The Role of 1031 Exchanges in Estate Planning


Completing a 1031 exchange can allow real estate investors to defer taxes today and plan accordingly to avoid burdening their heirs with a hefty tax bill later.

A 1031 exchange involves selling a piece of real estate investment and reinvesting the proceeds in a like-kind real estate investment of equal or greater value to defer capital gains and depreciation recapture taxes ultimately.

The possible tax benefits that the 1031 exchange may offer, in combination with the option to divide assets appropriately to benefit heirs down the line, make 1031 exchanges an estate planning strategy worth considering.

Step up in cost basis

While there are reasons a real estate investor would want to sell a property in a standard transaction and pay the required taxes, this path could cost the investor upwards of 30-40% of the profits, which go straight to the IRS.

In a 1031 exchange, taxes on the gains on the relinquished property are deferred. Neither the estate nor beneficiaries face a tax liability upon the owner’s death. Instead, the tax basis for the real estate investment that heirs inherit steps up to the fair market value of the date of death when they take possession. If they decide to sell the asset immediately, they will not owe capital gains taxes. They also will not be responsible for any of the depreciation recapture from which you may have benefited over the lifetime of your investment.

If the heirs wish to retain the asset, they would only be liable for taxes on gains in the future that accumulated as of the date they received the step up, up until when they sell the property. They might even consider including the property in a future 1031 exchange to defer taxes and reinvest the proceeds to defer that gain too.

Swap ‘til you drop

When investing in real estate, the properties you currently own may not be aligned with your investment objectives down the road.

It is possible to enhance your real estate portfolio over time and, through 1031 exchanges, defer the taxes each time. There is no limit to the number of 1031 exchanges an investor can complete. Investors can “swap until they drop” so long as each transaction’s intent is for long-term investment rather than solely tax avoidance.

It is an opportunity to keep your own investment goals as the priority and use previous growth to have further compounded growth while also positioning your portfolio to benefit your heirs.

When there are multiple heirs

For investors who plan to leave assets to multiple heirs, it is possible to consider their financial situations when structuring your 1031 exchange.

As part of the exchange, investors may purchase multiple, or in some cases, an unlimited number of properties, setting the stage to leave different assets to different heirs. For example, let us suppose one heir will likely need to sell the investment after taking possession while another might want to hold the asset. In that case, it is possible to make it easy for both by purchasing multiple properties and listing each heir as a beneficiary of an individual asset.

Keep in mind that replacement properties must be identified within 45 calendar days after selling the relinquished property. It is viable to identify up to three replacement properties. Still, that limit can be surpassed so long as the replacement properties’ value does not exceed 200% of the relinquished property, or the investor closes on at least 95% of the value of the replacement properties identified.

Consider a Delaware Statutory Trust (DST)

A Delaware Statutory Trust is a long-term passive real estate investment in which beneficial interests of a real estate trust are owned rather than individual properties directly.

DSTs provide benefits for an investor’s current situation by eliminating the headaches that come with active management properties while still obtaining all of the benefits of real estate ownership.

When it comes to estate planning, DST interests can be split among heirs, either ahead of time when purchasing the interests through the purchase of multiple of the same DST or upon death via reregistration based on instructions of Will’s or Entity documentation. This streamlines decisions while defusing potential estate conflicts. Investors should be aware that DSTs are typically designed to last five to ten years, and there is no active secondary market for investors should they need to sell.

1031 exchanges offer benefits for individuals looking to maximize their real estate investments today while setting up beneficiaries to continue building wealth. We always recommend consulting your tax or financial professional regarding how 1031 exchanges may fit your situation.

To learn more, please contact us at any time.

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