As mentioned in previous blogs, the only things certain in life are death and taxes. And what’s certain is that if you sell a real estate property, you’ll have to pay, at the very least, capital gain and depreciation recapture taxes.
What’s also been mentioned in previous blogs is that the procedures outlined through 26 U.S. Code § 1031 – “Exchange of Real Property Held for Productive Use or Investment” can help you potentially defer taxes.
But what properties benefit from a 1031 exchange? There are a couple of answers to this. First, properties that appreciate a great deal in value. And second, those that are slated for estate-planning purposes.
There can be two primary strategies for real estate investments: Potential cash flow and possible appreciation. Through the latter process, the idea is that when you’re ready to sell your property, you hope to generate a capital gain from that sale.
That’s the good news.
The not-so-good news is that a straight sale can trigger a taxable event, which can whittle down your capital gain. The higher the total gain, the higher your taxes – and the less your after-tax gain when you walk away from a sale. A properly executed like-kind exchange can offer a viable tax deferral strategy to help your investment strategies.
There are two ways in which you can use the 1031 exchange to ensure your property benefits your heirs.
Planning the distribution of your commercial real estate assets can generate ugly disputes among your heirs and beneficiaries. This can be counteracted if you exchange those assets into more than one physical property or a Delaware Statutory Trust (DST) via the 1031 exchange process. This allows everyone to get a share of the real estate pie. It also allows them to determine whether to keep or sell their properties without getting into fights.
If you use the like-kind exchange to trade your real estate, this can benefit your heirs. The reason is that when you pass away and real estate passes to your heirs, they’re not stuck with a huge tax bill if they want to sell. This is because they receive a step-up in basis with that real estate. In other words, the property is re-established at the current fair market value, which technically wipes out the capital gain – and can also possibly eliminate the pre-existing tax liability if your heirs decide to sell.
Highly appreciated real estate and that which is designated to be passed on to your heirs can benefit from the 1031 exchange process. But there are pros and cons to the like-kind exchange. As such, work with an experienced professional before deciding whether this action suits your situation best.