When I started practicing law decades ago, the tax part of estate planning focused almost exclusively on minimizing estate, gift and generation-skipping taxes (collectively, “Transfer Taxes”). Back then, the highest Transfer Tax rate was 70%, and the exclusion was only about $120,000.
Today, after several rounds of legal changes, Transfer Taxes are not a major factor for most apartment owners.
But, after years or decades of appreciation, capital gains taxes, other income taxes and property taxes have come to dominate the tax aspects of estate planning for a majority of apartment owners. As shown in the example below, income taxes on a sale can easily eat up 35-70% of the proceeds of a sale.
Further, even for those facing estate taxes (with estates over $11.4 million for a single person, and $22.8 million for a couple), planning to optimize income and property tax consequences remains important. In fact, in some cases it may make sense to pay a small transfer tax if we can save even more in income taxes for an apartment owner’s heirs. Income tax savings largely come from the Step-Up in basis.
While the Step-Up usually requires the owner to die, the Accelerated Step-Up Strategy discussed below can give you a material Step-Up without dying!
Death as an Income Tax Shelter – Step-Up in Basis
For more than 80 years, the Federal income tax system has mitigated the effect to the estate tax (on transfer at death) by permitting the basis of property included in an estate to adjust to fair market value (“FMV”) at the date of death.
We generally refer to this as a “Step-Up” in basis (although in some cases it can reduce income tax basis if property is worth less than income tax basis before death). Fortunately,California allows this Step-Up for California income tax purposes as well.
The law does not limit the Step-Up to properties that actually cause the payment of an estate tax. So long as the property would be included in your estate for estate tax purposes, the Step-Up applies, even if exclusions protect your heirs from paying any estate tax. This makes “death” one of the most valuable tax shelters around. Sadly, this shelter traditionally came with a big cost – you had to die to get it for your heirs.
In California, the Step-Up can be maximized at the first death for married couples by careful drafting to assure property is community property, and then by using portability instead of “B”, credit shelter, exemption or similar trusts.
In general, basis before death will equal the cost paid for property, plus the cost of capitalized improvements (but not repairs which are expenses) less accumulated depreciation (whether or not claimed on an income tax return).
The Huge Importance of the Step-Up in Basis
For most apartment owners in California, basis today totals much less than FMV. This results from both appreciation and from the impact of depreciation. Many of our clients have income tax basis equal to as little as 10-20% of FMV.
Generally, when you sell property, you pay income tax on the difference between your then income tax basis and the proceeds of the sale (including any debt to which the property was subject).
For example, if you bought an apartment building in 1979 for $1,000,000, and allocated $700,000 to the building and $300,000 to the land, you have probably taken close to $700,000 in depreciation (ignoring salvage value), and your basis has fallen to about $300,000. Of course, when you bought the building, depreciation helped reduce your income taxes and enhance your after tax return, but after 27.5 years, the shelter of depreciation is probably gone.
If you sell the apartments today and net $4 million after selling expenses (only approximately 3.5% per year of appreciation), your taxable gain will be approximately $3.7 million for Federal and California income tax purposes.
Depending on your other income, the Federal capital gains tax (and depreciation recapture tax) would total about $775,000. On top of that, most of the gain will usually be subject to a Net Investment Income Tax at $3.8%, for up to about $141,000. But then,California wants its pound of flesh, at up to 13.3%, which could be up to $492,000. Total potential tax burden can equal about $1.4 million, roughly 35% of your sale price after expenses.
It can feel even worse if the property is subject to debt. Suppose you had $2 million of debt on the property. Your cash proceeds would have totaled $2 million, and 70% of your proceeds could be confiscated by Federal and State income taxes!
On the other hand, if you hold the property until you get a Step-Up at death, your heirs can sell without paying capital gains or depreciation recapture taxes. If they do not sell, then they can benefit from much more tax free income due to increased depreciation and 199A deductions.
