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- How can a real estate developer legitimately protect assets from creditors ?
- How can a real estate developer achieve capital gain instead of ordinary income ?
- How can a real estate developer minimize estate taxes without liquid assets ?
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This paper explores an approach to comprehensive and integrated planning for privately-owned developers of for-sale residential real estate, including developers of mixed-used projects that include residential components. Within our office this planning approach is referred to as D3 (or “D-cubed”), reflecting the integration of strategies for (1) asset protection planning, (2) income tax planning and (3) estate planning.
The planning described in this paper is suitable for developers that are family owned as well as those that are partnerships among unrelated persons. The specific techniques described in this paper are intended for the developer who is committed to establishing and maintaining a sound organizational structure. To do so, the developer must have a strong internal staff and dedicated external professionals (CPA and lawyer) to support it.
Even for established developers, lack of an overall organizational structure and strategy is common place. The typical developer of for-sale residential real estate probably describes its organizational structure as follows: a development or construction company, often in the form of a subchapter S corporation, and separate companies (usually limited liability companies) for individual projects. When asked to describe how those entities are connected or what the overall organizational strategy is, the developer will typically be at a loss to answer and will refer the question to his accountant or lawyer. The lawyer, more often than not, is a solid real estate attorney who can instruct on the formation of entities on a project-by-project basis but has neither the time nor the experience in ancillary areas such as estate and income tax planning to develop an overall multi-dimensional organizational strategy.
There is nothing wrong with a central development company that serves payroll, marketing and general contracting functions, with individual projects taken up by limited liability companies. But just as important are: how those entities are owned, what the entities own and how the entities relate to one another. How does money move tax efficiently from one entity to another? How are project profits distributed and reinvested? How are investment assets owned (e.g., the retail portion of a mixed-use property, land bought on speculation for possible future development, excess land that might be resold or developed for retail or other non-residential use)?
Over the years we have refined a prototype organizational platform for residential real estate developers that serves as a platform for (1) asset protection planning, (2) income tax planning and (3) estate planning. Each component of this platform is discussed below.
I. ASSET PROTECTION PLANNING.
Developer exposure to creditor claims is of an “upstream” and “downstream” nature. Proper planning should attempt to mitigate exposure at both levels.
A. Upstream Claims.
Upstream exposure to creditor claims arises at the project level and includes uninsured or underinsured claims on job sites, construction defect claims, subcontractor disputes, environmental issues, adjacent property owner claims, purchaser warranty claims and other claims from purchasers, including increasingly novel claims such as lack of disclosure of nearby developments that impair views or open space or otherwise diminish value.
Upstream claims have generally been addressed by comprehensive insurance coverage and having the developer own each of its projects through separate limited liability entities such as corporations or limited liability companies.
B. Downstream Claims.
It is customary in the middle market for the owner of the developer (we refer to that person as the “principal”) to personally guaranty all or a substantial part of project financing. A principal whose development company runs several meaningful projects at the same time will generally have guaranty exposure many times his or her net worth and is at risk of being decimated financially by one bad project.
Downstream claims have generally been addressed by having the principal’s residence owned in the name of the principal’s spouse, and conventional planning has not gone much beyond that.
C. Strategies for Risk Mitigation.
In relation to upstream liabilities, the standard approach of using limited liability entities is sound, but a refined approach to planning should (i) reduce the amount of project equity that is exposed to creditor claims in the first instance and (ii) prevent cross-collateralization that occurs through the use of a single limited liability entity to own multiple projects or recycling limited liability entities for successive projects.
Avoiding cross-collateralization is as simple as avoiding the temptation to save on entity formation costs. The benefit of using multiple limited liability entities is compelling relative to cost.
Reducing the amount of equity that is exposed to creditor claims in the first instance requires a broader strategy of identifying and then separating the investment component of a development. This is discussed in later sections of this paper.
By lack of an organizational structure that separates personal or investment assets from the principal, most principals leave substantially all of their assets exposed to claims of project lenders, quite unnecessarily. There is no question but that a principal must be able to present a strong balance sheet in order to secure financing in the first instance, but in a construction context the guaranty is often more about having the principal’s interests aligned with the lender than the actual amount of personal assets of the principal that the lender can reach.
II. INCOME TAX PLANNING.
Developers of for-sale housing should generally expect to realize ordinary income, which is taxed at rates approximating 35 percent (Federal). In contrast, capital gains are generally taxed at 15 percent (Federal). Unfortunately the 20 percent rate reduction for capital assets is the province of real estate investors, not developers.
The law recognizes that a real estate developer can own real estate for investment and thus qualify for the reduced rate of tax on capital gains, but achieving this result requires careful planning. By separating the developer’s core development activities from non-core investment activities (including investment in real estate), opportunities for realizing capital gain can be preserved.
