Advanced Planning For High Net Worth Clients Using EquityKey^®

Mark V. Kenny, MBA, CPA, CFP^®
Director of Advanced Planning for Centara Capital Management Group, Inc.

The EquityKey Option is a unique concept that was developed by the principals at Centara Capital Management Group, Inc. in 2004 as a means of monetizing real estate assets in a tax-deferred manner without incurring debt or mortgage payments. The product is a forward Option to participate in the future appreciation of a client's home or investment property, and will settle at either the sale of the property or at the end of the client's life. A qualified participant with a residential property may receive between 10% and 15% of the Initial Appraised Value (IAV) of the underlying real estate asset, while a commercial property generally yields 8% to 12% of the IAV. The ideal client for an EquityKey transaction is an individual or couple between the ages of 65 and 85 and in reasonably good health.

The amount of EquityKey's participation in the future appreciation of the property is 50%. The immediate question asked by clients and advisors alike is, "Does it make economic sense to give up 50% of the future appreciation for somewhere between 8% and 15% of the IAV in cash now?" The answer is, "It depends." If your clients believe that their residence or investment property will appreciate at an extraordinarily high rate over the next 10 to 20 years, and have alternative sources of cash to fund planning options, perhaps not. However, if they have a need for cash today to fund planning strategies that will materially reduce estate taxes, enhance estate liquidity, defer current taxation, provide capital for investments with high yielding returns, transfer assets to children or future generations, or avoid additional debt and mortgage payments, then EquityKey may be the answer.

For moderate net worth clients, EquityKey can be utilized to meet immediate cash needs such as pension replacement, long-term care costs, education funding for grandchildren, travel, or charitable donations. However, the product becomes an especially powerful tool when utilized in advanced estate and wealth transfer planning. The ability to access future equity in high-end residential and commercial real estate without the additional burden of income taxes or mortgage payments is a very attractive option for clients who have large, illiquid, taxable estates. Even clients with liquid estates find the tool to be very attractive when their existing liquidity is wished to be maintained for lifestyle or other personal reasons. The benefit of EquityKey is only limited by the amount of planning involved with the transaction, and this article aims to discuss some of its more effective uses.

Why EquityKey Requires at Least One Healthy Participant

Simply put, EquityKey purchases a life insurance policy on the participant in the Option contract that represents 150% of the IAV of the property to hedge the short-term risks involved with the Option. If the client should pass away before the property has had time to appreciate, then EquityKey would likely lose its investment. Because the strike price is set at the IAV of the underlying real estate, the Option has no intrinsic value. Therefore, the Option's value is only derived from the time value the Option requires for the real estate to appreciate. Historically, real estate appreciates over time.

For example, let's take a $20,000,000 commercial property that would yield a payment of $2,000,000 (10% x $20,000,000). If the real estate has not appreciated due to a shortened time frame, the bank would receive virtually no money due to little or no property appreciation. This is not a compelling investment for EquityKey. In order to mitigate this risk, EquityKey hedges its investment by purchasing life insurance on the participant in the option; much like a business owner would purchase key-man insurance on an employee essential to the company's profitability.

Conversely, the longer the property has to appreciate, the higher the value of the asset. At settlement of the Option, EquityKey may be required to purchase the property from the participant or their estate for its future value, less their 50% participation. EquityKey will then sell the property for its full value, thus realizing its gain. If our $20,000,000 commercial property used in our example grows to $40,000,000 over the client's lifetime, EquityKey may be required to purchase the property from its owner(s) at $30,000,000 ($40,000,000 Fair Market Value - $10,000,000 - EquityKey's 50% profit interest). In order to ensure this transaction is completed in a reasonable amount of time, the key-man insurance policy now serves as buy-sell insurance to provide immediate liquidity for acquisition.

