As some say it, the way to get the most out of 1031 exchanging is to “swap till you drop.”
When investors continue the cycle of swapping real estate indefinitely, they continue to defer the payment of the capital gains taxes indefinitely.
The longer investors keep their equity invested in real estate and defer taxes, the greater their opportunities are to increase their wealth at exponentially faster rates.
If the investor ever sold a property without reinvesting the gains into replacement real estate, the deferred taxes would become owed.
BUT if the investor continues to own the exchanged real estate until the time he or she passes away, the deferred tax liability is not transferred to the heirs with the real estate property inheritance.
Read the full article or skip to a specific section:
- Step-up in basis for heirs
- Death During 1031 Exchange
- Can You Depreciate Inherited Property?
Step-up in basis for heirs
When the real estate is transferred to the investor’s heirs, the heirs receive a step-up in cost basis equal to the fair market value at the time the investor passed away.
The heirs do not inherit any depreciation recapture or capital gains tax liabilities on the real estate.
Often investors add a family member to the title of a property, unknowingly gifting the property to that family member and breaking the chain of events that would give their heirs the step-up in cost basis.
In many cases, holding assets in joint ownership with one’s beneficiaries may be the easiest way to transfer the assets after the primary owner becomes deceased.
However, as long as the property has a living owner, be it the original exchanger or a joint owner, that owner is responsible for the tax liability on the property.
In order to eliminate the accumulated capital gains taxes owed on real estate that has been acquired through a 1031 exchange, the real estate must pass to the heir after the owner has passed away.
For example…
- On the date of his death, a father owned a piece of real estate with a fair market value of $500,000 (property was purchased for $200,000)
- The daughter received the property through the father’s will
- Because the daughter received the property with a step-up in cost basis equal to the fair market value, her cost basis is $500,000
- If the daughter chose to immediately sell the property for $500,000, she would not have earned any capital gains or incurred any capital gains taxes
- If she held the property for some time and later sold the property, she would only recognize gain for the amount greater than her original $500,000
- Therefore, if she sold the property for $600,000, she would owe capital gains taxes on the $100,000 gain.
- However, the daughter could consider the option to defer the capital gains taxes incurred as a result of this sale and complete a 1031 exchange by replacing the inherited property for like-kind real estate.
- The father’s purchase price, date of purchase, and exchange history become irrelevant to taxation of the real estate once it is in the daughter’s possession.
*It is worth it to note that the fair market value of the real estate will be included in the father’s estate and may be subject to federal and/or state estate taxes.
Swap ‘till you drop to make the most of leveraging your income through 1031 exchanging.
Leave your heirs with assets that offer an opportunity to continue to build wealth and defer tax liabilities.
If you’re worried about managing real estate investments long after retirement or worried your heirs will not be interested in a management-intensive investment?
A Delaware Statutory Trust could be an option.
DSTs are a 1031 exchange qualified real estate investment without the intensive property management responsibilities of traditional real estate ownership.
Death During 1031 Exchange
If an investor dies during a 1031 exchange, you have two options to choose from:
1. Let the Exchange Fail
You could decide to stop the exchange and return the unused proceeds to the estate. In this case, the personal representative for the estate would file a tax return for the last year of the deceased’s life.
This return would show that the sale occurred and the deceased realized all of the gains on the property.
2. Continue the Exchange
Going through with the exchange allows the estate’s representative to purchase the replacement property. By continuing with the exchange, the sale of the relinquished property won’t incur any capital gains.
This avenue eliminates any tax liabilities for the heir inheriting the replacement property and saves them a significant amount of money.
Can You Depreciate Inherited Property?
Depreciation is the process of deducting the cost of a property over its useful life.
If you inherit a property, the depreciation process works differently than when you purchase it.
Property Requirements
You must use the inherited property you own as a source of income, such as a business or rental property. You can also use the property for personal purposes, but depreciation is only based on the percentage of the property used for business.
Depreciation Periods
Depreciation begins when the property is ready for business use, regardless of whether you are actually using it at that time. The number of years the property depreciates depends on the type of property it is. The Internal Revenue Service (IRS) defines the depreciation period for the different property types per the Modified Accelerated Cost Recovery System (MARCS).
Basis
Basis refers to the monetary amount to depreciate. For inherited property, the basis is the property’s fair market value on the decedent’s death date. This value is typically found on a state or federal tax return for estate tax. If no tax return was filed, you’re entitled to any reasonable method to determine the property’s fair market value.
Costs of Improvements
To calculate inheritance depreciation, add your basis to the cost of any improvements you made to the property between your inheritance date and when you started using it for business.
Inherited Rental Property
Inheriting a rental property has its pros and cons. It allows you to benefit from the property’s rental income, though you’ll be legally and financially responsible for the inherited property, including tax liability.
The IRS treats an inherited rental property as an investment property, which means you’ll have to pay capital gains tax when you sell it.
When the property is transferred to you, it receives a step-up in basis to the fair market value.
If you sell the property for more than the fair market value, you can defer capital gains tax on the sale through a 1031 exchange, which allows you to replace the inherited rental property with a different investment property.
Looking for Less Responsibility? Consider a DST.
A DST allows investors to benefit from property investment gains without being responsible for management.
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The concept of "swap till you drop" is a core principle in 1031 exchanging. This strategy involves continually exchanging real estate, deferring capital gains taxes indefinitely. The longer investors retain equity in real estate through these exchanges, the greater the potential for exponential wealth growth. It's crucial to note that selling a property without reinvesting gains triggers deferred tax liabilities. However, if an investor holds exchanged real estate until their passing, the deferred tax liability doesn't transfer to heirs along with the property inheritance.
The article introduces the concept of a "step-up in basis for heirs." When real estate is passed on to heirs, they receive a cost basis equal to the fair market value at the time of the investor's death. This step-up in basis shields heirs from inheriting depreciation recapture or capital gains tax liabilities on the property. The article emphasizes the importance of maintaining ownership continuity to secure this step-up in basis, cautioning against unintended gifting that could break this chain.
In the scenario presented, the daughter inherits a property with a step-up in cost basis. If she sells the property immediately, no capital gains are incurred. However, holding the property and later selling it could result in capital gains taxes on the gain above the stepped-up basis. The article suggests the option to defer these taxes through a 1031 exchange, allowing the heir to replace the inherited property with like-kind real estate.
The piece also touches on the implications of an investor's death during a 1031 exchange. Two options are presented: letting the exchange fail or continuing the exchange. Continuing the exchange allows the estate to purchase a replacement property, avoiding capital gains on the sale of the relinquished property.
Finally, the article delves into the depreciation of inherited property. Depreciation is based on the property's fair market value at the decedent's death, and the calculation considers improvements made post-inheritance. The inherited property, especially if used for business or rental purposes, may be subject to capital gains tax upon sale. The mention of a Delaware Statutory Trust (DST) as an alternative for those concerned about post-retirement management further enriches the discussion.
In essence, the article provides a comprehensive guide to navigating the complexities of 1031 exchanges, inheritance tax implications, and strategies for preserving and growing wealth through real estate investments.
