 million. Both programs allow the combination of properties to achieve the required minimums.

These programs, however, are not without their limitations. The primary constraints for qualification are a property owner’s health and age. One of the property owners must be at least 65 years old with a maximum age of 85. The reason for these limitations is the cost of life insurance. Therefore, the owner must also be healthy enough to qualify for life insurance.

This has been interpreted to exclude smokers, insulin dependent diabetics, cancer patients and those with heart disease. If the cancer has been in remission for more than five years, a person may still qualify. One other consideration involves the allowable loan-to-value ratios. In addition to the health and age requirements, the current loan-to-value on any property cannot exceed 70%.

The cash payout also varies by program. The noncommercial program pays 10% to 15% of the property’s fair market value in exchange for 50% participation. Two people owning the same property may qualify for a 20% to 30% cash advance in exchange for giving up 100% of the future appreciation. The commercial program applies to properties ranging in value from $5 million to $30 million. The cash advance on the option is 8% to 12% of the property’s fair market value.
Both programs are currently available in California, New York, New Jersey, Connecticut, Massachusetts and Florida. This year, in just the Western U.S., the program plans to add Washington, Oregon, Nevada and Arizona.

Estate Planning
One of the challenges for property-rich San Francisco clients is having the liquidity available to meet estate taxes. For many people, a lack of planning can cause a forced liquidation of property to meet estate taxes, which can run as high as 45% for some property owners. Many clients fund life insurance to be held outside the estate in an irrevocable life insurance trust. Upon the death of the property owner, the death benefit is available to pay the estate taxes and, equally important, avoid a forced liquidation of the real estate at potentially depressed prices to the detriment of the family.

Using the option program as an estate-planning tool offers many benefits. The property owner can monetize otherwise illiquid real estate without selling income-producing properties or creating debt. It allows the property owner to diversify real-estate risk by placing the cash advance into other investments. It also allows the owner to “freeze” property assets by selling the appreciation that would be otherwise subject to estate tax.

Owners can preserve and transfer wealth by purchasing life insurance outside of the estate. The option creates instant liquidity for the heirs/estate because they do not have to manage the sale of the property upon the client’s passing. The program has the cash to settle the estate because of the life insurance policy. This means the estate can be liquid even before the property is sold.

Let’s review the benefits in the context of an example. We have a 76-year-old male who’s married with four children and a dozen grandchildren. His net worth is $14 million, which includes a $10 million commercial building. He receives a lump sum payment of $1 million from the program in exchange for 50% of the future appreciation of the commercial building.

Let us assume the client uses cash from the payment to purchase a $6 million life insurance policy; the client lives until age 86; the estate grows by 4% per year; the estate tax rate equals 50%; and the estate exclusion is $1 million per person. Given these parameters, we can extrapolate that by using the option program wisely, the estate/heirs have increased their overall net worth by over $4,700,000. (See box for details.)

Results with No Estate Plan
Gross estate in 2018	$20,723,000
Approximate estate tax liability	($8,602,000)
Net available to the heirs	$12,121,000
Results with an Estate Plan
Gross estate in 2018	$18,322,000*
Approximate estate tax liability	($7,498,000)
Tax-free proceeds	$6,000,000
Net available to the heirs	$16,824,000
*Reflects the net of the option share of the appreciation, which also creates a lower estate tax liability.

We have seen significant appreciation in real estate in the last ten years. Many investors have not updated their estate plan to account for this increase in value and the potential tax impacts. Now is the time to run the numbers to make sure your estate actually goes to your heirs and not the government.

Because qualification is based on a property owner’s health and is a one of a kind product, it makes sense to have the calculations performed while still healthy. Once a person doesn’t qualify, the options again become very limited.

Although the benefits are obvious, there are many other applications for commercial, investment and residential property owners. The funds can be used to restructure debt, supplement retirement income or fund a charity.

There are many more details outside the scope of this article that will require you to consult with a CPA, attorney or financial advisor familiar with this program.

 

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The opinions expressed in this article are those of the authors and do not necessarily reflect the viewpoint of SFAA or SF Apartment Magazine. The information provided is for informational purposes only and does not consider your particular financial situation. Individuals should contact their own tax and investment advisors or other professionals to help answer questions about their specific situations or needs prior to taking any action based on this information. Larry Weiss CPA, CSA is a tax and investment professional with Lau Financial Services located in San Francisco. He can be reached at 415-794-4360. He is a registered representative offering securities through NEXT Financial Group, Inc., member FINRA/SIPC. Patrick Carney, CPA is an Alliance Account Executive with First California Mortgage Company located in Petaluma. He can be reached at (415) 233-0565 or at pcarney@firstcal.net. Copyright © 2008 SF Apartment Magazine. All rights reserved.