This insurance is paid for by EquityKey. The price of the insurance is factored in as part of the Option's pricing matrix used along with other factors, such as future appreciation potential and cost of funds. A number of major insurance carriers have agreed that the insurance is a combination of key-man and buy-sell, and should not impact insurance capacity for the client.

Unique Planning Strategies with EquityKey

As stated before, the proceeds from the EquityKey Option may be utilized for any number of planning purposes. When planning for high net worth estates, financial professionals have found funding a life insurance policy outside of their client's estate in an Irrevocable Life Insurance Trust (ILIT) to be one of the simple, yet effective uses of the funds paid by EquityKey. By exchanging a portion of the equity in their taxable estate for paid-up life insurance, the client would have to see their property grow somewhere between two to five times its IAV in most cases to reach the break-even point of the transaction. (Please refer to the webinar EquityKey 101: Advanced Planning Strategies for details.)

Additionally, for professionals involved in estate planning, EquityKey offers another important advantage to clients who transfer assets outside of their estate with advanced planning strategies. Its unique structure creates an additional level of discount in the range of 15% to 25%. Exactly what level of discount that can be applied is determined after an analysis of the Option premium, the expected growth rate of the property, restrictions in the Option, and the percentage of future appreciation agreed upon in the Option contract. This "top tier" discount can greatly enhance the wealth transferred to future generations by minimizing gift and estate taxes when properly incorporated into a client's estate plan.

To illustrate these advanced planning applications, let's look as a sample case study.

Client Goals:

1. Tom and Sue would like to maintain their current lifestyle.
2. They would like their home to go to their children.
3. They would like to commercial property to pass, in trust, to their children.
4. They believe their $8,000,000 investment portfolio is more than sufficient to meet their lifestyle costs, and would expect to make annual exclusion gifts, as appropriate, to reduce this amount to the applicable exclusion amount. They also retain sufficient assets to avoid §2036 and 2038 issues.
5. Excess funds accumulated at the second death will be consumed by testamentary charitable gifts.

EquityKey in the Transfer of a Primary Residence

Let us look at several planning opportunities, beginning with the personal residence valued at $6,000,000 which is owned free and clear. Left unprotected, the home today would be subject to a 45% estate tax. Assuming estate tax rates remain constant and the property appreciates at 5% a year for 20 years, the property would be worth $15,920,000. The estate tax due on this property at that time would be $7,164,000. One possible planning solution to consider is a Qualified Personal Residence Trust (QPRT). If designed correctly, the clients could possibly transfer the asset outside of the estate, thus greatly reducing the tax liability. However, for two 74 year old clients, a 12-year term QPRT would create a taxable gift of $2,580,000. A longer term QPRT may reduce the gift element, but increase the probability of failure. If the clients were able to use their total lifetime gift tax exclusion of $2,000,000, they would still have to make a taxable gift of $580,000 which would require them to come out of pocket $261,000 ($2,580,000 - $2,000,000 = $580,000 X 45% = $261,000) to implement the 12-year QPRT strategy.

Gift tax consequences are one of several obstacles for clients who consider using a QPRT to transfer their property to future generations. If a fractional or split interest QPRT was used, we could expect a 20% discount to reduce the present value of the gift from $2,580,000 to $2,064,000. However, the client must still use their entire lifetime gifting limits and pay gift taxes.

However, if the clients utilize an EquityKey strategy with a QPRT, we could expect an additional discount of approximately 20%. When combined with a fractional interest discount, we could expect a total discount of 40%, or $2,400,000. By utilizing EquityKey we have further reduced the taxable gift on this transfer to $1,548,000, thus eliminating any gift taxes due, and leaving additional gifting capacity of $452,000 for future planning.

Table 1: QPRT Split Interest & EquityKey Discounts

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Webinar: EquityKey 101 - Advanced Planning Strategies Using EquityKey

September 9, 2008 at 10:00am PDT

Webinar: EquityKey 201 - Advanced Wealth Transfer Planning with EquityKey Discounts