Many real estate investors focus on building wealth over time with the intention of passing their assets on to their heirs. However, without proper planning, your heirs could inherit un-welcomed financial burdens.
This is one of the reasons why many property investors recognize the value of 1031 exchanges as a powerful estate planning tool. By engaging in one or more 1031 exchanges throughout your lifetime, you can defer capital gains taxes and depreciation recapture on your investment properties and enable your heirs to inherit those properties without residual tax obligations.
Section 1031 of the U.S. Tax Code allows investment property owners to defer capital gains taxes and depreciation recapture by exchanging their relinquished property for “like-kind” replacement property. Since you can invest the entire sales proceeds into a new property, engaging in a 1031 exchange can allow you to “buy up,” purchasing a replacement property of higher value or better quality.
There’s no limit to the number of times you can engage in a 1031 exchange, so many investors use multiple exchanges over time and repeatedly defer capital gains and grow their assets.
Under current U.S. tax laws, dependent on structure of ownership, when a property owner dies, the property’s cost basis is stepped up to the fair market value on the date of death. Therefore, if your heirs were to sell the property right away, they would owe little to no capital gains taxes since the sales price would likely be close to the current fair market value.
If they decided to hold the property, they would only be responsible for capital gains taxes on the appreciation that occurs after the step-up. Your heirs could also consider using a 1031 exchange to purchase a replacement property, continuing the legacy of “buying up” tax-free.
While the ability to potentially defer capital gains taxes for generations is undoubtedly an attractive estate planning strategy, many investors find that they no longer want to actively manage property investments as they age. This can make the prospect of holding properties throughout their lifetime unappealing. However, engaging in a 1031 exchange with a Delaware Statutory Trust (DST) as your replacement property can solve this problem.
A DST is a legal entity created under the laws of Delaware. The DSTS holds one or more income-producing commercial properties and meets 1031 exchange requirements for like-kind replacement property. The DST sponsor handles all of the decision-making and daily operations of managing the underlying properties in the trust, allowing investors to experience the benefits of owning real estate without the day-to-day hassles of property management.
DSTs have an added advantage over the traditional 1031 exchange as an estate planning tool. DST investors own fractional interests of the property in the trust, which can be split among heirs. This allows each heir to decide whether to stay in the 1031 exchange cycle or cash out, once that DST liquidates. Many estate planning attorneys have found this benefit can reduce disputes among heirs.
While private real estate investments can offer some significant estate planning advantages, the potential benefits don’t end there. Investors may also be able to take advantage of additional tax efficiencies. To learn more about your options, download our free e-book, “Tax-Advantaged Investing: The Power of Private Real Estate.”
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Because investor situations and objectives vary this information is not intended to indicate suitability for any individual investor.
The numerical example is for illustration purposes only as individual results may vary. Potential cash flows/returns/appreciation are not guaranteed and could be lower than anticipated.
There are material risks associated with investing in real estate securities including liquidity, tenant vacancies, general market conditions and competition, lack of operating history, interest rate risks, the risk of new supply coming to market and softening rental rates, general risks of owning/operating commercial and multifamily properties, short term leases associated with multi-family properties, financing risks, potential adverse tax consequences, general economic risks, development risks, long hold periods, and potential loss of the entire investment principal.
IRC Section 1031, IRC Section 1033 and IRC Section 721 are complex tax concepts; therefore, you should consult your legal or tax professional regarding the specifics of your particular situation.