Note #13: Leveraging Acquisition Dollars, Or, What Does The Seller Really Really Want?
The bottom-line message of my latest book, The Business of Open Space: What’s Next??, is that we need a bigger toolbox. Private land conservation has flourished for the past three decades, because of conservation easements and government funding. Continued growth at the same remarkable rate, in reliance on conservation easements and government funding, is not sustainable.
We need a bigger toolbox. See The Business of Open Space: What’s Next??, for the longer discussion of some of the tools that we can develop, and tools that we can use more often, to expand the toolbox and make more private landowners who care about their land happy.
The book talks about new tools, such as the development and sale of “environmental commodities,” that are just beginning to be developed but are not yet widespread, and the list of participants in the discussion continues to be too limited. However, in the meantime, techniques such as “bargain sales” and “tax-free swaps” (see Note #2) are among the few creative techniques that show up in land protection transactions.
But without any new environmental commodities at all (or, for that matter, with them), we still have what I call “leveraging acquisition dollars.” The threshold issue is not so much leveraging techniques (more on some of those below), but on developing a NEW MINDSET. To put more leveraging into play, we don’t even need new tools that haven’t been invented yet. We just need a NEW MINDSET.
Chapter 5 of The Business of Open Space is entitled “LEVERAGING ACQUISITION DOLLARS.” Almost all of this Note #13 is taken directly from that Chapter 5, although I have made some minor changes in the text.
Remember this: the NEW MINDSET involves asking the question, “What does the seller really really want?” More on that below.
My Introduction To Leveraging
More than a decade ago, I was involved in two different transactions around the same time that opened my eyes to a new way of thinking about land acquisition projects. Keep in mind I’m not now talking about conservation easement gifts, or other charitable gifts. I’m talking about when a government agency, or a land trust, or another non-profit, wants to buy land but the deal needs creative tax and/or financial planning to close. Most of the time, the participants don’t even know that the deal needs creative tax and/or financial planning to close.
In the first transaction, I was approached by a representative of a government agency that had money to buy land.
“We have been talking with an older couple about buying a wonderful piece of land they own. We want to preserve it as open space,” she said to me. “We have more or less agreed on a purchase price in the range of $1,500,000. We’d like you to do some tax planning and put together a deal for us. We want them to be in the same economic position as if they’d listed the property with a real estate broker, sold it to a developer for $1,500,000, paid the broker a commission, paid capital gains tax, put what’s left in the bank, and had an annual income stream from that bank account. But we want you to do it in a way that we end up paying less than $1,500,000.”
I thought this was a pretty tall order, but we went to work on the planning. What we came up with was a fairly complex solution but it worked. The sellers ended up with what they wanted and the buyer paid less than the $1,500,000 they were originally prepared to pay.
Leveraging Requires A New Mindset
There are three points to this Note. One is to share with you a few more specific examples of how leveraging works. The second, I think, is more important, and that is to make the point that “leveraging acquisition dollars” requires a new mindset, whether you are the buyer or the seller. The third is back to “synergy” again – leveraging is a tool, the creative acquisition of certain property rights is a tool, good tax planning is a tool. Leveraging stands on its own but it works well with other tools in the toolbox.
Marketplaces will acknowledge, develop, and set values on natural capital. Environmental commodities will be worth money. New pools of money will become available. Buyers will understand how to leverage acquisition dollars. Once we begin to open our eyes and broaden our thinking, new and better ideas will come on line.
Traditionally, the way to close a real estate sale has been to negotiate over the price. Leveraging requires a different mindset. It requires that at least one of the parties ask the questions, “What does the seller really really want out of this transaction? Has anyone even asked the seller the right questions, or provided a menu of choices? Put another way, how can we structure this deal in a different way, mindful of tax and financial planning opportunities, to make the bottom line better than with a simple straight purchase for both the seller and the buyer?” If you ask the questions (see, “What Does the Owner Really Really Want,” below), and then actually explore different ways to make the bottom line better, chances are excellent that you will find new and different ways to close the deal.