A Few Words about Basis and § 199A
Furthermore, under IRC § 199A (added in the 2017 Tax Cut and Jobs Act), the availability of an extra 20% of taxable income deduction for higher income apartment owners is generally limited to 2.5% of “unadjusted basis immediately after acquisition (UBIA)” of the property, and disappears once the property is fully deprecated.
Fortunately, property which gets a Step-Up in basis at death gets a new UBIA, which can turbocharge after tax returns. That can mean the Step-Up saves income taxes even if your heirs do not sell, through enhanced depreciation and 199A deductions due to the Step-Up in basis.
Traditional Solutions If You Don’t Want to Pay Income
Taxes When You Sell, but Do Not Want to Hold Property until You Die
If you don’t want to pay income taxes when you sell your apartments, there are few traditional tactics you should consider.
1031 Exchanges: The most common tactic to defer income taxes on sale is the 1031 Exchange. This is the tactic Ann Baber of the AOA Real Estate Division recommends at her seminars: “Swap ‘til you drop.”
- The goal here is to defer taxable gains until you can get a step-up in basis at death. Exchanges can, however, present at least three problems:
- In today’s tight market, can you make a good deal on the “BUY” side of your exchange within the 45-day maximum identification period?
- Are you willing to rely on someone else to manage your property if you exchange for a TIC (tenant in common property), triple net, or Delaware Statutory Trust, given built-in costs, risks and lack of control if you do not find “your own” upleg?
- No step-up in basis for new depreciation to the extent of the deferred gain UNTIL you die, so you lose much of the saving from “new” depreciation.
Too many times, we have seen exchanges which deferred taxes, but ultimately lost much of the deferred gain and/or principal.
Capital Gains Bypass Trust (“CGBT”): The CGBT is a trust that benefits you, your spouse and maybe your heirs for a period of years or specified lives, but which pays no income taxes, either on current gains or on sale of property. You also get a charitable deduction when you put property into the CGBT. You can retain management of the CGBT, and can reinvest in most prudent investments – you are not restricted to “like-kind” real estate. If you own a highly appreciated building, a well-planned CGBT can provide significant benefits for you:
- Freedom to Sell your building when it makes sense economically (like now, when cap rates are low and multiples are at historically high levels), without fear that income taxes on the gains will erode your reinvestment proceeds;
- Escape From The Dreaded 3.8% Obamacare Tax on net investment income;
- Cash Flow Increases, sometimes doubling the cash flow you have available to spend;
- Reduced Management Headaches – no more troublesome tenants, no more toilets to repair or other maintenance hassles, and no more bureaucratic property owner red tape;
- An Immediate Income Tax Deduction
- Reduced Liability Risks
- Meaningful Estate Tax Savings
- Preservation of Values for Your Heirs
Whenever the tax law gives a benefit, it does so only if you follow the “rules.” The Internal Revenue Code and related regulations set forth rules that must be followed in using a CGBT. Some of the rules relate to how the CGBT can be structured, while others prevent or punish abuses of the tax benefits. Fortunately, the structuring rules provide a great deal of flexibility in designing a CGBT to meet the different objectives of different property owners.
However, when the CGBT ends (after no more than 20 years or the lives of the designated beneficiaries end), the property that remains goes to a charity (which may be a fund managed by your heirs).
That’s a good thing if you have some charitable motivation. Even if you don’t, the economics are often better on an after-tax basis than a taxable sale. And, in many cases, even for relatively old clients, you can use just a little bit of the extra cash flow to purchase wealth replacement insurance for your heirs.
Two Strategies to Get a Step-Up in Basis without Dying
Accelerated Step-Up Strategy (“ASUS”) – With the massive increases in the exclusion from estate taxes over recent years, many people have more estate tax exclusion than they need. If you have an older relative or friend in this condition, particularly one with a short life expectancy, the ASUS can set you up to get a Step-Up when the relative or friend passes.
The ASUS strategy uses long-established principles of the tax law, many of which were originally promoted by the IRS back when transfer tax exclusions were much lower. You do not need to give the relative the benefit or use of the property, just a technical power that takes advantage of provisions of the income tax law that date back to the middle of the last century. Around the country, at advanced estate planning seminars, strategies to do this have become one of the hottest topics.
