This is part of the Real Estate Series–episodes focused at helping nonresidents buy, hold, and sell U.S. investment properties–profitably.

We All Die

Our clients are wealthy individuals and families. People.

People die.

Even people who own U.S. real estate.

This episode of the Friday Edition is about an investment risk that pretends to be a tax problem. Sometimes this investment risk is best managed with ideas from a tax lawyer. But not always.

Estate Tax and Nonresident Real Estate Investors

The United States has a wealth tax at the time of death. It is called the estate tax. A nonresident/noncitizen of the United States who owns U.S. assets will have this tax imposed on those assets when he dies.

You might think of this as an inheritance tax. In the United States, an inheritance tax is paid by someone who inherits money from a dead person. The estate tax is imposed on the property of the dead person (the dead person’s “estate”), so we call it an estate tax. One is a tax on the recipient of an inheritance, the other is a tax on the source of the inheritance. The U.S. system places the tax on the source.

This Friday Edition tells you how to buy and own U.S. real estate and eliminate the estate tax. Your heirs will thank you.

But more important, this Friday Edition shows you why treating the estate tax as a tax problem to be solved will lead you to make wrong decisions. I want you to think about estate tax as a mathematical exercise in investment risk management and investment operating cost management.

TL;DR

Look at the U.S. estate tax as an investment risk you manage, just like the risk of a fire burning down your building.

Find the lowest-cost risk management strategy and buy it. Sometimes you will buy your risk management strategy from an insurance company. Other times you will buy it from a lawyer.

Your tax lawyer should speak to you with spreadsheets.

Successful Real Estate Investors

Successful real estate investors have two special skills.

They See Risks

Real estate investment rewards people who can identify risks and solve them. Tenant mix risk. Demographic risk. Location risk. All sorts of risks.

If you can see the risks, you are less likely to lose money.

If you know what to do with the risks that you see, you will make money.

They Can Do Mental Math

Every successful real estate investor I have ever met has an odd skill: the ability to do sophisticated mental mathematics while simultaneously doing something else.

A couple of weeks ago I was in a car with two friends who are planning an extremely interesting project in Las Vegas. Five minutes of mental math–construction costs, tenant improvements, land, the impact of time delays on the rate of return, and how much the project would sell for when finished. Back and forth they went, like a tennis match. Bang. Equation solved. “We’ll make $4 million dollars. Let’s do it.” (Hint: they are looking for investors.)

Risk and Math For Nonresident Investors

Look at the owner’s death as an investment risk, not an unwanted interaction with the U.S. government. Manage that risk to avoid losing money.

The magic number for your mental arithmetic is 40%. The estate tax will be approximately 40% of property value at the time of death.

Solving Risks The Right Way

Remember we are managing the financial consequences of a death. If the owner dies, you receive a big tax bill from the U.S. government. It is like fire. If someone lights a match in the right place, then things happen with your building and it burns to the ground.

We cannot eliminate death. We live, we die. So we manage the financial consequences of death. Here are the steps I take to do that.

Step One: The Benchmark

The first thing I look at is a tool designed specifically to solve the mortality risk. Life insurance. If you have a nail, you reach for a hammer. If you have a financial calamity that will occur if someone dies, you look at life insurance.

A real estate investment has a time horizon. There is a date in the future when the property will be sold, if conditions follow what is expected. (If you don’t have a date in mind for when you are going to sell, then you do not have an investment strategy.)

Go get a price on life insurance. Make your expectations on value appreciation over the holding period you have selected. Buy life insurance with a death benefit of 40% of the highest property value in your projections. Maybe buy a little bit more for good luck. 🙂

The present value of the future stream of life insurance premiums payable is the cost of managing the investment risk of death.

This is the measuring stick. The benchmark.

Step 2: Get Alternatives, Get Numbers

Next, find alternatives to life insurance. These alternatives will all do the same thing as life insurance–make sure your heirs do not get hit with a big tax bill. For this, you will be talking to a tax lawyer. That is where you buy alternatives to life insurance.

The tax lawyer’s strategies fall into two categories:

  • There is no estate tax because the dead person did not own anything taxable; or
  • There is no estate tax because the dead person owned something taxable but the value is zero, so the tax is zero.

Eliminate ownership, or reduce value. Those are the strategies that lawyers use to manage estate tax costs.

The lawyer will tell you a lot of stuff. If you have someone skilled, you will understand what is proposed. But you can decide what to do without fully understanding all of the legal technicalities. You need to know the answer to two questions:

  • Does it work? “Please confirm that if I die there will be no U.S. estate tax imposed on the U.S. real estate I own.”
  • What does it cost? What will it cost to build and operate this thing you are telling me to do?

The answer to the first question is an instant “Yes”. There is no other acceptable answer.

The only acceptable answer to the second question is a reasonably sophisticated spreadsheet with a number. If you do not have a spreadsheet from your tax lawyer, you are doing it wrong.

Step 3: Low Cost Wins

Now you have numbers. I hope they are all reduced to a lump sum present value, because that (for me) is the easiest way to compare the choices that you have.

Low cost wins. That might be insurance, or that might be a Clever Lawyer Trick.

Lawyer Solutions (Three I Like, One I Don’t)

There are two methods I use to solve the estate tax risk. Probably everyone else uses these, too. There is no magic.

  • Corporation structures (you own the shares of a non-U.S. corporation that owns a U.S. corporation that owns the real estate).
  • Trust structures (a carefully constructed irrevocable trust owns the U.S. real estate).

Some people like to use multiple layers of partnerships–so many it starts to look like a wedding cake, sometimes. I do not use this idea because I am conservative. This type of idea has been debated by law professors for decades. Academic debate means uncertainty in real life. Investment strategies need certainty. I can achieve the same tax results with certainty, so why use something that has not been proven to work. But that’s me.

These methods (two that I would use, one that I would not) take advantage of the “I don’t own anything taxable, so if I die there will be no estate tax” theory of risk management.

The “Yes, I own it but it is worth zero dollars” strategy uses debt. A 40% tax on $0 is $0.

You own the real estate but you have a mortgage that is higher than the property value. This only works well if you are, effectively, lending to yourself. Banks are not interested in lending you money if the security is less than the debt.

Risk Management Costs Affect Investment Yield

Take the numbers from the life insurance premium price quote, and the numbers from the ideas given to you by your tax lawyer, and build the lowest cost alternative into your investment analysis as an expense item.

Now you have priced the estate tax investment risk (40% of the value of the property at any given moment in time) and you have priced the cost of eliminating that investment risk. That risk management cost is reflected in your projections for investment returns over the life of your investment. You have eliminated a potential catastrophe for your heirs.

If the risk management cost (cunningly disguised as an insurance premium or legal fees) makes the investment performance for your real estate investment unacceptably low, the investment is probably not a good one. Do not buy the property.

Disclaimer

As usual … I’m not your lawyer, and this is not legal advice. Hire someone to tell you the answer.

And especially this is not legal advice this week. The advice this week is “live inside a spreadsheet to get the right answer.” 🙂

Questions? Suggestions? Need More?

Thanks for reading. Topic suggestions and comments are always welcome. Shoot me an email by hitting “Reply” and send me your thoughts.

/Phil.