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Succession Planning

Investment advisory services are offered through CliftonLarsonAllen Wealth Advisors, LLC, an SEC-registered investment advisor.


Owners of real estate portfolios have several options to consider as they transition out of the daily management of their assets.

Preparing for transition

Succession Strategies for Owners of Privately Held Real Estate Portfolios

  • 7/9/2015

For clients who hold commercial real estate, the discussion of what to do with these assets in the future can be complicated. Often the owner or owners manage the assets actively either with their own property management employees or the oversight of third party property managers. Issues such as the owner’s age, estate planning, or rate of return considerations, figure into exit strategies.

Our discussions always begin by determining the net proceeds, after income tax, of the liquidated portfolio. This is the baseline from which other options can be considered. The following opportunities all have greater risk than liquidation, but they also have potential to increase value or income.

Triple net lease properties under Section 1031

Most real estate owners understand Section 1031 exchanges and may have entered into an exchange of a real estate parcel for another property in a tax deferred transaction a number of times. With capital gain tax rates at 20 percent (federal) and usually 25 percent for real estate owners due to prior depreciation, when you add in state tax and a potential 3.8 percent net investment income tax, exchanging real estate using Section 1031 is a good option.

What makes this exit discussion a little different is that if owners no longer want to burden themselves or the future of their heirs with a lot of management responsibilities, they often look into triple net lease assets. A triple net lease property is most often a property with a long-term lease (ideally 10 years or greater) in which the tenant, not the property owner, is responsible for all operating expenses related to the property.

For example, if a privately held business has owned an apartment building for many years and wishes to sell that asset and repurchase a less management-intense asset, if they comply with the requirements under Section 1031, they might purchase a retail or industrial property leased to a single (or several) tenants under a triple net lease. If this “replacement” property purchase price is equal to or greater than the sale price of the apartments, and the Section 1031 conditions are met, the income tax otherwise due on sale is deferred. Now the entire sale price (rather than the net price after tax) is invested into a leased property and can provide a predicable cash flow. I have seen private real estate owners systematically sell their portfolio and acquire multiple replacement properties over a period of time in an effort to reduce their management requirements.

Triple net lease assets are not without risk. Due diligence is necessary to confirm the credit status of the tenants. The purchase price of these assets will likely be greater than the value of the real estate alone, since the length of the lease add to the valuation. Accordingly, the value of the asset may drop if the tenant does not renew the lease or defaults on it.

Develop a board to manage your portfolio

Owners can ease into having less involvement in their businesses by allowing hired management and a board of directors to continue to operate the portfolio. When you already know your portfolio well and merely desire good stewardship of the assets, using an independent fiduciary board to hold management accountable can be an effective strategy.

Management may be the children of the existing owners or outside professionals. Ideally, the strongest board is made up of existing owners and carefully selected independent board members. The goal is to have independent directors controlling the enterprise on behalf of the shareholders and serving with family members of the owners. Owners should consider the following as they weigh the merits of this approach:

  • Select the board carefully — members should not just be friends of the owners.
  • Board members should understand the industry, ask hard questions of management, and understand the concept of being an independent advisor.
  • By-laws should provide good governance, and guide and connect board members.
  • Outline and agree upon key metrics.
  • Select a strong chair of the board.

Create employee stock ownership plans

Privately held business owners are often fiercely loyal to their employees, and should consider how they will be affected by the succession plan. When internal employees have been active in the management and leasing of the organization’s portfolio, it may be possible for owners to sell their interest in the company to an employee stock ownership plan (ESOP).

Congress has created some significant tax incentives to sell equity to an ESOP and allow deductible contributions into it by the business. Real estate businesses often don’t have enough employees to allow this model to work, but it’s an option worth considering and can sometimes be very effective for a service portion of the business that includes property management, sales, or leasing activities.

Benefits of real estate investment trusts

One exit strategy unique to real estate is a contribution of the assets to a private or public real estate investment trust (REIT). A REIT is a legal entity that has a significant percentage of its assets and income from direct or indirect ownership in rental real estate or real estate mortgages. Additionally, a REIT must annually distribute 90 percent of its annual net taxable income to its owners. These attributes allows a REIT to produce the following advantages:

  • Diversified real estate holdings — your portfolio is part of a larger group of assets
  • Liquidity — after a waiting period, the owners can sell their interest
  • Professional management
  • Annual cash flow through dividends from the REIT

The contribution of the portfolio would generally be structured as an income tax deferred transaction, whereby the owner receives units in a partnership or a publically traded REIT commensurate with the value of the equity in the real estate portfolio. The total value and sector of your portfolio, along with the asset class, can impact whether this strategy is the correct path.

Assess the impact on your estate

Under current law, a decedent’s heirs inherit assets upon death at a stepped up basis on the date of death. Therefore, depending on your entities’ ownership structure, the gain on any real estate owned (individually or through a partnership) is generally wiped away, and heirs are not burdened with the income tax upon sale after death (although estate tax may be applicable for estates valued in excess of the lifetime exclusion which is $5,430,000 per decedent for deaths in 2015.)

This factor becomes another critical part of the thought process in reviewing transition options. If a 100-unit apartment building caused a $1 million income tax on sale, and replacement property is purchased under Section 1031, and the entire gain is deferred, this $1 million tax is deferred. If the owner later dies while still owning the replacement property, the heir will not pay the income tax from the imbedded gain on the replacement property.

However, this situation will differ quite a bit if the real estate is owned by a privately held corporation. Again, estate planning should be a part of the discussion. If decedents with a taxable estate own the portfolio they may benefit from the using Section 6166, which allows the deferral of estate tax over a much longer period of time for qualified estates. This provision, if applicable, is only available when there is active management of the real estate portfolio, therefore some of the options presented above will not qualify for this benefit.

As with most decisions in life, planning will help you weigh your various options and evaluate the potential results. The owners of closely held real estate portfolios have a surprisingly wide range of options as they plan for their transitions to a different stage of life.