Using 1031 Exchanges as Part of Your Estate Plan

Very few people think of 1031 exchanges as anything other than a vehicle to defer taxes from the sale of a current property to a future property. However, Section 1031 can be a very powerful estate-planning tool that allows you to transfer a substantial part of your estate to your heirs tax-free. This article shows you just one way of doing this.

Let's say Fred and Sue are selling a small rental property for $500,000. They plan on buying a much larger rental property for $1 million and they begin transferring some of their wealth by having their adult children participate with them in the purchase. 

If you want to avoid paying tax when you do a 1031 exchange, you must buy a new property at least equal in price to that of the old property sold. The key concept here is that Fred and Sue buy only half of the new property while their kids buy the other half. So after their exchange, what they've done looks like this: 

Now Fred and Sue own half of Property B, and their kids own the other half. How did the family finance the purchase of B? Fred and Sue have to roll all the cash from the sale of Property A into B, so they may have rolled as much as $500,000 of cash over. The rest can be financed, meaning the kids can buy their half with 100% financing. Is it a problem if Fred and Sue loan their kids the money for their share of the purchase? No--as long as they charge them a reasonable rate of interest. If the kids borrow the money from a bank, can the bank take a security interest in the entire property? Yes. And if this is the case, Fred, Sue and the kids should sign a debt sharing agreement that says even though there is debt securing Fred and Sue's half of the property, the debt and the payments on it are the responsibility of the kids, and that the kids make the loan payments out of their share of the income on the property. 

It's also important to note that Fred and Sue and the kids need to own their share of the property as tenants-in-common. If you drop the property into an LLC or a Family Limited Partnership, you'll screw up the plan. 

A few years go by and they sell Property B for $1.5 million. Fred, Sue and the kids do 1031 exchanges and buy Property C for $2 million. Again, the secret of this wealth-shifting plan is that Fred and Sue exchange for an equal dollar amount of Property C, which means their exchange will look like this: 

From the diagram you can see that Fred and Sue did a 1031 exchange and rolled their $750,000, 50% share of Property B into a $750,000, 37.5% share of Property C. The kids also did a 1031 exchange and rolled their $750,000 share into a $1,250,000, 62.5% share of Property C. To summarize, Fred and Sue bought equal and the kids bought up in their exchanges. Again, you want to make sure you do a debt sharing agreement specific to Property C if they borrowed money from a lender and keep the ownerships as tenants-in-common. 

Another few years go by and the family sells Property C for $3 million and buys Property D for $4 million. Fred and Sue's share of the sale of C is $1.125 million and again in their exchange they just buy an equal dollar amount of D, which gives them a 28% share. The kids exchange up from $1.875 million to a 72% interest in D for $2.825 million and the exchange transaction looks like this: 

We have the same debt sharing and ownership issues with Property D as we had with B and C: make sure you update your debt sharing arrangement and keep the ownership as tenants-in-common. 

Now if tragedy strikes and Fred and Sue are both killed shortly after buying D, how does this affect their estate? First, because they own a minority interest in real estate, their 28% share of D receives what estate specialists often call a "haircut" meaning that the $1.125 million value is reduced to reflect impaired marketability. The smaller the percentage of the ownership interest in the property the larger the haircut. I've seen haircuts as large as 50%, which would mean that their $1.125 million interest might be valued as low as $562,500. To be less aggressive, let's assume this haircut is 25%, which would set the value of their interest in D at $843,750. 

Let's recap what happened here: had they not embarked on this wealth shifting program when they bought B, the kids would end up paying estate tax on $4 million rather than on $843,750. At the top estate tax rate of 35%, that represents a real savings of over 1.1 million dollars! 

Most frequently my clients embark on a wealth-shifting program like this when their kids go off to college, although I've had one father do it with his 10-year-old daughter. 

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