If you owned investment property before 1986, you know how advantageous real estate once was as a tax shelter. The tax code has changed considerably, but there are still some unique tax features of real estate that, when combined strategically over time, have the potential to produce significant financial benefits for both you and your heirs.
Categorically, these advantages are:
- 1031 Exchanges, and
- Step-Up in Basis
These strategies help mitigate the tax consequences of leasing, trading and bequeathing real estate, respectively. Used together, they have the potential to offset much of your tax on rental income and all your tax on gains.
The tax code allows you to deduct the notional depreciation of your real estate, every year, against your rental income. For most owners, the annual cap on this depreciation deduction is between 2.5% and 3.6% of the value of your improvements (i.e., the structures above the land). Once these deductions add up to the original value of the improvements, they stop—unless you have added more improvements (aka capital expenditures) to the property.
Depreciation is the method whereby the IRS recognizes an asset’s wear and tear over the course of its “useful life”, which is an arbitrary time period found in IRS tax tables. When any business purchases an asset with a useful life of longer than a year, the IRS requires that to be depreciated over a set timeline (27.5 years for most rental housing). For many assets, this approach makes sense; by the time an asset is used up or worn out, it has no value, and its full value has been deducted through depreciation.
Real estate, of course, is a little different. Quality buildings typically do not erode over only a few decades, and most properly-maintained properties will actually appreciate over time, despite what the tax tables say. It is common for a fully-depreciated property to be worth a multiple of its original value.
Regardless of whether a property’s resale value is increasing or decreasing, for owners in high tax brackets, depreciation deductions can reduce annual taxes by tens or hundreds of thousands of dollars. But there is a catch. When the property is sold, all of the prior cumulative depreciation is “recaptured” by the IRS at a tax rate that is not much lower than the original income tax that was avoided.
Unless you sell your property as part of a…
A complete 1031 exchange potentially allows you to sell one investment property and buy another, without recognizing any taxable gain. You are able to defer both the capital-gain tax on your appreciation and the recapture tax on your depreciation.
Like many tax strategies, the rules and process of completing a 1031 exchange are multifaceted and often changing. A key 1031 exchange mandate centers around the notion of reinvesting proceeds into an equal or higher-value “like-kind” property. While like-kind can sound specific, it is quite broadly defined and allows for the exchange of any type of investment/business property for another. For example, an apartment building can be exchanged for a shopping center, single-family rental, raw land, or any combination thereof.
More importantly, you can execute this strategy an unlimited number of times over the span of your life, repeatedly kicking a larger and larger tax can down the proverbial road. Be mindful, however, of crucial deadlines when participating in a 1031 exchange as the Internal Revenue Code spells out very specific timeframes for such transactions.
While tax-deferred exchanges have existed for over a century, threats from politicians in Washington to severely limit—or do away with them altogether—have become a routine exercise. While the latest legislation didn’t result in changes, 2022 may be a great time to exercise 1031 exchanges before they end up in the crosshairs again. Finally, upon your passing, your heirs get a…
STEP-UP IN BASIS
Yes, you do have to die for someone to benefit from this last strategy, but the positive tax consequences are among the highest in the entire tax code.
In almost all circumstances, the “cost basis” of your real estate investment property (the price paid including maintenance and improvement costs) is “stepped up” on the date of your death to its fair market value. As real estate tends to be an appreciating asset, in most cases, the fair market value of the property ends up being much higher than its cost basis.
If you sold the property (prior to your passing), you would have paid taxes on the difference between the cost basis and the market value. However, the “step-up in basis” law effectively wipes away all capital-gains and depreciation-recapture taxes that would have been payable if you had sold the property immediately preceding your death.
If your heirs keep your property for any length of time before selling, they could owe some taxes, but only relating back to the value of the property upon your passing.
The step-up in basis has been criticized as being only advantageous to the wealthy. As such, this is another tax strategy that certain populists in Washington periodically threaten to limit or eliminate.
As with anything tax-related, the devil is in the details, and you should always work with tax and investment professionals who are well-versed in the relevant rules and regulations.
Richard D. Gann, JD is a Managing Partner with 1031 Capital Solutions, with locations in San Diego, San Francisco, Portland and Seattle. Richard is an author, registered securities representative, member of the California State Bar and grandson of Proposition 13 author, Paul Gann. For more information, please contact 1031 Capital Solutions at (800) 445-5908 or visit their website, 1031CapitalSolutions.com.
This information is for educational purposes only and does not constitute direct investment advice or a direct offer to buy or sell an investment, and is not to be interpreted as tax or legal advice. Please speak with your own tax and legal advisors for advice/guidance regarding your particular situation. Because investor situations and objectives vary, this information is not intended to indicate suitability for any particular investor. The views of this material are those solely of the author and do not necessarily represent the views of their affiliates.
Investing in real estate and 1031 exchange replacement properties may involve significant risks. These risks include, but are not limited to, lack of liquidity, limited transferability, conflicts of interest, loss of entire investment principal, declining market values, tenant vacancies, and real estate fluctuations based upon a number of factors, which may include changes in interest rates, laws, operating expenses, insurance costs and tenant turnover. Investors should also understand all fees associated with a particular investment and how those fees could affect the overall performance of the investment.
Securities offered through Concorde Investment Services, LLC (CIS), member FINRA/SIPC. Advisory services offered through Concorde Asset Management, LLC (CAM), an SEC registered investment adviser. Insurance products offered through Concorde Insurance Agency, Inc. (CIA). 1031 Capital Solutions is independent of CIS, CAM and CIA.