Tax Planning Tips For Inherited Properties
Q: My mother recently died, and her wish was that her estate be divided equally among her four children. My three siblings and I inherited three properties from her. Two were rental properties, of which one has been sold. We will soon be closing on the sale of the other rental. 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 would make sense to consider an exchange for the remaining property, anyway.
Real estate investors generally do a 1031 like-kind exchange to defer the large capital gain they may make when they sell their properties. (Exchanges are not an option for the sale of your own residence.)
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 that ordinarily is required from a sale of investment properties. The tax bill comes due when you eventually sell the property, take your profits and do not roll them over into another real estate investment.
Here's an example: Say you bought a property many years ago for $100,000 and have always rented it out. Now it can be sold for $600,000. For the sake of simplicity, we'll forget the value of improvements, sales commissions and other expenses that must be considered when calculating how much tax you would have to pay. So, for this example, you made a profit of $500,000. Currently, the capital gains tax is 15 percent of your profit, so you would owe the Internal Revenue Service $75,000. Depending on your local laws, you may also have to pay a state capital gains tax.
However, if you were to arrange a Starker exchange, your tax basis on the "relinquished property" would become the basis of the new property (the "replacement property").
What is this "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 and deduct such items as real estate commissions and seller concessions to determine the "adjusted selling price." Depreciation must be factored into this calculation, too, 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 would cost $700,000, your tax basis for that property would be only $100,000. When you ultimately sell (and not exchange) that property, the IRS would be knocking at your door, expecting you to pay the tax.
Now, let's look at your situation. You and your siblings 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 would not have made any profit and thus would not owe any capital gains tax. On the other hand, should you be able to sell for, say, $600,000, then you would have to pay tax on only the additional $100,000 -- or a tax bill of $15,000.
If you will not make any real profit from a sale -- and therefore will have to pay little or no capital gains tax -- I see no value in trying to arrange 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 advisers. The rules for Starker exchanges are particularly complex, with specific deadlines limiting how long you have to search for a replacement property, and all those rules must be strictly applied. If you decide on a Starker exchange, please discuss all of this with your financial and legal advisers before trying to sell your investment property.
Benny L. Kass is a Washington lawyer. For a free copy of the booklet "A Guide to Settlement on Your New Home," send a self-addressed stamped envelope to Benny L. Kass, 1050 17th St. NW, Suite 1100, Washington, D.C. 20036. Readers may also send questions to him at that address or contact him through his Web site, www.kmklawyers.com.