I took a call from a new client last week describing a strategy that she had employed to lessen the tax burden to her heirs. Her goal was to liquidate her investments so her heirs would not be burdened by future management responsibilities and the sale of a dozen properties. Over the course of the preceding year, she sold two of her investment properties and pocketed the proceeds. Much to her surprise, her CPA advised her that this method resulted in a big fat tax bill! In her haste to unburden her heirs, she has transferred the tax to herself.
The reality is that had she not taken the step to liquate, her investments would be passed to her heirs at a stepped-up basis or at the then current market value, thereby negating capital gains tax altogether. In the end, her estate has been diminished!
The most important aspect is to understand the goals and objectives of the investor. As this client found out, while cash is always the gold standard, touching it can lead to unintended and expensive tax consequences. If the sale of investment assets leads only to cash, the long hard work of achieving equity can be diminished by over 30%. A strategy that utilizes a Section 1031 approach can keep all of the cash intact and tax deferred. Since the majority of her investment assets are in real estate, a Section 1031 Exchange will produce optimum tax relief.
After spending some time discussing the options, the client revealed that she wanted to relocate her investments to the three communities where her heirs were residing to make future management easier. Together, we created a stepped plan to liquidate one property at a time, this will spread out the timing issues and allow for a careful selection process for the replacement properties. As soon as she has a sale agreement on the first property, we will produce an Exchange Agreement to provide the net proceeds of the real property will be redirected to us as QI for the acquisition of “like-kind” new or Replacement Property. This can be any kind of real estate and located anywhere in the United States. In addition, it can be more than one piece of property. The value is exchanged, not the quantity, quality or character of the old or Relinquished Property.
The Replacement Property options are as varied as stand alone whole interest in real estate, partial interest, Tenancy-In-Common (TIC) interest, Umbrella Partnership Real Estate Investment Trust (UP-REIT), and subsurface real estate in the form of Oil and Gas Leases. A combination of any of these options will produce a diversified portfolio of income producing property. Remember, since the net tax effect on the investment owner could easily approach 30%, this savings significantly increases buying power of any one, or combination of these strategies.
Reinvestment of the assets will produce a steady stream of income, and they can be as passive or active as the soon to-be retired investment owner desires. The benefits are encased in what the cash can acquire and not the cash itself. The selling of an investment is typically the largest transaction in the investment owner’s career, failing to recognize the available tools, specifically the advantages of Section 1031, can have devastating effects on the investment owner’s future quality of life.