For some investors, one of the goals of building wealth and accruing a real estate portfolio is the intent to distribute it as a legacy to the following generation. With that in mind, you may want to consider how to effectively plan your bequests to manage the impact of taxes for your beneficiaries. Let’s take a look at some potential means of doing so. One term that you will hear when discussing estate planning is the step-up in an asset basis.
How Does a Step-up in Basis Affect a Bequest?
A step-up in basis means that when you gift an asset to your beneficiary at the time of your death, the recipient receives the asset at the fair market value at the time of the transfer, rather than your original basis in the asset. So, the value is “stepped-up” to the value at the current time, eliminating the beneficiary’s burden of capital gains on any prior appreciation in that asset. Here is an example:
Investor A buys a commercial building for $100,000 and enjoys the appreciation in value to $500,000 before providing it to their sibling in their will. The sibling, B, can assume the asset with a current value of $500,000. If instead, Investor A sold the asset and provided the cash to B, they would have owed capital gains taxes (and possibly depreciation recapture and NIIT) on the $400,000 difference between the original basis and the current fair market value.
What Assets Are Eligible for a Step-up in Basis?
Any real estate investment transferred from the investor to the heir after the investor's death is eligible for the step-up in basis, including all commercial sectors (and some non-real estate assets as well, like stocks, antiques, and collectibles). However, gifts made during the investor's lifetime are transferred at the original cost basis, and the recipient is responsible for taxes due on capital appreciation.
Also, if assets are held in revocable or living trusts, they are likely eligible for the step-up treatment, while investments in irrevocable trusts tend not to be. Other assets that typically don't provide access to a step-up are retirement accounts, money market funds, pension plans, and other financial tools.
What Are Some Ways to Pass Real Estate Assets to My Intended Heirs Without a Tax Burden?
Investors who have built their real estate portfolios may face complex decisions about estate planning, especially if they want to divide their assets among several heirs. Splitting properties can be contentious, but such conflict can be exacerbated if the intended beneficiaries don’t all have the same needs and financial preferences. Forward-thinking investors can consider some options to simplify their holdings before their demise to reduce potential disputes and possible tax burdens.
One option could be using a 1031 exchange to refashion the portfolio into individual asset portions (think of one substantial property exchanged for several smaller pieces) or into shares of a Delaware Statutory Trust (DST). In either case, the investor can make the swap using the 1031 exchange, thus deferring recognition of capital gains, preserving the appreciation for the time when the heir will benefit from the step-up provision that eliminates it. While both approaches are feasible, the DST option may offer a more straightforward tool for packaging your real estate assets into individual portions for a group of heirs. It may make sense since you can invest in DSTs using a 1031 exchange (both as you enter and for the heirs if they later want to exit) in customizable amounts.
This material is for general information and educational purposes only. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions.
Realized does not provide tax or legal advice. This material is not a substitute for seeking the advice of a qualified professional for your individual situation. Costs associated with a 1031 transaction may impact investor's returns and may outweigh the tax benefits. An unfavorable tax ruling may cancel deferral of capital gains and result in immediate tax liabilities. No public market currently exists and one may never exist. DST programs are speculative and suitable only for Accredited Investors who do not anticipate a need for liquidity or can afford to lose their entire investment. All investments have an inherent level of risk. The value of your investment will fluctuate with the value of the underlying investments. You could receive back less than you initially invested and there is no guarantee that you will receive any income. Examples are hypothetical and for illustrative purposes only.