I understand that a 1031 exchange is a method of postponing tax liability on the recaptured depreciated (taxed at 25%) and any remaining capital gain (taxed at 15%), excluding any boot. But in the long term, this tax liability does not go away and if one eventually decides to sell, then all this deferred tax comes due. So is it correct that the long term strategy is to grow an investment property portfolio but never sell? Eventually whatever property or properties I end up with get put into a family trust and my heirs take care of it when I become senile?
In this strategy, I will never be able to access the equity growth (cash) directly, unless I do an equity loan, a re-finance, or a 1031 exchange into a property of less value and then pay taxes on the boot? Is this right? (I’m thinking about kids’ college and that sort of thing.)
Well, actually there is another possible scenario – you inherit at stepped up basis.
Do you have a family member who is about to die? No one? Perhaps you know a prisoner on death row who has exhausted all appeals and has with no possibility of stay of execution.
Deed this person your property, then have them put the property into an irrevocable trust with you as beneficiary. Now, when you “inherit” the property at its stepped up basis, you can freely sell at FMV without incurring any capital gains tax.
Don’t want to go the trust route? Then put all your property into a family LLC, maybe with you and your spouse as the sole members. Set the ownership interest such that the member most likely to die first has the majority ownership interest, maybe 70-30. Now upon death, you as the surviving member can step up the basis on the deceased member’s 70% interest.
By the way, it is UNrecaptured depreciation that is taxed at 25%. Recaptured depreciation has already been taxed.
Does this work the same way with non-partner heirs? When I die and they inherit the LLC - the stepped up basis on the properties goes up to FMV?
What about if everything is in a family living trust? If I die and then my heirs become trustees, I assume the same thing happens - a new stepped up basis is determined. Does anything else affect the sale of properties in a trust? Or is this the case where the trust has to be dissolved before a property can be sold?
Dave, thanks for the correction. Do you know of someone actually doing the “find someone about to die” thing? Seems like a clever scheme that never gets used intentionally in practice. Unless you have CPA grandpa who wants you to set it up.
Does this work the same way with non-partner heirs? When I die and they inherit the LLC - the stepped up basis on the properties goes up to FMV?
Yes, I thought that is what I said when I suggested you find a prisoner on death row. I never assumed that you had a family relation on death row.
What about if everything is in a family living trust? If I die and then my heirs become trustees, I assume the same thing happens - a new stepped up basis is determined. Does anything else affect the sale of properties in a trust? Or is this the case where the trust has to be dissolved before a property can be sold?
Yes, the basis is stepped up to FMV at the date of death. If the trust only has one asset, then the trust should be dissolved when the asset is sold if the proceeds are to be distributed to the beneficiaries. If the proceeds will be held within the trust and reinvested, then no need to dissolve the trust.
Do you know of someone actually doing the “find someone about to die” thing?
No, I don’t know anyone who actively sought someone about to die. Just freewheeling here. However, if you have a serious chat with an estate planner, you will quickly realize that the focus of any estate plan s/he will recommend revolves around which spouse is likely to be the first to die because the goal of an estate plan is to minimize the federal tax impact upon a transfer of wealth at death.