Estate Planning Using 1031 Exchange

Estate planning worksheet

“The major fortunes in America have been made in land” — John D. Rockefeller

Investors have long known that real estate can be one of the very best asset classes in which to build wealth.  And, while an experienced financial adviser might recommend spreading investment capital over multiple asset classes to mitigate risk i.e., stocks, bonds, cash; real estate should be considered a “hard” asset that is tangible and offers considerable opportunity to reduce overall investment portfolio risk.  Real estate investments share a very unique characteristic that can benefit the investor; that characteristic is the embedded estate planning feature that can aid in the reduction or elimination of federal, and state tax burdens.

Examples of Federal and State taxes that are potentially impacted:

  • Long term capital gains tax (maximum rate of 15 to 20%
  • 25% of gain due to depreciation deductions
  • 3.8% tax on certain investment income imposed by Affordable Healthcare Act
  • State capital gains taxes can range from 0 to 13.3 %.

The Internal Revenue Code, §1031 Exchange allows for the deferring of taxes paid on capital gains from one property onto the next.  Generally, a real estate investor’s activities will span multiple purchase and sale transactions each with a forward progression of accumulated wealth and with each sale comes the exposure to capital gains taxation.  Utilizing a properly qualified and structured exchange, the capital gain from each transaction is deferred onto the next property, the individual sale is therefore a non taxable event.

This is where the estate planning comes into the picture.  As the investor ages and plans for their ultimate twilight, the remaining property(ies) that are held by the investor can normally be passed, through the estate process, to his/her heirs with a “step up” in basis.  A non taxable event, the heir(s) now owns the property with the new “cost basis” equaling the current market value.  The prior capital gains of the donor investor are therefore never taxed, including any from prior 1031 exchanges.  It is also possible, when in the case of multiple beneficiaries, the donor investor may choice to sell one property in favor of purchasing multiple properties to match the number of beneficiaries so that the “wealth distribution” takes place before the passing of the donor.  For example, a parent with three children owns a large farm.  Prior to the parent’s passing, the parent sells the large farm and with the proceeds, three smaller like kind properties are purchased.  Until his passing, the ownership of all the properties remains with the father.

As with all questions regarding applicability of tax programs, it is critically important to seek the counsel of a tax and/or legal adviser to be certain of all provisions of the tax code to the individual’s situation.


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