Options for Inherited Property Including a 1031 Exchange

What happens when someone dies, and their heirs inherit the investment real estate? Should their heirs sell the real estate as part of a 1031 Exchange or can there be other tax implications?  

Potential for Step-Up in Basis 

Here’s an example. Suppose Grandpa has investment real estate that he purchased for $200,000, with an adjusted basis of $100,000, and a current fair market value of $500,000. Prior to his death, Grandpa would be able to sell this property as part of a 1031 Exchange and defer the Capital Gains taxes on his investment. If he were to completely sell it without using a 1031 Exchange, he would incur a Depreciation Recapture Tax of 25% on the $100,000 of depreciation that he has taken, and a Capital Gains tax hit of 20% on the $300,000 of gain, costing him $85,000 in federal taxes. Depending on which state Grandpa lives in, there could also be State Taxes to consider. However, if Grandpa were to die today, with the $500,000 fair market value, his heirs would inherit the property with a “step-up in basis.” 

The step-up in basis is a provision in the current federal tax law that allows heirs to inherit the property at the fair market value as of the date of death of their relative. In this example, the current basis of $100,000 is adjusted, or “stepped-up,” from the previous basis to the $500,000 fair market valuation at the time of Grandpa’s death. Thus, Grandpa and his heirs have deferred capital gains and depreciation recapture taxes indefinitely. 

If Grandpa has a will, the property will pass to his heirs according to his plans as articulated in the will. If Grandpa does not have a will, or if his will is determined to be invalid, his estate will have to go through the process of probate. A court will appoint an administrator of Grandpa’s estate. The administrator will locate Grandpa’s heirs, inventory his estate, and then distribute the various assets according to state law.

Effects of Inherited Property on Heirs 

When heirs inherit property, there is more to take into consideration than just the fact that they received property at no initial cost. This is where Estate and Inheritance taxes become important.  

Estate and Inheritance Tax 

At the federal level, there is an Estate Tax on assets over $13.61 million. Thus, in this example, if Grandpa’s total estate is valued at or below that threshold, there is no federal Estate Tax owed. Twelve states, plus the District of Columbia impose Estate Taxes, and another six states impose Inheritance Taxes. The difference is that Estate Taxes are paid by the estate, on the value of the estate, whereas the heirs pay Inheritance Taxes, on the value of what they receive. State level Estate Taxes would be imposed on Grandpa’s estate above certain thresholds. For example, Oregon begins to impose its Estate Tax at $1 million, and Connecticut starts at $12.92 million. As for the states with Inheritance Taxes, all of them exempt spouses from having to pay Inheritance Taxes, and some fully or partially exempt children or parents. However, in Pennsylvania, for example, Grandpa’s children or grandchildren would be required to pay 4.5% Inheritance Tax on the value of what they receive. 

Example of Potential Financial Obligations with Inherited Property 

If Grandpa has a will and leaves his investment real estate to his Pennsylvania grandchild, that grandchild would be inheriting $500,000 of investment real estate, and their Pennsylvania Inheritance Tax burden would be $22,500. The grandchild could then sell the real estate and use the cash proceeds to pay this Inheritance Tax obligation. If the grandchild were to sell the property to pay the Inheritance Tax obligations, there likely is no current capital gains implication since the sale will occur shortly after the inheritance at the stepped-up basis. 

But the grandchild could also pay that tax obligation with personal funds, and then maintain the property as an ongoing investment for years to come. If they choose this option, and later sell the property for $750,000, their capital gain is $250,000 ($750,000 - $500,000 = $250,000). The practical effect is that the capital gain between Grandpa’s adjusted basis and the grandchild’s inheritance of that property was eliminated by the step-up in basis. Without it, the grandchild would have had a significantly higher taxable gain after the sale ($750,000 - $100,000 = $650,000). 

Inherited Property: Keep or Sell?  

Heirs of inherited property must determine what they wish to do with the property long-term. If they choose to hold onto it, they will incur the typical costs of ownership of real estate, including property taxes, insurance, maintenance, etc.  

One option would be to keep it as a rental property, using the income to offset expenses, and perhaps derive additional passive income. This, of course, means that they now must undertake all of the activities of a landlord, perhaps in a community that is inconvenient. If they maintain the property as a rental, they could also benefit from potential additional appreciation over the years. Historically, the national average appreciation rate is 3% to 5% for residential real estate, though this is not guaranteed. In fact, during the 2007 market correction, the average home in America saw a 13% decrease in value. 

After holding the property as a rental for a few years, the heir could sell this property as part of a properly structured 1031 Exchange, perhaps to relocate the property to a more convenient location, reinvest in a different asset class, or even consider a Delaware Statutory Trust if they do not wish to be an active landlord. 

In this example, Grandpa included his investment real estate in his overall estate planning strategy, passing an appreciated asset to a grandchild. Investors are encouraged to discuss their specific tax and estate planning needs with their financial planner, attorney, and accountant. 

1031 Asset Solutions has dedicated specialist to help with your inquiries about 1031 Exchanges and inheriting property. Give us a call today at 844-401-1031.