One Way to Avoid New Death Taxes on Real Estate in 2010

Using Section 1031:  

Tax – Deferred Exchanges For Real Estate

 

In our recent blogs and articles we have shown how for many families, the new death tax in 2010 will cause families to pay more taxes when someone dies in 2010 that they would have paid in 2009. This is because in 2010, there is no step up in basis for property received from a decedent, except for the $1.3 million and marital exemptions.

Home Occupancy Exemption

In the past, a person could exclude up to $250,000 from the profit on the sale of their principal residence if they lived there two of the last five years from the date of sale. What is new in 2010 is that the heirs of the decedent can use this $250,000 exemption even though they did not live there.

Example: Dr. Sam’s $250,000 exemption. Dr. Sam bought his house in 1981 and paid $100,000. Over the years, Dr. Sam made $100,000 of improvements. If Dr. Sam had sold his house for $950,000, his taxable gain would have been calculated this way: Determine what Dr. Sam paid for the house ($100,000) plus his documented improvements ($100,000), giving him a basis of $200,000. You deduct from his $950,000 sales price his $50,000 of sales expenses (real estate commission, settlement expenses and seller concessions) to determine net sales proceeds of $900,000, giving him a taxable profit of $700,000. You multiply the $700,000 profit times his estimated combined federal capital gain and state taxes of 20% times $700,000, for a total tax of $140,000 ($700,000 times.20 equals $140,000).

However, since Dr. Sam lived there two of the last five years, Dr. Sam gets a $250,000 exemption from this tax on the sale of his principal residence so that his taxable gain is $450,000 for a combined estimated tax of $90,000, giving him a tax savings of $50,000.

Example: Sally Inherits the $250,000. If Dr. Sam had died in 2009, his house would have received a “step-up” in basis to $950,000, the value at the date of his death in 2009 and his daughter Sally could have sold his residence for $950,000 and paid no federal or state capital gain (assuming state law is the same as federal law). But, with step up in basis gone in 2010, Sally receives the property at its basis of $200,000 and would have to pay the full $140,000 of taxes if she sold it, unless she uses part of the $1,300,000 exemption.

However, there is a special exemption in the new 2010 law that allows Sally to use Sam’s $250,000 exemption even though Sally never lived in the property. If Sally does live there for a while, Sally’s time of residence gets tacked on to Dr. Sam’s time of residence.

Section 1031 – Tax Deferred Exchange Beats Death Tax

In addition, real estate has another tax break that is not available for stocks and bonds and has only a narrow application for gold. Under Section 1031 of the US tax code, owners of real estate can complete a qualified tax deferred exchange (trade) of their old rental or business real estate for a new (to them) piece or pieces of rental or business real estate and defer indefinitely any gains.

The reason 1031 provides for a deferral of gain is that when doing a 100% exchange, the seller of the property never has the right to receive any cash and therefore has not taken any money out of the investment and has only continued her investment in real estate. However, when the investor cashes out, then the investor has to pay the deferred gain from all of the predecessor properties which were exchanges.

Example: Dr. Sam’s Rental Property. Dr. Sam had bought a modest home in 1972 on Main Street for $40,000. When he bought his new residence, he didn’t sell his Main Street home, but kept it over the years as a rental property. Dr. Sam deducted his depreciation on the Main Street rental property so that his basis was reduced to $10,000 when he died in 2010. With the Main Street property now being worth $500,000, Sally could pay nearly $100,000 in taxes if she sold Main Street after inheriting it from Dr. Sam with a basis of $10,000 ($490,000 times.20 equals $98,000 of taxes).

Since Main Street is rental property, there is no $250,000 exemption for it, but it is eligible for a 1031 exchange. Sally believes that she could make more money by exchanging Main Street for other real estate. She completes a qualified tax deferred exchange of Main Street and defers all of the gain on Main Street, thereby having almost $100,000 more available to provide her income from the new properties. Under 1031, Sally can continue to do this for the rest of her life and pass these properties on to her children. She could eventually exchange into a very nice house which she later uses (after a period of rental use) as her home. She could exchange into properties where she has virtually no management headaches and a solid income guaranteed by a large national corporation.

Post Mortem Planning

As you can see, there are lots of ways heirs can reduce the impact of the new Death Tax. Since federal capital gain rates are very likely going up, you have to investigate whether a tax deferred exchange makes sense. If you are an heir of property in 2010, make certain that you consult well informed tax, legal, accounting and financial planning professionals to avoid costly mistakes.

Need Advice or Help at No Cost? 

If you would like to discuss any these details (or other estate planning matters) at no cost, contact our Preferred Provider for Funeral Estate Planning suppport.  Roger McClure, at (571) 633-0330 or visit  http://www.wealthcounsellors.com.  Roger can help you go over whether your plan is up to date, uses all of the new exemptions and how you can take advantage of current rules.  Here is some information about Roger:

Roger McClure is a practicing attorney with over thirty years experience. He maintains a business, estate and charitable planning law practice based in Virginia.  His undergraduate degree is in international Studies and he holds a Masters Degree in Political Science from Northwestern University and a Juris Doctorate with honors from the Ohio State University Law School.

McClure has conducted civil and criminal trials in local courts, represented creditors in bankruptcy proceedings, and litigated antitrust and trade regulation cases involving the largest corporations in America in federal regulatory proceedings. He served ten years in the Virginia legislature (House of Delegates), has been a radio talk show host, received a bronze star for service in Vietnam, and has written and published several books and numerous articles.

He is a sought after speaker nationally. Through the National Network of Estate Planning Attorneys and the Wealth Institute of Washington, McClure works with professionals in every state to assist their clients in solving problems and enhancing planning.

Christopher P. Hill, Founder of Funeral Resources