By Mark de Stefanis, SCSP
Being the beneficiary of a prized piece of real estate comes with a heavy price tag now that the estate tax and generation skipping transfer taxes have been reinstated.
However, counsel can significantly reduce the IRS take by recommending a Real Property Deficiency Study. In most cases, the benefit can more than offset the professional fees.
Inherited real property can bring unexpected complications that tax preparers, attorneys, and accountants must tackle. The property is subject to a 35% tax on its value exceeding $3.5 million, and such a tax can have a devastating effect on the survivors trying to maintain ownership.
To determine the tax bill, the executor is required to calculate the FMV of all the assets including real estate. When the estate includes real property, it is time to get an appraiser involved.
While it is necessary to hire an appraiser to provide the FMV of the property, this is only the first step in the due diligence process. It is strongly recommended that the buyer retain the services of a professional engineer and environmental consultant to guard against deficiencies that a standard appraisal is not intended to uncover.
Regulation §20.2031-1 defines FMV as “the price at which the property would change hands between a willing buyer and seller, neither being under any compulsion to buy or sell having reasonable knowledge of relevant facts.” These five words essentially allow an estate to justify a reduction in the FMV, which in turn will reduce the estate tax due and protect the taxpayer from burdensome real property estate taxes.
To calculate the FMV of the real property, the estate tax preparer typically engages the services of an appraiser.
However, the methods used by an appraiser have one common shortfall: they do not address the property’s structural defects, accrued physical deterioration, building code and ADA compliance, environmental liabilities, etc.
An appraiser’s approach is no substitute for a professional engineer that has been trained in the preparation of a comprehensive study that identifies the remaining useful life of each building system and any deferred maintenance that is going to require new ownership to invest additional capital.
Should a property be encumbered with any such deficiencies, the costs to remedy these conditions should be taken into consideration when seeking to determine the property’s FMV for estate tax purposes.
A Real Property Deficiency Study should include a preparer certification, scope of work, methodology, property narrative, schedule of deferred maintenance costs, detailed construction costs, photos, professional experience, references to the IRC, and a copy of the engagement letter. A quality study should bear in mind that the IRS requires “significant support” to justify estate valuations. To this end, the Real Property Deficiency Study should be submitted along with all other information to support Form 706 (Federal Estate Tax Return) FMVs.
In a recent study, an appraiser submitted a report for a property that was being transferred that identified the FMV of $7.95 million.
The Real Property Deficiency Study completed by our firm found that the cost to remedy the deficiencies totaled $1,070,000. The documented structural deficiencies, needed repairs, code issues, and maintenance required for the real property components of the building helped significantly reduce the FMV. The appraiser only provided a general allocation for deferred maintenance of $75,000. The study documentation served as the required “significant support” and produced a tax savings of $348,250. Ideally, the Real Property Deficiency Study would be completed prior to the appraisal and should be discussed with the appraiser.
The cost of a real property deficiency study should always be based upon a lump sum fee derived from the amount of time the consultant anticipates to be associated with the preparation of the entire report. The IRS will vigorously challenge studies that they find were prepared on a contingency basis.
A comprehensive estate tax strategy including a Real Property Deficiency Study is critical to minimize the estate tax.
Tax preparers and estate attorneys can differentiate their practices from those of their colleagues by engaging tax and engineering experts to prepare a Real Property Deficiency Study as soon as a ballpark estimated value of a property is known.
The additional fee to have these studies completed is always dwarfed by the tax savings that such studies generate.