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Using 1031 Exchanges as an Estate Planning Tool

How do you take a mixed-use investment property and split it equitably among four heirs without starting a family feud? Accruit subject matter expert David Gorenberg presents a simple solution leveraging 1031 exchange.
couple consults with estate planning attorney about a 1031 exchange in new jersey

Many investors are aware of 1031 exchanges and their usefulness in their real estate portfolios. These investors use a 1031 exchange to reposition their investments to other neighborhoods, or other states, or to redistribute their investments to different asset classes. However, many investors overlook the value of a 1031 exchange as an estate planning tool.

The Situation

Mr. Spencer currently owns a mixed-use building on a prime downtown corner in a small town in central New Jersey. There are 21 office spaces, four apartments, and off-street parking. Mr. Spencer’s current estate plan would have this property pass to his four grandchildren upon his death.

The Problem

Mr. Spencer’s new estate planning attorney has pointed out that if each grandchild inherits 25% of the same property, they may not be able to agree on what to do with the property when they inherit it. The attorney suggests that one may wish to sell the property to receive the cash windfall; another may wish to refinance it so they can make upgrades to it and increase the rent; the third may want to refinance it so that they can use the cash in other ways; and perhaps the fourth grandchild is a little Bohemian and cannot decide what he wants to do. At the same time, Mr. Spencer does not want to sell the property outright and pay hefty capital gains and depreciation recapture taxes.

Let’s assume Mr. Spencer acquired the property 20 years ago for $250,000 and has made $50,000 in improvements during that time and took approximately $125,000 in depreciation, resulting in an adjusted basis of $175,000. It is anticipated that the sale price of the existing property will be $850,000. Without a 1031 exchange, Mr. Spencer would be expecting to pay taxes as follows:

20% capital gains on the appreciation ($675,000 x 20%) $13,500
25% recapture on depreciation taken ($125,000 x 25%) $31,250
Affordable Care Act tax ($675,000 x 3.8%) $25,650
NJ State capital gains on the appreciation ($675,000 x 8.97%) $60,547
NJ State depreciation recapture ($125,000 x 8.97%) $11,212
     
Total tax paid   $142,159

 

 

The Solution: 1031 Exchange

Mr. Spencer will structure the sale of the existing mixed-use property as part of a Section 1031 tax-deferred exchange. He has determined that he will trade equal or up in value and maintain a mortgage of at least the same value as on the mixed-use property, to fully benefit from Section 1031.

Upon the sale of the mixed-use property, the exchange proceeds were sent directly to Mr. Spencer’s qualified intermediary (“QI”) to be held in escrow until the purchase of his replacement properties.

Within 45 days after the closing on the sale, Mr. Spencer properly identified four identical condos in one condo complex, conveniently located less than a mile from the local university. Each condo will be acquired for $249,000, with a gross acquisition value of $996,000—which is greater than the sale price of his relinquished property. Closings for the four condos all occurred within 180 days of the sale of the relinquished property, utilizing the exchange proceeds held by the QI and additional mortgage financing.

Thereafter, Mr. Spencer revised his Will to direct that each grandchild would inherit their own condo.

The Result

Mr. Spencer has successfully completed a 1031 exchange from one relinquished property into four replacement properties. He exchanged equal or up in value, equal or up in equity, and equal or up in mortgage value, fully deferring the $142,159 in anticipated taxes. Upon Mr. Spencer’s eventual death, the grandchildren will inherit the condos at the fair market value as of the date of his death, receiving a step-up in the basis. The depreciation recapture and capital gains taxes will have been completely avoided.

Learn the step-by-step process involved in completing a tax deferred exchange to review with your tax and legal advisors.

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