The preferred partnership for encumbered real estate is used to obtain both an income tax-free step-up in basis at death for the preferred partnership interest included in the decedent’s gross estate and an estate freeze by disposing of the common partnership interest that is allocated the appreciation in the value of the partnership’s assets that occur while the decedent is living. The step-up in basis at death is especially attractive for encumbered real estate with negative capital accounts since it can eliminate the potential for having to report the phantom capital gains without a transfer tax cost. The materials will first describe how to structure the preferred partnership and how to transfer the common interest that is allocated the appreciation in value to a grantor trust to implement the income tax savings and the estate tax savings that can be obtained at death. As part of the formation materials, we will describe how to financially structure the preferred partnership to reduce the leaky freeze that occurs while the decedent is living and allocate all the liabilities to the preferred partnership interest.

What is not generally addressed is that after the preferred partnership is initially formed and after the common partnership interest is owned by an irrevocable grantor trust that is not exposed to the estate tax, the client’s advisors need to address the income tax impact from distributions of cash from future financings of the partnership’s real estate that occur while the client is alive. If these future cash distributions from the refinancings of the partnership’s real estate are made to the preferred partner, the income tax treatment of these distributions can increase the preferred partners negative capital account, increase the tax-free step-up in basis at death, and reduce the value of the preferred partnership interest that is included in the decedent’s gross estate.