Using a 1031 Exchange for Reducing Estate Taxes: Getting More Mileage from the Code

One little-known way that could end up saving your heirs a bundle in taxes is by combining the benefits of a 1031 exchange with a revocable living trust. A 1031 exchange is a reference to Section 1031 of the Internal Revenue Code that permits property owners to defer taxes on the sale of residential, business or investment properties, so long as the proceeds are used to buy a “like-kind” property – one that will serve the same purpose as the sold property. To qualify for tax deferral you must select the like-kind, or replacement, property within 45 days of the sale and take title to the new property within 180 days.

In recent years, droves of individuals, investors and developers seeking alternatives to the stock market or a more broadly diversified portfolio have taken advantage of Section 1031 to upgrade, defer paying capital gains taxes, consolidate a real estate portfolio, as leverage for making additional investments in real estate, or as a way to unload the tasks associated with property management.

Besides these valuable uses, a 1031 exchange has become a popular estate planning tool for reducing taxes and dodging problems often associated with probate. In this scenario, a homeowner or investor sets up a revocable living trust and names himself trustee; the trust assumes ownership of all the trustee’s assets. Although the trust is a separate legal entity, it does not have a distinct tax ID nor does it file a tax return. The trustee maintains control of, and has unlimited access to, all assets during his lifetime – (s)he can buy or sell property or other holdings just as before.

Let’s say that a trustee sold property held in the revocable living trust and bought a replacement property via a 1031 exchange. Upon the death of the trustee, the tax basis in the replacement property is stepped up so that any built-in gain on the replacement property is erased. Heirs of estates that are exempt from the federal estate tax take title to the property without having to pay taxes on the built-in gain that the original owner would have incurred.

Trustees of estates that are subject to the federal estate tax (currently estates valued above $600,000) need to take a closer look at the tax implications of holding a replacement property until death. Since such estates can currently be taxed at rates of up to 55% and the current top capital gains rate is only 20%, individuals with larger estates should compare the amount of income tax savings from a 1031 exchange to the potential estate tax liability if the replacement property is held in the trust at the death of the trustee. If the numbers don’t make sense, the trustee likely would be better served by giving a gift of the original or replacement property to heirs during his or her lifetime.

However, replacement property that is gifted may not meet the “qualified use” requirement of Section 1031. In addition, very few lenders will make loans to trusts or trustees. So before you decide to use this strategy for estate planning purposes, be sure to consult a tax advisor who is versed in both matters.

By: Andrew Gitt, Principal of Westwood Net Lease Advisors

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