Before we get to some examples of leveraging, here is one additional new thought. In the past, and in the following examples, the key question has been, “What does the seller really really want?” Now, and certainly in the future, we have to add two more questions: Does the seller really understand all of the rights she has to sell? Does the buyer understand the bundle of rights that is available to purchase?
Another Introduction To Leveraging
In another one of my early leveraging transactions, I represented a landowner who had hundreds of acres of important agricultural land in an area where agricultural land was disappearing fast. The local land trust had put together a very complicated deal involving money from two land trusts and three government agencies. The land trust and government buyers were prepared to purchase some of the farmland from the owners (and lease some of that land back to the family), and were prepared to purchase conservation easements on some of the farmland from the owners. The family was prepared to donate conservation easements on some, but not all, of the rest of their land.
The owners were in their mid-sixties, with three children, and the family planned to stay in the farming business at least while the parents were alive. The family’s plans were unclear after that. The land was so important the consortium of buyers wanted to be able to preserve even more of it for agricultural purposes, by outright purchase or by purchasing easements, but there simply wasn’t any more money and the family wasn’t interested in more charitable gifts beyond the generous gifts (through gifts and bargain sales) they had already committed to. (For purposes of this discussion, let’s call the two most important remaining pieces of unprotected agricultural land Parcel D and Parcel F.)
We did some extensive tax planning and estate planning for the owners. We were also mindful of the fact that the owners still faced a heavy estate tax burden, wanted to see their land stay in agricultural use past their deaths, and had a good, friendly, longtime working relationship with the local land trust and some of the government agency people involved in the deal.
Closing The Deal, Or, Good Tax Planning Makes The Sellers Happy And Leverages Scarce Acquisition Dollars
This was some of the planning we came up with.
We set up a charitable remainder trust (“CRT”) for the owners. For purposes of this Note, here is a very brief and simplified explanation of a CRT. A CRT is a charitable trust. People will often contribute to a CRT an asset or assets that have increased in value. If the owners (assume husband and wife) had sold the asset themselves they would have had to pay substantial tax, but when the charitable remainder trust sells the asset it pays no tax. After the CRT sells the asset, the CRT invests all of the proceeds and, more often than not, pays out income annually to the husband and wife for the rest of their lives. In many cases, though not all, that income stream is used to purchase a life insurance policy that will pay benefits at the death of the second spouse to die (a so-called “second-to-die” policy). At the death of the second spouse to die, the principal remaining in the charitable remainder trust is paid to a charity chosen by the husband and wife. Sometimes in such cases, people in the financial products business call the plan a “wealth replacement trust,” that is, the money in the trust goes to charity (not the kids), but the life insurance goes to the kids. When the transaction is properly structured, there is no estate tax on the life insurance proceeds.
In this case, we set up a charitable remainder trust for the husband and wife. Then, here were the steps.
First, they contributed to the charitable remainder trust some of the land they were planning to sell to the government agency buyers as part of the pending transaction.
Second, at closing, the government agency buyers purchased the land from the charitable remainder trust.
Next, once that purchase had closed, the husband and wife designated the local land trust as the charity to receive the proceeds from the CRT after their deaths (the land trust was named the “remainder beneficiary”). This was a very important deal point.
Finally, once that happened, the land trust acquired from the husband and wife an option for the land trust to purchase Parcels D and F from their estates, at appraised estate tax value.
What is happening here? First, at the death of the second spouse, the CRT terminates. Then, the money in the CRT, which was originally state government money that was used to buy land from the family’s CRT, will be “recycled” into the hands of the local land trust. The local land trust planned to exercise the option, purchase the two parcels from the estate, and “recycle” the money back into the hands of the family!!!
Result using leveraging and creative tax planning: the same dollars are being used twice – when the government agencies initially made their purchases and then again when the CRT distributed its principal to the land trust – both times to acquire important land and both times to benefit the sellers!!! Buyer and seller are very happy and the deal closes!!
