FEATURE ARTICLE, SEPTEMBER 2006

SWAP, DON'T STOP
1031 exchanges can help property owners and investors avoid steep taxes when dealing with estate planning.
Gabrielle Glass and Jeffrey Doornbos

When an investor sells investment real estate, he or she may face a large tax bill. Sellers may owe tax on depreciation deductions previously taken and on appreciation from the date of purchase and from prior trades, which could be enormous based on the velocity of soaring real estate pricing over the last several years, especially in places like California and Arizona. Section 1031 of the Internal Revenue Code allows taxpayers the option of deferring accumulated taxes, indefinitely.

Commercial and investment property owners are loathe to fork over money to pay taxes on the sale of highly appreciated low-basis assets. Even though the long-term capital gains tax rate for the individual investor class was reduced by Congress from 20 percent to 15 percent in 2003, and was recently extended to expire at the end of 2010, the capital gains tax bite can still sting because depreciation recapture remains at 25 percent. There are also state income taxes and certain states impose additional withholding requirements. Furthermore, a taxpayer may be subject to the short-term rate, which is higher than 15 percent, and the taxpayer seeking the deferral may be a corporation facing a tax rate as high as 35 percent. The tax deferral may be compounded forward after a series of 1031 exchanges, so it is critical that the investor looks at the issue of tax liability more broadly.

Most investors want to fully defer the recognition of gain in the year of sale while some taxpayers participate in partially tax-deferred exchanges, which means that the exchanger winds up deferring the recognition of gain on the amount reinvested, as well as deferring the payment by buying short and/or pulling cash or equity out.

Clients like to know when they roll from one exchange property to another if they can completely avoid paying taxes on the gain from the sale of property that is held for investment or held for use in a trade or business. No doubt, selling appreciated real estate that has been depreciated down can be difficult, so why pay taxes? Assume that the blended tax rate is 20 to 25 percent on average — when property is exchanged, the investor winds up reinvesting and capitalizing on the tax savings rather than reinvesting after tax with limited funds. As interest rates are rising, taxpayers can still leverage up and generate yields that meet or exceed their hurdle rates of return. So, investors continue to be attracted to real estate that qualifies as like-kind for 1031 exchange purposes.

The bottom line is that investors are reluctant to pay the tax and have their day of reckoning when selling their last piece of investment property. Tenant-in-common (TIC) investments, as well as the conversion of rental homes to single-family homes, can create practical exit strategies for 1031 exchange clients.

Preliminary Tax Considerations

There comes a point in time at which real estate investors have the opportunity to look back at what they have built and accumulated over a lifetime. The nagging question that consumes investors is what happens to the real estate assets in a portfolio at the time of death, as the real estate assets will often outweigh the value of the rest of the estate. What happens to one’s investment and assets after the investor’s death? It is important for investors to engage competent advisors to carry out and evaluate estate planning strategies such as probate avoidance. The beneficiaries can benefit from understanding what is being done to protect their inheritances.

While death is not the most pleasant subject to write about, the beneficiaries need to understand what happens when the exchanger dies. Currently, the beneficiaries that inherit exchange properties will receive a new property income tax basis stepped up to the fair market value of the property at the date of death determined by the probate court and the gain is wiped out. (Basis typically represents the property’s original cost basis plus or minus adjustments for depreciation taken and for non-expensed capital improvements). When an investor dies holding assets and never having paid capital gains taxes, the gain currently escapes income taxes because of this thing called stepped-up basis.

Phase-Out of Federal Tax and Repeal of Step-Up in Basis

On May 25, 2001, the United States Congress passed the Economic Growth and Tax Relief Reconciliation Act of 2001. This act resulted in a very complicated change in Federal tax law. Investors and advisors are prone to misunderstanding the changes in the tax law, believing that the taxation on estates will be eliminated; this is not the case. Estate planning will soon become an even bigger priority than it is today. (See Table 1.)

Current law applies to assets inherited from decedents dying before January 1, 2010. For decedents dying in 2010, unless Congress acts to continue the current law, the step-up in basis is eliminated except that the executor can allocate an increase of basis up to $1.3 million for a beneficiary and up to $3 million for a surviving spouse. The allocated step-up is added to carryover, but the total cannot exceed fair market value at the date of death. Numerous conditions must be met to qualify for the allocation of step-up.

The step-up in income tax basis is limited for 1 year in 2010. So, for individuals who die in 2010, not all of the assets passing to heirs will have a stepped-up basis. Looking beyond 2010, because of the built-in “sunset” provision, the basis step-up is set to be restored, as is the estate tax that was in effect in 2001. If the step-up is ultimately eliminated, the beneficiaries would inherit the decedent’s property at the original cost basis of the last replacement properties acquired under one or more 1031 exchanges, and the gain could be quite substantial and perhaps unknown. Beneficiaries may be unable to trace the basis once the original 1031 investor is deceased.

