Before you sell your investment property, STOP and read this article! It could not only save you hundreds of thousands of dollars (possibly even millions!) in unnecessary tax payments, but it could also result in generations-worth of tax-free investing for you and your family.
I’ll show you step-by-step how to make the sale of your investment property tax-free and how you can pass those tax savings along to your heirs and even to their heirs so that neither you nor your beneficiaries will ever have to pay capital gains taxes on any real estate investment. Plus, you’ll see how you can take the proceeds from the sale and put them to work, producing two to five times greater returns than what you’re probably earning now, with zero landlord hassles. But I’m getting ahead of myself.
See if you can relate to this scenario. I recently 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 have to face a hefty tax bill. Theirs was the typical story we hear each time we sit down with people who no longer want to actively manage their real estate investment properties but who still want real estate to be a part of their portfolio. I shared with John and Sue exactly what I just shared with you: that there is a solution which will not only get them out of the landlord business, but will also exempt them from paying capital gains taxes, allowing their investment to grow tax-free for life.
Readers who don’t know me might think I’m exaggerating, but, when it comes to investment practices, just like ole’ Joe Friday in Dragnet, I’m a “just the facts, ma’am” kind of guy. (Claims made about my golf or pickleball abilities might be another story.) This is no exaggeration: with a little planning and a properly set-up estate, lifetimes of tax-free investing for you and your heirs is a very real possibility. And, as you’ll soon see, it doesn’t have to be all that complicated.
There are three players involved in planning your “capital-gains-tax-and-landlord-hassle-free” investment. The first is a 1031 Exchange. You’ve probably read previous articles where I wrote about 1031 Exchanges, 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 strategy, a “step-up in basis,” is an estate-planning tool which involves the readjustment of the value of an appreciated asset upon inheritance. When an asset is inherited, it typically will have increased in value since its initial purchase, which is great — but so does the tax burden. Through a step-up in basis, the asset gets “stepped-up” to the current fair market value, eliminating the tax gain and therefore the tax burden for the beneficiary.
The third, very important player in our “capital-gains-tax-and-landlord-hassle-free” scenario is Guardian, our investment fund that owns hundreds of homes in multiple geographic locations in the affordable core rental market. What does Guardian Fund bring to the game? Investors can do a 1031 Exchange with Guardian for the same tax-deferred benefits of a typical 1031 Exchange, PLUS, Guardian Fund offers a few unique features we’ll touch on in a minute.
Now that you have a basic understanding of the strategies at play, let’s look at how they can work together for a lifetime of hassle-free, tax-free real estate investing with a healthier net profit. We’ll go back to my meeting with John and Sue.
I explained to the couple that, by doing a 1031 Exchange with Guardian Fund, they would essentially take the equity from the sale of their higher-priced California property and “exchange” it for several homes owned by Guardian Fund. In addition to the standard 1031 Exchange benefit of selling their current real estate investment property without a recognized capital tax gain and being able to grow their investment tax-free, an exchange with Guardian Fund would also relieve John and Sue of all landlord duties (since Guardian is a 100% passive investment with the properties fully-managed for them), and they’d be protected as investors in the fund.
As a quick recap, through a 1031 Exchange with Guardian Fund, John and Sue will:
• Have zero recognized capital tax gain on the sale of their home
• Reinvest the tax-free proceeds into multiple Guardian properties which are geographically diversified for protection and produce two to five times greater returns than an average rental
• Be investors in a fund, not landlords fixing roofs and toilets
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 sell their property and do a 1031 Exchange with Guardian Fund, 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 the assets in their estate. 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 which means 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). At some future point, the beneficiary could sell the property through a 1031 Exchange, which 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.
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.