Inherited property may generate wealth
1031 exchange option ‘can be pretty beneficial’
If you’ve inherited your mom’s 1960s-style house, you might wonder what to do with it.
The most obvious options are moving into it, renting it or selling it.
But there’s another lesser-known option called the 1031 exchange that allows you to sell the property and buy a “like-kind,” or same type, of property of more or equal value as an investment.
The best part? You won’t immediately have to pay taxes on any of the deal if you do it correctly. The replacement can even be “better, bigger, more expensive property,” said Rob Matt, director of tax services at the certified public accounting firm Kaufman Rossin.
Executing a 1031 exchange wouldn’t be easy, especially with strict timeline requirement, but if you can find the right professionals to help you, “it can be pretty beneficial if part of your wealth building journey includes real estate,” said Dimitri Pan, senior wealth adviser at the financial services firm Ally.
How does a 1031 exchange work?
If you own property used for business, trade or investment like a vacant lot, commercial structure or residential building that has appreciated in value, you can swap it with like-kind property.
“Like-kind” means only that the property has the same nature or character, not quality. You can replace a warehouse with an office building, a single-family home with an apartment building, or one investment property for multiple ones.
The new investment property must have a purchase price equal to or more than the selling price of your property and have a loan amount equal to or more than the original one or you may incur taxes. You must pay taxes on any benefit or money you pocket in the exchange.
Basic example: You sell a property for $650,000 with a $150,000 mortgage. You’d have to buy a replacement property for at least $650,000 and borrow at least $150,000 to pay for it.
Timing and the money trail are key
Important steps you must follow to stay compliant with IRS rules:
⬤ You only have 45 days from the date
of the sale of the inherited property to identify your replacement property that must be equal or greater value than the sold property.
⬤ You have only 180 days from the date of the sale of the inherited property to close on the new property.
⬤ You must use a neutral qualified intermediary to hold the money from the sale until it’s used to acquire the replacement property. You can’t ever hold that money or you’ll be disqualified from a 1031 exchange.
Note: In the case of your parent’s old home, experts differ on whether you can immediately sell that house in a 1031 exchange. Matt says that because the IRS considers the “intent” of a property, such as how long you may have actively sought or had tenants, he suggests putting “a year of daylight between transactions” to be safe. “It’s easy to have a tenant and rent for a year and then sell it for larger, better place.” Other finance experts say that’s not necessary, but it’s best to consult with a professional before doing anything.
What are the benefits of a 1031 exchange?
Deferring taxes is the biggest benefit. You don’t have to pay capital gains tax, or tax on profits of the property you sell, because you’re using all the proceeds to buy another property.
With a property inherited as a result of a death, you also benefit from the “step-up basis,” which means the property’s valued at the current market value, not the original purchase price.
So, if the house your mother bought for $100,000 is worth $500,000 at her death, you would inherit it at the $500,000 value. If you sold it immediately, you wouldn’t pay tax on the $400,000 increase in value. If you used
it in a 1031 exchange, you also wouldn’t immediately pay tax, but you’d also own a half-million dollar or more investment property.
Is there a limit on 1031 exchanges?
Because there’s no limit on how many times you can use a 1031 exchange, you can split the inherited house with a sibling. You each can use a 1031 exchange for an investment property worth $250,000 or more. Neither of you would immediately pay taxes.
Once you have an investment property, you can repeat this as often as you like. If you have investment property but your kid goes to college, you can do a 1031
exchange for property where your child is attending school and rent it out to your child and classmates. You just can’t do this with overseas property, the IRS says.
Can I use a 1031 exchange to build wealth?
Yes.
“You can sell a property, buy another and keep building up your portfolios of property,” he said. “If it gets to the point that I pass away, all these capital gains die with me. Heirs get the properties at a step-up cost basis and won’t inherit tax liability.”
Or they can use your properties in 1031 exchanges to build their portfolios and
continue deferring taxes. “This can create generational wealth,” Pan said.
When do you finally pay taxes?
Taxes are due when the property is sold without replacement. You’d pay capital gains tax on the appreciation of any property you sell.
Even then, there’s one last way to avoid some of those taxes you’ve put off.
“The 1031 exchange lets you kick the can down the road, and then when you’re done, you throw out the can,” Matt said. “When you pass away, you step-up the tax basis of the property, so if you sell shortly after death, you won’t realize much gain if any.”