In addition, as a further benefit to younger generations of the family, the husband and wife did in fact use part of the annual income payments from the CRT to purchase a second-to-die life insurance policy.
Now, most of the time these days when a government agency or charitable organization has money to acquire land, it seems that the “creative” part of the negotiation is simply the negotiation, which essentially boils down to skirmishing over the purchase price. What these two early “leveraging” transactions taught me is a whole new mindset. The way to close the deal, I realized, might be to do some creative tax and financial planning for the seller, to achieve the seller’s goals, make the seller happy, and stretch the buyer’s dollars. If we can do this, the chances of closing the deal are enormously increased!
What Does The Owner Really Really Want?
Very often the key to leveraging involves determining exactly why the seller is selling. Is it to put a lot of money in the bank? Generate an income stream for retirement? Create some liquidity as part of the inheritance for the children or grandchildren? Come up with the cash to buy another property? Is the owner/seller interested in making a charitable contribution as part of the deal (which contribution could be used to “shelter” some the income from the sale)? Is the seller interested in doing a “tax-free swap” for some other real estate? (Again, see Note #2.) The structure of a deal could be completely different depending on what it is the seller wants to get out of the deal.
In one transaction, the seller was a 90-year old woman in excellent health, and the local land trust was trying to be the buyer. The only issue was the purchase price. I spoke to her son. We had a pleasant and informative conversation.
“Just what is it that your mother is trying to accomplish here?” I asked. “Does she want to put a lot of money in the bank? Take a long trip? Generate more cash flow to support her lavish lifestyle?”
“No,” he said, “mother doesn’t really need the money.”
“Well, what about for you and your sister?” I asked. “Is your mother doing this deal to be able to liquidate the property and leave you more cash?”
He gave that some thought. “No,” he said. “We’re okay, and we already have some inheritance coming. Now that you ask, I think we’d like to find a way to get this money down to her grandchildren.”
Now That You Ask!!
Now that you ask!!
This conversation opened up a wide range of planning possibilities the family (and the land trust) had not even begun to consider. The possibilities included, just as one example, mother conveying the property to a charitable remainder trust, having the sale proceeds paid by the CRT to the son and daughter over, say, a fifteen-year period, and having the son and daughter use those sale proceeds to acquire life insurance on their lives for the benefit of their children (the property owner’s grandchildren). Note that there are a number of tax planning issues that come up here, not at all insurmountable, but they are beyond the scope of this Note. Suffice it to say the deal closed and all parties were happy.
One common definition of alchemy means (more or less) turning ordinary metals into gold. Let me share with you an example of something like that.
I was called by the mayor of a prosperous town maybe fifteen years ago. The town had $1,800,000 in its land acquisition fund, and it wanted to buy a wonderful and important piece of land owned by Mrs. Green. The land had been appraised at $2,600,000. The mayor told me that Mrs. Green was prepared to sell it to the town if she could end up with $2,600,000 “in the bank for her children,” as she put it. Note that this would have been after paying any capital gain tax associated with the sale of her land. Mrs. Green was not the least bit interested in discussing any tax she might have to pay on the sale. The land was worth $2,600,000 and she wanted to end up with $2,600,000.
“We only have $1,800,000,” the mayor said to me, “but I have heard that you have talked to other communities about tax planning for the seller in land acquisition projects. What can you do for us in this one?”
If there was ever a transaction when I thought, “You can’t get there from here,” this was it. If the town had only $1,800,000 to start, how could Mrs. Green possibly end up with $2,600,000?
Here’s how. This is not simple but it taught me an important lesson: never say never. At least, at the beginning of one of these leveraging transactions, never say never.
