Imagine this: you acquire your first real estate investment – a value-add duplex for $100,000. After $50,000 in renovations, the new value of the property is $200,000. One year after acquisition, you sell the property for $200,000 with a gain at sale of $50,000. Rather than pay capital gains tax on $50,000, you execute a 1031 exchange into a $200,000 value-add fourplex. 50 years and numerous 1031 exchanges later, you’ve worked your way up to a $20 million apartment complex. Then, you pass away and the $20 million apartment complex is inherited by your children.
Now the question is: will your children be required to pay a capital gains tax upon the sale of the $20 million apartment complex if they elect to not execute a 1031 exchange?
The majority of real estate investors know about the benefits of executing the 1031 exchange strategy. As long as the 1031 exchange requirements are met, you can defer capital gains tax upon the sale of a property. As a result, you have more capital to leverage to acquire more or larger properties.
However, one potential major long-term drawback of the 1031 exchange is the large, lump-sum tax payment at the sale of an exchanged property that isn’t 1031’ed into a new deal. One way to effectively eliminate the requirement to pay taxes on your deferred gains is to continue to 1031 until your death.
Suppose, like the “imagine this” story, that you implement the 1031 exchange strategy until you pass away and the property is inherited by your heir. If the property is a replacement property (i.e., a property acquired with a 1031 exchange) that is inherited from your estate, the replacement property will have a stepped-up basis equal to the property’s fair market value. As a result, the deferred gains are effectively eliminated.
Let’s say you sell your first investment for $200,000 with a $50,000 gain at sale. After a handful of 1031 exchanges, you own a property worth $2 million. If you were to pass away prior to selling the $2 million exchanged property and it is inherited by your heir, the basis is stepped-up to the fair market value, which is $2 million. If your heir decides to sell the property at the fair market value, rather than paying a capital gains tax on over $1.8 million, they won’t have to pay capital gains tax at all.
Therefore, the 1031 exchange strategy is a great legacy building tool. As long as you continue to implement the 1031 exchange strategy until your death, you are allowed to pass on all of your capital gains to your heirs tax-free!
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