Investing in real estate offers an outstanding path to long-term wealth. And, many investors consider this wealth-building power a key pillar of their financial legacies. That is, the wealth generated through real estate can play a major role in estate planning, providing investors with nest eggs to leave to children and grandchildren. To maximize these nest eggs, savvy investors understand the inheritance-related tax benefits of real estate. As such, we’ll use this article to discuss real estate and the inheritance step-up in basis tax strategy.
Specifically, we’ll cover the following topics:
- Building Long-term Wealth with Real Estate Investments
- Estate Planning Considerations
- Minimize Taxes with the Inheritance Step-up In Basis
- Final Thoughts
Building Long-term Wealth with Real Estate Investments
Real estate offers five key benefits for investors looking to build long-term wealth:
Benefit 1: Leverage
Generally speaking, if you wanted to purchase $250,000 in stocks, you would need $250,000. Yes, some brokers offer services to buy stocks on margin, but this strategy entails tremendous risk and is not available to all investors.
Real estate investors, on the other hand, can take advantage of leverage. Let’s say that, rather than purchase $250,000 in stocks, you wanted to buy a rental property for that amount. Most conventional lenders offer 75% loan-to-value mortgages for rental properties, meaning that for $62,500 – ignoring transaction costs – you could purchase a $250,000 asset.
Benefit 2: Cash Flow From Rents
When you then lease this asset to a tenant, you gain the benefit of cash flow from rents. Of course, these cash flows need to cover your property’s 1) operating expenses, and 2) debt service. But, with a well-analyzed deal, cash-in will exceed cash-out, letting you pocket the difference.
Benefit 3: Loan Amortization
As stated, a portion of your rental revenues will go towards paying your mortgage. But, you then gain the benefit of loan amortization. With an amortizing loan, a portion of every payment goes to loan principal, with the remainder going to interest expense. So, with every mortgage payment you make, your loan balance decreases, and your ownership (or equity) in the property increases. Eventually, you’ll pay off the loan balance and own the property free and clear.
Benefit 4: Depreciation
Investing in real estate also lets you take advantage of depreciation, that is, deducting a portion of your property’s acquisition costs every year. While the details of calculating depreciation can become complicated, the concept proves straightforward. Depreciation expense reduces your taxable income without an associated cash outlay. This system leads to many rental properties generating a taxable loss while still providing positive cash flow for investors.
Benefit 5: Property Appreciation
Combined with the above benefits, property appreciation serves as the foundation for real estate’s long-term wealth-building characteristics. While property values may fluctuate in the short-term, over extended periods of time, real estate consistently appreciates in value.
Appreciation rates vary by market and property quality, but nationwide, long-term averages hover around 3.5% year-over-year. These rates mean that, if you held the above $250,000 property for 30 years, paying off your mortgage in the process, your rental property would be worth just over $700,000! And, you’d own this asset free and clear.
Estate Planning Considerations
Estate Planning Overview
Estate planning requires an in-depth understanding of both the law and Internal Revenue Code. Accordingly, this article should not be viewed as a comprehensive estate planning guide.
But, conceptually, estate planning is actually quite simple. At its core, estate planning involves building a strategy for how your assets will be distributed when you die. In other words, who gets what? If you’re fortunate to have built enough wealth to leave behind (to children, grandchildren, charity, etc.), an estate planning strategy helps you pass along that wealth in accordance with your wishes – not a probate court’s decision. And, minimizing taxes plays a major role in this planning.
Capital Gains Concerns
Let’s return to the example of the $250,000 rental property now worth $700,000. Also, assume that you have two children, both of whom you want to inherit an equal share of this wealth. At face value, the easiest way to accomplish this plan would be to sell the property while still living, divide the proceeds in two, and put them into savings accounts for your children.
But, selling a property – particularly one held for so long – will trigger major capital gains taxes. In this example, you’d recognize a $450,000 capital gain at sale (ignoring transaction costs). At the 20% long-term capital gains rate, that translates to a tax bill of $90,000. Additionally, you’d likely have taken full depreciation by this point. If $200,000 of the initial purchase price served as your depreciable basis (a reasonable estimate), that would leave you with another $50,000 in depreciation recapture taxes ($200,000 in total depreciation times 25% depreciation recapture rate).
So, by selling this rental property before you die, you’d owe $140,000 in taxes. Now, rather than leaving $700,000 to your children, their inheritance would drop to $560,000.
Minimize Taxes with the Inheritance Step-up In Basis
This capital gains trap poses a potential problem for investors who want to pass on appreciated assets to their heirs. Fortunately, a tax planning solution exists: the inheritance step-up in basis.
To determine capital gains, the IRS assesses a cost basis for an asset, typically the acquisition cost. To calculate capital gains, you subtract an asset’s cost basis from the sales price (net of transaction costs). However, the Internal Revenue Code includes a provision for a step-up, or increase, of an asset’s basis when you die. This means that, when you leave an appreciated asset as inheritance, the beneficiary’s basis in that asset becomes the market value at death (or six months later if more advantageous).
Continuing the above example, let’s say that, rather than sell your rental property and divide the cash for your children, you hold the property. In your will, you designate your two children as the two beneficiaries, so they will each receive 50% ownership in the property. But, when they inherit the property, they will also receive a step-up in basis to the current market value – $700,000 in this example.
If your children then decide to immediately sell the property, they would not recognize any capital gains, effectively increasing their inheritances by $70,000 each! Alternatively, if they choose to continue renting the property, whenever they do sell, they will have a cost basis of $700,000 – not $250,000.
Once again, we didn’t intend to provide a comprehensive estate planning guide with this article. Rather, we wanted to illustrate the role real estate and the inheritance step-up in basis can plan in maximizing what you leave to your loved ones. While selling appreciated real estate may seem to simplify your estate planning, it can also come with a huge tax bill. Taking advantage of the inheritance step-up in basis strategy may offer a far more effective strategy.
If you’d like to discuss different real estate investing options for your unique situation, we’d love to chat! Drop us a note, and we’ll set up a meeting to talk about available passive real estate investment opportunities – and the associated tax implications.