“Real” Estate Planning Considerations

There continues to be considerable pressure to sell farm property when it is in the path of development, and farmers are actively solicited with very generous offers. According to the Illinois Society of Professional Farm Managers and Appraisers’ 2006 Illinois Farmland Values and Lease Trends, land values increased in 2003 by approximately 10 percent, values in 2004 were up 20 percent and values further increased in 2005 by as much as 15 to 20 percent. The outward migration of development and accelerated farm sales are not limited to Illinois, but apply throughout the Midwest and extend to other parts of the country where agricultural land use is prolific.

Imagine a not-so-atypical scenario where an elderly farmer, who happens to be a surviving spouse, decides to sell farmland that has been held in the same family for three generations. The $250,000-per-spouse capital gains tax exemption on personal residences will flow through the estate for the benefit of the heirs. The exclusion applies to the estate or the heir if the decedent’s principal residence is sold within 3 years of the decedent’s death, which complies with the 2-out-of-5-years rule and tacks on to the decedent’s use of the residence while alive. The landowner assumes that the only available option in order to generate income for themselves and to have money for their heirs is to sell the land now and pay the capital gains tax. However, the prospect of selling now and paying the tax does not sound like a good deal. Of course, the decision to sell and also pay tax is inappropriate given the current tax law, which allows beneficiaries to receive a step-up in cost basis for the farmland at the date of death. Alternatively, the client could sell now and reinvest the sale proceeds using a 1031 tax-deferred exchange. The farmer would not be locked into acquiring more farmland, but could exchange out of the farmland and trade into a triple-net-leased, income-producing replacement property that would eventually be transferred to the heirs with a step-up in basis.

When beneficiaries resell real estate assets, they currently only pay tax on the increase of value, if any, since the date-of-death value, or since they inherited the property — unless the beneficiary exchanges the property using a 1031 exchange. For emphasis, in 2010, there will be no estate taxes and the capital gains tax will replace the estate tax. As the tax rules for inherited property currently stand, if beneficiaries who inherit in 2010 resell without a 1031 exchange, they can expect to pay hefty taxes on the gain that accrued over the decedent’s lifetime.

Implications of Limited Step-Up

In the second example (see Table 2), it is assumed that the farmer dies January 15, 2010 and the step-up in basis rule has been eliminated, except for a limited amount allocated by the executor of the estate up to a maximum of $1.3 million for assets transferred to any beneficiary. Any step-up is added to the decedent’s carryover basis. So, if the executor allocates the entire $1.3 million of allowable increase in basis to the farmland, then the beneficiary’s basis in the farmland is $1.4 million and the uncovered gain of $3.6 million in the farmland is taxed if the beneficiary does not exchange the inherited land. For multiple heirs, the executor can spread the available $1.3 million of stepped-up basis among beneficiaries proportionately depending on the beneficiary’s income levels and the length of time each beneficiary expects to hold inherited assets.

Currently, a beneficiary that holds onto inherited property at stepped-up basis versus carryover basis can start to “re-depreciate” the property. Imposing a limit on the step-up in basis in 2010 will lower the degree to which new basis of inherited property can be depreciated without first selling the property and exposing it to capital gains tax. Alternatively, the heir can get more basis to depreciate by trading up to a more expensive property.

The federal estate taxes will be fully phased out by January 1, 2010 (see Table 1); the step-up in basis will be partially lost. Thinking ahead, it all seems rather dicey, since we don’t know what tax laws will be in effect when we die. It is anyone’s guess if the new estate tax law will be repealed, stand as written or morph into some other complex tax rate schedule. Beneficiaries should be aware that the step-up in basis is not automatic as to persons dying after December 31, 2009. The step-up in basis was repealed in the 1980s and then reinstated because the ability to determine the decedent’s carryover basis was difficult for heirs to figure out. It is critically important for taxpayers who hold investment property to use 1031 exchanges to build wealth. It will also be important for their beneficiaries to know how to use 1031 exchanges for themselves, so that they don’t unknowingly minimize their inheritances.

Gabrielle Glass serves as assistant vice president and regional account executive with Investment Property Exchange Services Inc. (IPX 1031) based in Chicago. Jeffrey Doornbos is the president and CEO of Chicago-based JP Group Financial.

Investors interested in estate planning and the treatment of capital gains taxes should consult their legal, tax and financial advisors because of the complex tax laws and financial implications. A full discussion on the changes in the estate tax laws are beyond the scope and limitations of this article.

©2006 France Publications, Inc. Duplication or reproduction of this article not permitted without authorization from France Publications, Inc. For information on reprints of this article contact Barbara Sherer at (630) 554-6054.