Structured properly, in many cases you can do this without incurring property tax reassessment or transfer taxes. Using leverage, you can make this work for property valued at up to 8 to 10 times your estate tax exclusion, or more. This strategy is normally structured so that you continue to report keep income and expense from the property on your income tax return. Sometimes (with a VERY CLOSE relative), it can be structured to move income to a lower income tax bracket relative.
You can even have your ASUS do a 1031 exchange before your “powerholder” passes, and then get a step-up on the upleg property. Finally, for those of you who do not expect to have an estate big enough to worry about transfer taxes, you may be able to use this strategy to help your kids get a step-up on “their” property when you pass away. The first ASUS we did was structured by Mom to give a Step-Up on property owned by her son.
Opportunity Zone Investments – The 2017 tax act introduced a new capital gains strategy to defer, and eliminate some, gains on the sale of all kinds of appreciated property. All this requires is that you reinvest the gain in a Qualified Opportunity Fund (“QOF”), which invests primarily in a low-income census tract designated as a Qualified Opportunity Zones (“QOZ”).
More than 10% of the census tracts in the country have been designated as QOZs, including the one around the L.A.Convention Center and the Hollywood and Highland complex. You can create your own QOF or invest in one created by others. You can either reinvest all the gain from a sale, or a portion of it in the QOF.
Generally, you have 180 days from your Capital Gain Event to make the investment in a QOF. But, there is no requirement to “identify” the QOF within 45 days. If the gain comes from sale of property IN a partnership, your 180 day period does not begin until December 31 of the year in which the partnership recognizes the gain. This can give you a very long time to make your decision to use the QOF, and to pick a QOF, if the partnership sells early in calendar year.
For Federal (but not California) income tax purposes, gains on the property you sold are deferred to the earlier of the date you sell the investment or 2026. That is like getting an interest free loan from the government for the amount of tax you would otherwise pay on the sale. And, if you held the investment more than five years (purchased by 12/31/21), 10% of the deferred gain is forgiven; if you held it more than 7 years (purchased by 12/31/19), 15% of the deferred gain is forgiven.
If you hold the property at least 10 years, your basis is stepped up to its FMV – another “Step-Up” without dying.
One of the best ways to grow wealth is to (legally) avoid paying taxes on gains and maximize deductions.
The Step-Up in basis on death is a legal tax shelter that gets this effect. The expanded transfer tax exclusions allow most of you to do this without paying the estate tax cost which was one of the original justifications for the Step-Up. 1031 exchanges can let you diversify or change holdings of like kind property and defer gains until they are “stepped-up” at your death, so long as you hold the exchanged properties long enough.
However, there are strategies like the ASUS and QOF investments that can get you Step-Ups, without dying, that will either save ongoing income taxes (from increased depreciation and 199A deductions) or allow a sale of the property free of the burden of capital gains and recapture taxes. If you have highly appreciated property, you should explore the use of these strategies now.
NOTE: Ken will be sharing more information on this at the upcoming AOA Million Dollar Trade Show and Educational Conference at the Long Beach Convention Center on April 17th.
This article offers only a brief introduction to the subject matter and is not intended as advice on which owners can rely. Every situation is different and laws can change. Ken or another professional can help you evaluate and compare other strategies for avoiding or deferring capital gains taxes. Please get advice from counsel you retain for your own planning.
Ken Ziskin is an estate planning attorney who focuses on integrated estate and tax planning for apartment owners. He also assists owners’ families with probate and trust administration. He holds the coveted AV Preeminent peer reviewed rating for Ethical Standards and Legal Ability from Martindale-Hubbell, and a perfect 10 out of 10 rating from legal website AVVO.COM.
Ken offers free Living Trust planning consultations for AOA members, and is also available to discuss the ASUS, CGBT and QOZ strategies. For more information about his estate planning process and reviews of his work by his clients visit www.ZiskinLaw.com or call (818) 988-0949.