Receiving an inheritance of property can be made better with fortuitous timing. For example, you might already have plans to conduct a 1031 exchange with another property. Another possible scenario is that you might want to sell the inherited property (or your share of it) quickly to a family member for financial gain, which you might be able to do with minimal tax consequences, thanks to the provisions of the 1031 exchange.
Benefits of a 1031 Exchange for Selling Inherited Property to Family: Value Stepped Up, Mortgage Paid
If you are the sole heir of a property, it is fairly straightforward to use it in a 1031 exchange. A 1031 exchange can be beneficial when a property is increasing in value rapidly and there is a big difference between its value at the time of the original owner’s death and time of sale. It can also be advantageous when the sale of the property coincides with your plans to conduct a 1031 exchange with other property. If you’re making an exchange of a property to reset the depreciation clock, for example, you can consolidate your new property into the exchange and secure a larger replacement property.
A property is automatically “stepped up” in value at the time of inheritance. This means that any capital gains the decedent may have accrued on the property are wiped out and you receive it at its fair market value. The only capital gains tax you will face is for any increase in the property’s value since the original owner’s death. For example, if you sell the property for more than the appraised value on the day of the original owner’s death, the difference is taxable.
Additionally, there is no federal estate tax on estates valued at less than $11,180,000 (and $22,360,000 for married couples). State taxes are based on the laws of the state in which the decedent resided, however, and can vary dramatically. If there is a state capital gains tax on the sale of the inherited property, it can be rolled over into the 1031 exchange.
If the inherited property is mortgaged, the debt may either be assumed by the heirs or paid off during probate if the property is sold under a Due on Sale clause. The settlement of the debt associated with the property is a help in a 1031 exchange. It simplifies the transaction, as mortgage debt in a 1031 exchange has to be balanced between the relinquished property and the replacement property. After the debt is settled, the proceeds of the sale can be transferred directly to a qualified intermediary, and the 1031 exchange can be conducted as usual.
What to Do If You Are a Partial Owner
If you own a share of a property with a group of heirs, and not all of them want to sell, you and the heirs who do wish to sell can do so by forming a tenants in common (TIC) ownership structure. Tenants in common have all ownership rights to a property, but only own a fractional interest in it. Crucially, the owners in this structure are not partners, as partnerships cannot participate in a 1031 exchange.
To establish a TIC, 15 conditions must be met. A private letter ruling can be requested from the IRS confirming your eligibility before you proceed with the exchange. The process can be expensive (the IRS charges a fee to do a private letter ruling) and time-consuming but, while receipt of the IRS letter is not mandatory, it can provide some peace of mind for more conservative investors. Finally, state law may have bearing on the creation of your TIC. In light of the complexities and risks involved in creating a TIC, it is highly recommended you seek professional advice to structure one.
At CWS Capital Partners, we are a fully integrated multifamily real estate investment management firm that offers everything from due diligence and risk management to transaction support and property management. We specialize in assisting our clients with 1031 exchanges, acquisitions, repositioning, and development. We also own and manage luxury multifamily investment communities in major markets around the country, and employ a team of experts who can help you hone your investment strategy.
For more articles like this one, check out our 1031 exchange blog posts.
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