One aspect of the 1031 exchange that investors may not be aware of is the opportunity to use it for estate planning. It’s probably the most overlooked benefit of exchanging and sadly roughly 20% of investors get to this point and that means most end up paying their capital gains and depreciation recapture. For those of you that aim for this goal or are approaching this milestone then this post is for you.
Specifically, investors who are nearing retirement age or who have a large estate can use a 1031 exchange to transfer their real estate holdings to their heirs in a tax-efficient manner. By using a 1031 exchange, the investor can transfer their investment properties to a trust or LLC, which can then be passed on to their heirs upon their death. This can be a smart estate planning strategy, as it allows the investor to transfer their real estate assets to their heirs while minimizing their tax liability.
In addition, if the investor’s heirs sell the property after inheriting it, they will receive a stepped-up basis, which means they will only pay capital gains taxes on the increase in value from the date of inheritance, rather than the original purchase price. This can result in significant tax savings for the heirs.
Overall, the ability to use a 1031 exchange for estate planning purposes is a valuable and often overlooked aspect of this tax-deferral strategy. However, it is important to work with a qualified tax professional to ensure that all rules and regulations are followed and that the investor’s estate plan aligns with their long-term financial goals.
1031 BENEFIT: Heirs Receiving Stepped-Up Basis
If you are holding investment property that had been part of a 1031 Exchange, upon your death, your heirs get the Stepped-Up Basis. All of the built in gain disappears upon the taxpayer’s death. What that means is the value of the property at the date of your death would pass through your estate to your heirs. If they decide to sell the property for that same appraised value, there would be NO capital gains tax due to be paid by your heir, as opposed to the 25% to 40% cash you would have had to otherwise pay the government if you sold outright, rather than exchanging. What better way to help the future of your heirs?
Here’s an example: You own an apartment building for many years. You are making estate plans and strategizing how to leave this one property to your three children in your estate. Rather than hold the one building you know your children do not want to own or manage, you decide to sell it for $1,800,000 as part of a 1031 Exchange.
Presumably you would consult with each of your children in the selection and acquire three separate replacement properties, each worth $600,000, to benefit from the 100% tax deferral.
Working with your legal counsel, each property could be placed into its own revocable living trust with one of the children being named as the beneficiary of the trust. When you pass away, the properties will automatically transfer to the named beneficiary, free of taxes and with a stepped up basis equal to the value of the property at the time of death.
1031 BENEFIT: Pulling Out Equity Later
By participating in a 1031 Exchange, you could have continued income from the new rental property. And you have the option later on to potentially pull equity out if you need funds for something else, such as supplemental living, improvements to be made or even paying for college tuition.
Here’s an example: You bought a rental property a few years back for $400,000 and now you are able to sell the property for $600,000. That is a potential gain of 200,000. That amount, minus any improvements made and closing costs, would be taxable at the capital gains rates. Paying $50-$80K in taxes now just to put the remaining funds in a low interest savings account may not be the best use of your equity.
1031 BENEFIT: Converting Rental to Personal Use Property
On the residential side, buying a Replacement Property in an area you plan to retire to allows you comfort of knowing the local market you are renting in now, continued income while owning the investment, and the option in a few years for you to convert the property use from investment to personal. At that time it could become a second home for you, family and friends to visit or even your primary residence in retirement.
Be certain to consult with your tax and legal advisors before entering into any plan relating to taxes and estate planning.
INSIGNIA Financial Services LLC and its affiliates do not provide tax, legal or accounting advice. This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, tax, legal or accounting advice. You should consult your own tax, legal and accounting advisors before engaging in any transaction.