Investing in real estate for wealth management and estate planning could potentially be a savvy move. If you make intelligent decisions concerning your real estate purchase, you could end up with a decent income flow. And, by the time you die, your heirs might not be penalized with extra taxes on your real estate investments, thanks to a concept known as “step-up in basis.”
Read My Lips: No New Taxes
It’s possible that real estate you acquire for income purposes will appreciate in value from the time you buy it until the time you pass it on to your beneficiaries. Meanwhile, when that real estate asset is passed down to your heirs, the step-up in basis adjusts the asset’s value for tax purposes. What it means for your heirs is that they might not incur capital gain taxes if they decide to sell the real estate after your death.
Let’s say you acquire a duplex. The cost basis – i.e., what you pay for the duplex – is $150,000. You own that duplex for years and derive a nice income from it. When you are no longer around, your heirs inherit the duplex, which is now valued at $650,000, according to your local property taxing authority.
That $650,000 is now your new cost basis. But before your heirs panic about owing the IRS on the $500,000 gain (the appreciated amount), they need to know that the step-up in basis could mean that the appreciation might not be subject to capital gain income taxes. If your heirs decide to sell that duplex for $650,000, they might not be on the hook to the IRS for the capital gain tax. Depending on the estate, however, there may be additional taxes or other considerations, such as an Alternative Minimum Tax. At Realized, we are not tax professionals nor provide tax advice, so consult a CPA or other tax professional if this is something that may concern you.
Or, perhaps your heirs want to hang on to that duplex for another few years. That works to their advantage, as well. If they sell the property after a five-year hold at $1,000,000, the step-up in cost basis means they would owe capital gain taxes only on the $350,000 gain ($1,000,000 - $650,000 = $350,000).
Your heirs could actually defer the capital gains taxes if the duplex is relinquished through a 1031 exchange. The exchange may both help you build equity in your portfolio, while assisting your beneficiaries in deferring that capital gain tax
Note, that there is the possibility that your heirs may inherit the property at a cost that is less than its original cost basis. Instead of being able to capture the reduction in capital gains taxes, however, your heirs would be unable to capture the capital gains loss that would’ve incurred if the sell of the property happened before death.
And in the situation that the value declines during the few years that heirs hold the property, the heirs may actually be able to realize a capital loss upon sale. Just like any real estate investment, there is the possibility of loss, with the silver lining being able to offset capital gains. For example, if the property were to sell for $400,000, the heirs may be eligible to offset other capital gains using the $250,000 loss from its inherited cost step-up in basis. And remember that short-term losses can only offset short term gains, and that long-term losses may only offset long-term gains.
The 1031 Wealth-Building Tool
Let’s go back to your duplex. Perhaps, instead of hanging on to it long-term, you want a change; you want to move from owning a residential property to owning a medical office building. You can exchange your duplex, valued at $650,000 for a medical office building (a “like-kind” asset), as long as the replacement asset is of greater or equal value to the property you are relinquishing (and you meet the mandated time frames set forth by the IRS). With that exchange, you can defer any capital gain tax.
Now. Let’s say that, following another five-year hold, you’re tired of hands-on management, and you have your eye on a Delaware Statutory Trust (DST). Your medical office building is now valued at $1,000,000. Once you’ve tagged the perfect replacement property, exchange your medical office building for that DST and, once again, you can defer any capital gain taxes. As the value of your asset continues to increase, you can keep exchanging into other, more valuable, real estate – and might not have to pay a dime of capital gain tax until you sell and do not re-invest your proceeds.
When you die, and the real estate is passed on to your heirs, the step-up in basis can pretty much wipe out any taxes that have been deferred through your exchanges. If they decide to sell that real estate for the valued amount, they might not owe the IRS for taxes, either. The strategy is known as “swap until you drop” and it can protect your heirs from penalizing the wealth you are leaving them.
So, don’t overlook the power of a 1031 exchange. In addition to having the ability to help you build equity in your portfolio, it can help your heirs realize the full value of your real estate assets when you are no longer around.