This case study gives the example of how a mom and dad can use property investment to build wealth, and in the future, pass this wealth on to their children. It explains the use of section 1031 exchanges, cost segregation, and basis step-ups to increase profitability and minimize tax liability. With the right tax planning, real estate can be an excellent way to transfer wealth to future generations.
Let’s take a look and see how these strategies can be used to build and transfer wealth.
In this example, Mom and Dad buy a property with a basis of $1 million and perform a cost segregation study to accelerate the depreciation deductions.
After taking depreciation deductions for 5 years, they decide to sell the property and perform a 1031 exchange to purchase a new property worth $2 million. They perform another cost segregation study on the new property, which allows them to accelerate even more depreciation deductions.
At the end of Year 10, Mom and Dad decide to perform another 1031 exchange and purchase a property worth $10 million. This property is now generating significant cash flow, thanks to the accelerated depreciation deductions they were able to take from the cost segregation studies performed on their previous properties.
However, Dad unexpectedly passes away in year 15 while the property is worth $15 million. At this time the property’s basis is stepped up to its fair market value of $15 million, which means that Mom can now depreciate the property using the new stepped-up basis.
Mom performs another cost segregation study on the property to identify any components that can be depreciated over a shorter timeframe.
By Year 20, the property is now worth $20 million when Mom passes away. However, because the property’s basis was stepped up to $15 million when Dad passed away and Mom performed another cost segregation study (to create accelerated depreciation), the children inherit the property with a basis of $20 million.
This means that when they sell the property for $20 million, there is no tax due as the sale price is equal to the inherited basis.
So, how did this family achieve such a massive wealth transfer, and how can you do the same? The key is in the use of cost segregation, section 1031 exchanges, and basis step ups.
Cost Segregation
Cost segregation is a tax planning strategy that involves the reclassification of property for depreciation purposes. The goal of the cost segregation is to identify assets within a property that can be depreciated over a shorter period than the building itself, allowing investors to take larger depreciation deductions over a shorter timeframe.
By accelerating depreciation deductions, mom and dad can reduce their tax liabilities, resulting in more funds available for investment or inheritance.
In the example above, Mom and Dad performed two cost segregation studies on their properties, which allowed them to accelerate their depreciation deductions and generate significant cash flow. When Dad passed away, Mom performed another cost segregation study, which enabled her to identify any remaining personal property components and depreciate them on shorter lives. This further reduced their tax liability and increased their cash flow.
Section 1031 Exchanges
The 1031 like-kind exchange allows investors to defer taxes on the sale of a property. In other words, an investor can sell a property, use the proceeds to purchase another property, and defer the taxes owed on the sale of the original property.
In the example above, Mom and Dad performed two 1031 exchanges to purchase new properties. By doing so, they were able to defer paying taxes on any gains from the sale of their previous properties and reinvest the proceeds into new properties that generated even more cash flow.
Basis Step Ups
A property basis step-up occurs when the basis of a property is increased to its current fair market value. Basis refers to the original cost of a property plus any improvements made to it over time. The basis is used to calculate the capital gains taxes owed when a property is sold.
In this example, when mom passed away, the basis of the property is “stepped up” to its current fair market value. When the children sold the property for its fair market value at the time of inheritance, there is no capital gains tax owing.
The Winning Combination for Wealth Transfer
One of the biggest advantages of using cost segregation, 1031 exchanges, and basis step ups is the ability to transfer wealth from one generation to another without incurring significant tax liabilities. In the example provided, the children inherited the property with a basis of 20 million and were able to sell it without any tax due. This can be a game changer for families looking to transfer wealth to their children without diminishing its value through taxes.
It’s important to note that the use of these strategies requires careful planning and execution, and it’s best to work with experienced professionals to ensure that everything is done correctly. It’s also important to remember that tax laws can change, so it’s essential to stay up to date on the latest regulations and how they could impact your situation.
In conclusion, the use of cost segregation, 1031 exchanges, and basis step ups can lead to significant wealth transfer for generations. By carefully managing your property investments and utilizing these strategies, you can minimize tax liabilities and pass down valuable assets to your children.