Achieving this result also requires holding properties in tax-efficient entities. While individual development projects can be held in subchapter S corporations, it its generally unwise for investment real estate to be held in corporations, including subchapter S corporations. The preferred manner of holding investment real estate (in most states) is the limited liability company.
In the case of mixed-use projects, having one entity own the entirety of a project can result in missed opportunities where investment real estate (that might otherwise be eligible for capital gain) is exposed to ordinary income tax. Take a vertical mixed-use property with for-sale condominiums atop a base of parking and retail. If the entire project is developed at once, and the retail component is leased up and sold at the same time as the condominiums are being marketed and sold, the vertically subdivided retail component of the project is less likely to qualify for capital gains treatment than if the retail component of the project had been separately owned. One can observe similarly with respect to large horizontal tracts developed with single family homes but where a portion of the parcel is separately developed as retail.
Somewhat more challenging (but of greater interest to developers) is the possibility of capturing for capital gain treatment the appreciation in the value of land between the time of acquisition and the completion of development. The easiest way to explain the objective of such project-specific planning is to consider the developer who has purchased a rapidly appreciating tract of land, chooses not to build on it and sells it after two years. Assuming that the land was not subdivided and that no improvements were made, the developer should be eligible for capital gain treatment on the appreciation in the value of the land (15 percent Federal income tax rate). But if the developer ultimately turns to developing for-sale housing on the land, the appreciation in value that occurred will become a part of the overall project profit subject to ordinary income tax (35 percent Federal income tax rate).
The tax law does not contain a ready mechanism for bifurcating project profits between the appreciation of the land (for which one might seek capital gain treatment) and the developer’s project profit (which is subject to ordinary income tax). But there are defensible planning strategies that are worthy of consideration. Proper planning involves not only establishing proper ownership of the components of a project, but also making certain (i) that those components (and the entities that own them) interact with one another on a commercially reasonable arm’s-length basis and (ii) to take account of specific recharacterization rules under the Internal Revenue Code.
The project-specific bifurcated planning structure described above is obviously not created for the income tax benefit, but is an integral part of an overall planning strategy that involves upstream and downstream asset protection (Section I) and estate planning (Section III).
III. ESTATE PLANNING.
A lifetime’s worth of building wealth may never resolve the developer’s liquidity dilemma. Developers often confuse a lack of liquidity with lack of transferable wealth and often do not view themselves as candidates for customary estate planning for persons of means.
Sound estate planning should be of compelling interest to developers. Apart from mitigating Federal estate tax (at rates approaching 45 percent on taxable estates over $2 million), proper estate planning should facilitate the transfer of family weather to successive generations in a rational way and facilitate the transition of management in an orderly way.
The techniques for accomplishing estate planning and succession planning objectives are well known to estate planners, but application of these techniques to the typical developer can be challenging. Passing investment assets to children in a tax-efficient way is a challenge when those assets are part of a development company or just part of a hodge-podge of companies.
A sensible organizational framework that concentrates control is an important part of keeping key management employees in place. Incentives for growing professional management can only be developed within a settled organizational structure, and the concentration of control allows for meaningful succession planning.
Many developers (even if established) do not view their organizations as necessarily surviving the current generation of ownership. It may well be that it will not, but insofar as substantial wealth building is concentrated in increasingly large projects undertaken as the developer grows, the risk of that wealth dissipating is greatest when the developer principal passes on. The benefit of an organizational structure to support a succession plan may not be to carry the business on into successive generations as much as to allow for an orderly winding up without substantial loss of accreted wealth. A logical succession plan layered upon a sensible organizational structure is key to working effectively with project lenders who will usually have the right to call loans on projects in process upon the death of a developer principal.
Estate planning is most effective for a developer when it works on a bifurcated organizational platform – one that separates appreciating investment assets (including real estate) from the core development business. The concept, so far as possible, is to separate the assets that creates the wealth (the development company) from accreted wealth that does not have to be reinvested in the business. Once the organizational platform creates separate places for these two types of assets, common estate planning strategies can be employed to minimize estate taxes, conveniently transfer non-business assets and transfer control of the development company and in-process development projects in orderly way. This is the same platform that attempts to separate non-core investment assets from development company risks for asset protection purposes (Section I) and may allow for more accurate (and favorable) income tax treatment (Section II).
IV. STRUCTURE.
Perhaps the best insight into the workings of a proper planning platform is the following flowchart. It is worthy of note that this is only one of many planning iterations we refer to as D3.
[Chart Not Included]
Caution is warranted in that this flowchart does not fully depict how the entities interact with one another and how our three objectives are actually realized. But what should be evident in the flowchart is the deliberate separation of investment (left side) and development (right side) activities. This separation lays the foundation on which good (1) asset protection planning, (2) income tax planning and (3) estate planning can take place for the professional residential real estate developer.
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