Nothing is certain but death and taxes right? Well, not exactly. Sorry, but I have yet to find a solution to the death part, but for the tax part, strategies do exist. One misnomer is no financially prudent exit strategy exists for highly appreciated real estate other than leaving it to your heirs. Well, let’s examine that.

1031 X

IRC Section 1031states no gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment if such property is exchanged solely for property of like kind which is to be held either for productive use in a trade or business or for investment. Uh, what? Layman’s translation: normally when you sell a property you have to pay a capital gains tax on the difference in what you paid for it and what you sold it for, minus any money you put into it while you owned it. So, if you bought a $100,000 four-plex in 1990 that sells for $350,000 today, then you might owe taxes on up to $250,000 of gain, ouch! So the IRS realized, hey, no one’s going to sell their property and that means stifling economic activity. Let’s give investors an incentive to roll these properties into new investments and increased economic activity is good for all, including us.

Well, that’s one story anyway.Regardless, they created section 1031 to allow people to sell their property and as long as the money is reinvested in a subsequent “like-kind” property, the capital gains taxes will be deferred until it is later sold outright, not exchanged. But the tax gurus advised their clients, don’t sell your highly-appreciated property, just leave it to your kids. Heirs get a “stepped-up” basis on inherited assets. So what the heck is a basis and where do we get one? A basis is simply the tax definition of what you’ve got in your property: purchase price + improvements. In the previous example it was the $100,000. However, when your heir inherits your asset they get a new basis and that is the fair market value of the assets at the time of your death. In our example the basis gets stepped-up to $350,000, so the heir can sell the property and avoid a capital gain.

So yes, that’s great for the kids, but what about me you ask. Well, there is another exit strategy, why not give the property to charity in exchange for an income stream?

Charitable Remainder Trusts

IRC Section 664 allows charitable donors to gift property to charity, retain an income stream, while the charity or foundation receives the remainder value when the trust terminates. Qualified charitable charities are tax exempt so we could give them the $350,000 four-plex and they can sell it with no taxes due. Again you’re thinking, well that’s great for the charity, but what about me? S.664 allows the donor to receive an income stream in either a fixed percentage of the cash value or via an annuity, often ranging between 4%-7% annually. Beneficially, there is “remainder value” deducted from this income. This is the estimated value the charity will receive after your and is a charitable deduction you can use today. And the best tax news is that we just got this asset out of your taxable estate since you no longer own it; i.e., no estate taxes due on it at your death.

But What About The Kids?

People like the idea of charitable giving, but not at the cost of disinheriting their kids. The solution is to use either a portion of the income distributions or a portion of the principal donated to purchase life insurance on the donor’s life to replace the value of the property donated. The life insurance proceeds are distributed to the heirs tax-free.

Putting It All Together

Now, please allow me to run my usual disclaimer. All that I have discussed is complex and you need an experienced CPA, lawyer, and charitable giving advisor to navigate this ship. Much of what I’ve discussed has exceptions and my strokes were admittedly broad. However, with the proper guidance this strategy can prove a routine endeavor.

In closing, such a strategy should be stronglymotivated by charitable intent and not just the tax savings. Whether it’s to grandchildren or charity, money or wisdom, we can leave relatively modest amounts behind that create rippling effects for decades to come, and that’s what estate planning is really about.