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Sec. 1031 & Stepped Up Basis

Tax is full of opportunities for people who have creativity. If you can master different pieces of tax knowledge, there’s possibilities for combining these pieces together to build effective tax reduction.  Or even tax elimination. But, in addition to having mental command over the material, you also need the ability to think outside the box.  That is, to think creatively and see links between things which may initially seem disconnected. To build a complex tax strategy, you have to be able to see how each piece of knowledge contributes to the overall strategy.  How each piece fits in the puzzle. One strategy which can be highly useful for real estate investors is a stepped up basis strategy.  That’s particularly true for properties used in a Section 1031 exchange transaction.  

Ordinarily, we think of 1031 exchanges as means to defer the capital gains taxes which would otherwise be due in a traditional sale, but the stepped up basis strategy can be a means to eliminate these gains altogether. In this article, we will look at the mechanics of this strategy and emphasize the role that this strategy can play in preserving your wealth across generations. If you’re serious about preserving your wealth on a long-term basis, then this strategy may be extremely useful. 

Sec. 1031 Mechanics: Quick Review 

As we’ve discussed before, a 1031 exchange is a sale of business or investment property followed by the purchase of more business or investment property for the purpose of deferring capital gain taxes. In a standard exchange, the relinquished property is sold.  Then the taxpayer has 180 days to purchase a suitable replacement property. The transaction must follow all applicable rules and regulations as outlined by the code. Unless the exchange is a direct swap, the taxpayer has to engage a facilitator (third party or qualified intermediary) in order to structure an exchange transaction. 

Section 1031 exchanges can result in the deferral of many thousands, and sometimes millions, of dollars owed in taxes. For this reason, they are popular with investors to help diversify, preserve and maximize wealth. 

Mechanics of the Stepped Up Basis Strategy 

Cost basis is a foundational concept in tax. Your cost basis is essentially your level of investment in a given asset.  Basis helps determine your gain when you later sell the asset. This makes intuitive sense: when you sell something, it doesn’t make sense to base your tax liability on the sales price or total funds received, it makes sense to calculate your liability solely from what was actually gained from the sale. Ordinarily, your basis in an asset is its initial cost.  Nonetheless, your basis can also fluctuate after a purchase.  When you sell an asset, you determine gain with reference to your basis. 

Acquisition Methodology Matters

How you acquire an asset can influence your basis. If you receive an asset as a gift, then your basis is the same as the basis of the original owner. If you receive an asset through inheritance, then the basis will be equal to the fair market value of the asset at the time of receipt. When a person inherits an asset the asset suddenly acquires a basis equal to its fair market value.  This new basis is referred to as a “stepped up basis” in those cases where basis increases over its previous basis.

Suppose a piece of real estate with a basis of $100,000 and a fair market value of $1 million is bequeathed to a relative through a will; when the new owner receives the property, the property will have a new, stepped up basis of $1 million. In such a scenario, the new owner could sell the property for $1 million and be liable for zero dollars in tax! 

This is how the stepped up basis strategy works: when investors conduct 1031 exchanges, they are rolling their tax liability forward to acquire more business or investment property and generate greater returns; but investors will eventually face a liability when they sell the property outright, and so investors who conduct 1031 exchanges can preserve their wealth and suspend their liability indefinitely if they choose to transfer their property through inheritance. This strategy will allow investors to potentially eliminate their gains altogether, even if those gains have been accumulating over a large period of time.  

It’s Time For An Example

For instance, suppose an investor purchases investment property for $200,000.  That same investor later exchanges this property when it has a value of $500,000. Let’s also suppose that this investor then exchanges this other property, received in the first exchange, when it has a value of $1 million. Let’s then further suppose that the investor conducts yet another exchange.  He does so when the newly received property has a value of $2 million. In this scenario, this investor might very well have gains which would translate into a liability of many thousands of dollars in a sale.  But, if the investor transfers the property to someone upon death, the beneficiary receives the property with an increased basis.  The basis in the hands of the beneficiary, in fact, rises to equal its fair market value.  This could potentially eliminate the accumulated gains! 

Future Blog Posts Regarding Business Entities

Conceptually, this strategy is fairly easy to grasp.  Clearly, it can be highly useful for investors.  Particularly for those with very large gains resulting from owning property for a long time. This exposition is actually a bit oversimplified, as well, because things can get more complicated when dealing with business entities.  For the sake of simplicity, we have limited the discussion here to individual taxpayers.  In future posts, we’ll come back to this topic to discuss how business entities can change things. Stepped up basis can be a marvelous way to preserve wealth and avoid paying large sums of taxes.

Call A NYC Tax Attorney For Assistance

The attorneys at Mackay, Caswell & Callahan, P.C. work hard on a daily basis to master these types of strategies.  We’re here to assist our clients resolve whatever tax issue they may have. If you’d like to schedule a consultation with a top tax attorney in NYC, don’t hesitate to reach out to us today. 

Image credit: Mark Moz