1031 Tax-Deferred Exchanges as an Important Estate Planning Tool

There are many factors which motivate taxpayers to complete 1031 exchanges when selling real estate.  Such considerations can include:

• Consolidate many properties into fewer properties
• Diversify fewer properties into more
• Trade appreciated low cash flow property for high cash flow property
• Maximize ability to borrow against properties using bank funds rather than owner’s
• Trade for higher basis property to take advantage of depreciation deduction
• Acquire property closer to owner in the event of relocation

Another very important, but often overlooked, reason to consider a 1031 exchange is to take advantage of a stepped-up basis for heirs upon the death of the property owner.  According to Investopedia a stepped-up basis is defined as:

“Step-up in basis is the readjustment of the value of an appreciated asset for tax purposes upon inheritance, determined to be the higher market value of the asset at the time of inheritance.  When an asset is passed on to a beneficiary, its value is typically more than what it was when the original owner acquired it. The asset receives a step-up in basis so that the beneficiary's capital gains tax is minimized."

In other words, the heirs receive a new basis in the property based upon its market value at the time of death and the built in gain attributable to the taxpayer essentially disappears.

When someone sells real estate there are a variety of tax components which are generally payable.  These can consist of capital gains, recapture of depreciation taken over the years, applicable state capital gains taxes and, depending on the tax bracket, an additional Net Investment Income tax.  Depending upon the state in which the taxpayer resides, the total taxes can be 30% or more.  As an example, if a taxpayer were to make a profit on the sale of $500,000, the sum of $150,000 would be payable in taxes.  The net amount of $350,000 would be available for reinvestment in real estate or some other investment.  Let’s also assume the new investment paid an annual return of 5%.  The taxpayer could expect an annual cash return on that amount of $17,500.  Upon the eventual death of the taxpayer, the net amount of $350,000 would be passed on to the heirs. However, a successful 1031 exchange can allow the total tax, $150,000 in the example above, to be deferred (although a few states require the state tax to be paid).

Let's dig into this further. Suppose in the example above a couple purchased the property, an apartment building, when they were middle-aged.  The couple maintained the property - the roof, the boiler, appliances, etc., kept it clean, cared for the landscaping, found new tenants, and more.  Said couple lives in International Falls, Minnesota and are tired of the “Three Ts,” toilets, tenants and trash, not to mention the cold. They decide to retire to Florida.  One option might be to sell the property, pay the taxes, invest the net and receive the annual income of $17,500.  Upon the death of the survivor, the heirs would receive the $350,000.

Alternatively, the couple could sell the property as a part of a 1031 exchange and reinvest the full proceeds of $500,000 into a passive real estate investment with an annual yield of 5% or more.  There are numerous such investments available all across the country.  Annual income would be in the amount of $25,000, plus the couple would participate in the appreciation of the property. And should the survivor of them still possess this property (or subsequent trade property) when he or she dies, the heirs would take a stepped-up basis based upon the property’s fair market value at of the date of death and would not be responsible for the deferred taxes.  Accordingly, those heirs would receive $500,000 rather than the non-exchange result of $350,000.

It is often said that the only sure things in life are death and taxes.  We can’t do much about death, but with a “swap ‘til you drop,” you may very well be able to defer taxes indefinitely.  

Updated 6/06/2022.