See if you can relate to this scenario.  I once met with a married couple (I’ll call them John and Sue) who were selling their rental home in California.  John and Sue were tired of being landlords but didn’t want to sell their property and face the hefty property sales tax bill.  Their story is one we hear every time we sit down with people who no longer want to actively manage their real estate investment properties, but still want real estate to be a part of their portfolio.  I shared with John and Sue exactly what I am about to share with you: There is a solution which will…

• allow you to save thousands of dollars in capital gains taxes on the sale of your property.

• allow you to reinvest the tax-free proceeds into properties that will produce two times what you were earning with your previous investment property (there is also the option to leverage your investment with financing and earn closer to 4X your current earnings)

Be an investor, not a landlord (no more fixing roofs and toilets — but you’ll still have real estate in your portfolio with the homes titled in your name)

Your hard-earned money is better off in your wallet than the government’s.  Use these two strategies to avoid the tax man!

Readers who don’t know me might think I’m exaggerating, but, when it comes to investment practices, I’m a “just the facts, ma’am” kind of guy.  (Claims made about my golf or pickleball abilities might be another story.)  All in all, this is no exaggeration, and, as you’ll soon see, it doesn’t have to be complicated.

There are three players involved in planning your “hassle-free, tax-free” real estate investment.  The first is a 1031 Exchange.  You’ve probably already heard of 1031 Exchanges from me or another source, but, for those of you who are unfamiliar, a 1031 Exchange is an IRS reinvestment option in which one investment property can be sold or “exchanged” for another without a recognized capital tax gain.

The second player, a “step-up in basis,” is an estate-planning tool that involves the readjustment of the appreciated value of an asset upon inheritance.  When an asset is inherited, it typically will have increased in value since its initial purchase, which is great — but the tax burden has increased in value as well.  Through a step-up in basis, the asset is passed on to a beneficiary and “stepped-up” to the current fair market value, eliminating the tax gain and, therefore, the tax burden.

The third, very important player in our “hassle-free, tax-free” real estate investment scenario is our Secured Portfolio investment option.  With a Secured Portfolio, you are able to exchange your investment property, tax-free, for a selection of homes that we have purchased, rehabbed, and filled with qualified tenants.  This last step makes it so you have no landlord hassles, a higher monthly income, and a safe real estate investment — with all the homes titled in your name.  The Secured Portfolio pulls everything together and makes it a 100% passive investment.

I explained to the couple that, by doing a 1031 Exchange into the Secured Portfolio, they would essentially take the equity from the sale of their higher-priced California property and “exchange” it for several homes with us.  In addition to the standard 1031 Exchange benefit of selling their current real estate investment property without a recognized capital tax gain, an exchange with the Secured Portfolio would also relieve John and Sue of all landlord duties (since the Secured Portfolio is a 100% passive investment).   With the Secured portfolio, John and Sue receive a set monthly income — their only expense is the owner’s insurance and we pay for everything else.  They will never have to fix another toilet, mow another lawn, or look for new tenants again; they just collect the (significantly higher) earnings, and we take care of the rest.  And they still get paid even if the property is vacant.

X With a normal 1031 Exchange, they could exchange their investment property for another, but they would still have to manage and maintain the new property.  

This is the point in the meeting where I talk with investors like John and Sue about keeping their newly-acquired, tax-deferred, hassle-free asset within their estate, so that years down the road, they can save on capital gains taxes again when the properties are inherited.  The surviving spouse and future beneficiaries will never have to pay capital gains taxes on their inheritance since the value of the property becomes stepped-up to the current fair market value.

Let’s use some example numbers to make this a little clearer.  Let’s say John and Sue purchased their property for $100,000 and today it’s worth $300,000.  They have a few different options:

    1. They could sell their property outright (not through a 1031 Exchange), and pay capital gains taxes on the $200,000 gain, plus get dinged on depreciation recapture.  Not so great!

