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09/08/09: Tax Planning For Inherited Properties

Housing Counsel

By: Benny L. Kass

Q: My mother recently passed and her wish was that her estate be divided equally among her 4 children. My three siblings and I inherited three properties from my mother. Two of those were rental properties of which one has been sold. We will soon be closing on the second. I just recently became aware of the 1031 tax exchange. Is this something we should consider?

A: Once you have sold a piece of property, and have received the sales proceeds, it is too late to do a 1031 exchange (also called a Starker exchange). But in your situation, I doubt that it makes sense to consider the exchange for the remaining property.

Real estate investors generally do a 1031 like-kind exchange (commonly called a “Starker Exchange”) in order to defer the large capital gain they may make when they sell their properties. The Starker is often mistakenly called a “tax free exchange”, which it is not. If you engage in such an exchange, you only defer – not avoid – any capital gains tax which ordinarily is required from a sale of investment properties.

Here’s an example: you bought a property many years ago for $100,000 and have always rented it out. Now it can be sold for $600,000. Forgetting for this example improvements, commissions and other expenses that must be calculated in determining how much tax you will have to pay, you have made a profit of $500,000. Currently, the capital gains tax is 15 percent of your profit, and you would owe the IRS $75,000. Depending of the tax laws in your state, you may also have to pay a State capital gains tax.

However, if you arrange a Starker exchange, your tax basis of the current property (called the “relinquished property”) becomes the basis of the new property (the “replacement property”).

What is this concept called “tax basis”? It is the way you determine the profit (or loss) you have made on your property. Oversimplified, you take the initial cost of the property, add the cost of any improvements you have made, plus any closing costs that you have not already deducted, and get what is known as the “adjusted basis”. Then you take the sales price, deduct such items as real estate commissions and seller concessions, to determine the “adjusted selling price”. Depreciation must be factored into this calculation, but that’s a topic for a future column.

Finally, you deduct the adjusted basis from the adjusted selling price to determine your profit (or loss).

So, if the replacement property will cost you $700,000, your tax basis for that property will be only $100,000. When you ultimately sell (and not exchange) that property, the IRS will be knocking at your door to pay the tax.

Now, let’s look at your situation. You all inherited the properties when your mother died. You are entitled to claim what is known as the “stepped up” tax basis. This means that the value of the property on the date of death becomes the basis for those who inherit the property.

So if each property was worth $500,000 when your mother died – regardless of what she paid for it — that value will be the basis for the four of you. If you were to sell each property for $500,000, you will not have made any profit and thus will not have to pay any capital gains tax. On the other hand, should you be able to sell for say $600,000, then you will only have to pay tax on the additional $100,000 – or $15,000.

If you will not make any real profit – and will have to pay little or no capital gains tax – I see no value in doing a Starker exchange. Of course, if you decide to hold on to the properties for some time, and they increase in value, then you may want to consider the 1031 exchange. And that too will be a topic for a future column.

The IRS is relentless in reviewing tax returns. Before you enter into any contract to sell real estate, explore your plans with your financial and legal advisors.

– Boilerplate –