We concluded that after selling the land to the town for $1,800,000, and after paying any tax associated with the sale (figuring in the $800,000 charitable contribution she would get for selling the land to the town for less than its full market value), Mrs. Green would end up with roughly $1,500,000 in cash. At that time, given Mrs. Green’s age, health, interest rate assumptions, and so forth, we found a company that would charge her $1,500,000 for what is called a “no refund immediate annuity.” The annuity would pay an amount to Mrs. Green that would give her additional income after taxes each year of roughly $150,000.
As part of this plan, Mrs. Green would set up an irrevocable trust, with benefits ultimately going to her children and grandchildren. The trust could purchase a life insurance policy on Mrs. Green’s life that would pay a benefit of $2,650,000 (that’s right, $50,000 more than $2,600,000) when she died. The annual premium payments for the life insurance policy were roughly $150,000.
So each year, Mrs. Green would end up with additional income from the annuity of $150,000. Each year, Mrs. Green would pay that $150,000 to the irrevocable trust. The irrevocable trust would use that money to pay the life insurance premiums of $150,000 each year. At Mrs. Green’s death, the life insurance policy would pay $2,650,000 to the trust. Under the tax code rules, and with the appropriate planning (which was done in this case), there was no estate tax on the life insurance proceeds.
As in the prior example, the intricacies of the tax and planning issues behind this transaction are complex and beyond the scope of this Note. Needless to say, however, this is one of my favorite examples of leveraging acquisition dollars. I still think it is a bit like alchemy to turn $1,800,000 into $2,650,000.
The Land Is Only A Part Of The Picture…
It is important to understand there is no magic formula for how to create the best deal for the seller (and the buyer). As I said at the beginning of this Note, the point is to change our mindset. The buyer can’t just be thinking, “How can we pay as little as possible?” The seller can’t just be thinking, “How can I negotiate the highest sale price for my land?” Of course, these are fair questions, but they are only two questions. The buyer and the seller need to work together on this, to help the seller answer these questions: What are the goals here? How much tax will I have to pay? Am I doing retirement planning, estate planning, liquidity planning? How can we make the bottom line of this transaction come out better?
Just as An Aside
As they say on some of those fast-car ads on television, “this is a professional driver. Do not try this yourself.”
In order to get real numbers and get away from a discussion of hypothetical what-ifs, you need to work with a sophisticated financial planner and/or sophisticated financial products person who has an imagination, has access to top-notch software for the tax and cash-flow side of this work, is creative, who has access to a wide range of financial products, including annuities and life insurance, and who can get real quotes for those products from real companies.
I have dealt with a variety of such people over the years, and they have the ability to help structure a transaction that will close because all the parties are happy. Recall that in the real-life alchemy case above, it cost roughly $1,500,000 to purchase the single-premium annuity to fund the life insurance payments for the insurance policy. Just to test the numbers in that “older” example with current numbers, while I was writing The Business of Open Space I contacted one of my financial products people, gave him the same facts, and asked, “Could we do the same sort of magic today, given different interest rates, life-expectancy assumptions, investment products, etc.?” Not only is the answer “yes,” but the answer is “We can actually do better than that. Using today’s numbers, the annuity to provide the cash to pay for the life insurance policy would cost $1,397,827.” Better alchemy. Mrs. Green could buy the annuity and fund the life insurance policy and have money left over.
So, as I have said many times, and as I said elsewhere in my book, run the numbers. There is no substitute for dealing with an experienced professional who can run the numbers and give you the facts and the spreadsheets.
Final Thought for This Note, Or, How It All Comes Together
And then, finally for this Note, just think about this: combine leveraging acquisition dollars with further economic and environmental leveraging with ACRE’s bundle of rights, and/or with the “new” kind of non-deductible conservation easement (still waiting to happen; see Note #7 and The Business of Open Space) that ties up land but throws off environmental commodities. The planning checklist does not stop here.
Does the seller really really understand what she has to sell? Does the buyer really understand all the options? Where there are knowledgeable and willing buyers and sellers, there is an entire new discipline here just waiting to be created.