    2. They could exchange their property through a normal 1031 Exchange and be stuck with another property that they will have to manage.  This is exactly what they are trying to get away from.

    3. They could sell their property and do a 1031 Exchange with the Secured Portfolio, pay NO capital gains taxes, earn a greater return than they did with their previous rental, and forget all their landlord headaches. 

Then, to take it a step further, John and Sue can continue to avoid paying capital gains taxes by keeping their investment until the property is passed on, and the “step-up in basis” takes effect.  That way, if the fair market value were to reach $300,000 when one spouse passes, the surviving spouse would receive the stepped-up basis of $300,000 — meaning there would be no recognized capital tax gain on the $200,000: it would be as if the property had been purchased for $300,000.  It also means that, if the surviving spouse were to sell the property at that time, no capital gains taxes would be owed.  (Of course, I’m simplifying this example to make the point.)

So, what happens after the surviving spouse passes away?

At that time, the property may be passed on to the next beneficiary who also receives the new stepped-up basis (whatever the fair market value is at the time of inheritance). The beneficiary can either sell the property and avoid capital gains taxes, or they can keep the property and, at some future point, sell the property through a 1031 Exchange.  This qualifies as a capital gains tax-free event again, and there still will have been no capital gains taxes paid on the property to date.  Since there is currently no limit to the quantity of 1031 Exchanges you can do, you can basically “rinse and repeat” for as long as is beneficial for those involved, assuming the current tax and estate laws remain in effect.

I’m throwing a lot of information at you with various numbers and scenarios, but the real nugget here — the point I most want to drive home — is that you could buy and sell real estate for generations and never pay capital gains taxes.  What a powerful wealth-building strategy!  And the real power of this strategy lies not in the perpetual tax savings, but in what you do with your tax-savings.

Consider the incredible profit that can be earned by reinvesting your capital gains tax savings through a 1031 Exchange, and the lost opportunity cost if you choose not to reinvest.  Look at it this way.  Just $1.00 of capital gains tax savings reinvested over a 50-year period (which isn’t all that long), compounded monthly at an annualized return of 8%, becomes $53.88. $100,000 reinvested becomes $5,388,000, and $1,000,000 reinvested becomes $53,880,000.  Those are some serious dollars for your investment portfolio and a great way to build wealth and peace of mind.

A little bit of planning and expert advice can save us a lot of money and headache in the long run.  Here at Hughes Private Capital, we will continue share the ways that you can pass your wealth on to your loved ones instead of to the government.

I know that’s a lot, but there’s even more for those who want to know a little bit more:

Sometimes the surviving spouse only gets half or a portion of the stepped-up basis.  This is primarily based on whether the property is located in a community property state.

There are nine community property states: Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington, and Wisconsin.  If the property is located in one of these states, the surviving spouse receives a full stepped-up basis.  Alaska is technically number ten because it offers the option for both parties to make their property a community property.

If the property isn’t located in one of those states, the surviving spouse only receives the deceased spouse’s portion as a stepped-up basis — essentially half, assuming property ownership is split 50/50.

Here’s an example.  A couple owns a property in Florida with a 50/50 ownership split.  They bought it for $100,000 and it is worth $300,000 today, resulting in a $200,000 gain.  After the death of a spouse, $100,000 (half) of the $200,000 gain would be stepped-up for the surviving spouse, but the surviving spouse’s $100,000 would not be stepped-up.  (So, the readjusted capital gains tax-free portion of the property would be $200,000.)  Upon inheritance of the property, the surviving spouse would owe capital gains tax on the $100,000 upon the sale of the property — the portion that did not get stepped-up.

Good news, though.  There are a few ways that the surviving spouse can receive the full stepped-up basis regardless of where the property is located.  To better explain these and other complex step-up rules, I enlisted the help of tax and estate planning expert Cindy Armentrout, Esq.  You can read her insights and suggestions here.