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Section 1031 exchanges are among the most powerful financial instruments in the field of real estate. These tools can be used to accomplish all sorts of investment goals. These transactions are very frequently used by rental property owners who want to either upgrade their investment or switch to a different type of investment (in a separate industry). Although many people know about the basics of these transactions, few people realize their full potential. In this post, we will discuss how these exchanges can be used in estate planning.
IRC Section 1031 as a Wealth-Building Instrument
IRC Section 1031 is commonly known as a powerful tool for tax deferral, but it’s also highly useful in building wealth over a period of time. When a taxpayer conducts a “1031 exchange,” that taxpayer is able to defer his or her tax liability from the sale of a business or investment property; these deferred taxes are used to purchase a “replacement property” which must be of like-kind to the original property. Hence, in a sense, 1031 exchanges use “borrowed” funds from the government to purchase new real estate. When this happens, taxpayers have all sorts of opportunities to increase their earning power as well as their overall financial condition.
Consider a familiar scenario: a taxpayer purchases an investment property for $250,000 and holds that property for 5 years. When the taxpayer sells this property as part of an exchange, he sells it for $1,000,000. The $750,000 in profit – on which the taxpayer would ordinarily be required to pay a tax liability – is effectively “rolled over” and reinvested entirely in a new replacement property. When the taxpayer acquires this new replacement property, which has a value upwards of $1 million, the taxpayer will likely receive higher yields, and also a more valuable property overall. If the taxpayer continues to repeat this cycle – exchanging into more and more valuable properties – we can see the potential for financial growth using Section 1031.
Stepped Up Basis Following Death
How does this play into estate planning? We can see how Section 1031 can be used to strategically build wealth, but how does this relate to long-term estate planning goals? The answer lies in the way in which property is treated in the event of death. When a taxpayer passes away, that taxpayer’s real estate assets – including those real estate assets acquired via 1031 exchange – will receive a “stepped-up basis” when bequeathed to beneficiaries. This stepped-up basis is equal to the fair market value of that property when the original owner passes away. In other words, the beneficiaries will receive a property that has a basis equal to its current fair market value. If the beneficiary receives a property with an FMV of $2 million, that property will also have a basis of $2 million. If the beneficiary were to immediately sell this inherited property, the beneficiary wouldn’t incur a tax burden on that sale. Hence, we can see how the gains built up via 1031 exchanges can ultimately translate to a very substantial financial improvement. This stepped-up basis can essentially enable beneficiaries to “cash out” of these real estate assets without incurring a sizable tax burden. For those readers who are familiar with estate planning basics, this fact should come as a very welcome bit of new information.
Contact the Murphy Law Firm for More Information
If you’d like to know more about this topic, or a related topic, don’t hesitate to reach out to one of the attorneys at the Murphy Law Firm today by calling 240-493-9116
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