We hate to be the bearer of bad news, but the cost of passing down a portfolio to your heirs can be expensive. You’ve spent your entire life working hard to build your estate. You should be able to do what you want with what you've created, right? Sadly, this is not the case.

Whether you are planning to pass on rental properties, your childhood house, or even a vacation home, you may incur significant expenses. Fortunately, there are estate tax strategies you can use to minimize the direct blow of taxation—even if you're leaving your portfolio to a beloved charity. Be sure to consider the hidden costs of inheriting real estate and leave a legacy your heirs can actually use.

Just a brief note before we begin: This article is not a substitute for your skilled attorney. Planning your estate should be done with the aid of a professional—not an online article. However, this can give you an idea of what to watch out for before you get in touch with your legal counsel.

The Importance of Estate Taxes

  • Federal estate taxes can be significant.
  • They apply to everything in the estate that has value.
  • This includes cash, investment portfolios, and even real estate.
  • Federal estate taxes do not kick in until the estate exceeds a certain threshold.
  • These numbers are published on the IRS website.

In short, every dollar over the limit of the estate tax threshold is going to be taxed at 50 percent. If the estate does not have enough liquid cash available, then the property will have to be liquidated to pay the estate tax. Overlooking the estate tax can lead to stiff financial consequences.

  • One of the most popular estate tax strategies involves the use of trusts.
  • Trusts will allow you to take advantage of various state and federal estate tax exclusions.
  • When one spouse dies, the assets flow into a credit shelter trust.

Even though this trust is under the control of the surviving spouse, that spouse never takes control of the assets. Therefore, the trust's assets are not included in the surviving spouse’s taxable estate. It is crucial to take advantage of every dollar of a spouse’s unused estate tax exclusion amount to maximize estate tax strategies. This can be an excellent method of estate planning for real estate investors.

Senior Adult Couple Going Over Papers in Their Home with Agent

Another alternative is to convert your properties into operating units in an UPREIT structure. Operating unit conversion doesn't trigger a taxable event until the units are converted into shares that behave much like other stock. This kind of translation from one property type to another also keeps passive income flowing in when you're transferring an investment property. This makes it an attractive and easy way to provide for your heirs in the future.

Considering Property Taxes

  • Property taxes are going to vary from place to place.
  • The location of the property can make a tremendous difference in what someone owes.
  • Even going a hundred miles in a single direction can lead to BIG differences in property taxes!

Many people forget about property taxes because they are typically included in the monthly mortgage payment. When you pass on a property that doesn’t have a mortgage, your heirs might forget that they still have to pay property taxes! It is important for you to set aside a certain amount of money every month to make sure their property taxes are covered.

Similar to dealing with the estate tax, you can rely on an UPREIT to handle this dilemma for your heirs as well! Once properties are converted into operating units, they are transferred to the UPREIT, removing the management element entirely.

Planning for Capital Gains Taxes

  • When a property is inherited, it is important for it to be valued in a step-up manner.
  • This means the new valuation will take into account any improvements, repairs, and renovations performed.
  • The step-up basis will help you minimize any potential capital gains taxes.
  • On the other hand, if you decide to rent out the property, the value of your property might start to go up.
  • If this property is later sold, it may end up owing a significant amount in capital gains taxes.

There are tax strategies you can use to minimize the amount of money your heirs may owe in capital gains taxes on property that you pass on. You may have heard about a 1031 like-kind exchange; however, this merely trades one property for another. It doesn't provide an exit for your heirs to avoid taxation in bulk!

Businessman working on the calculator

This is where an UPREIT comes in to play again: the conversion of a property to operating units triggers no capital gains taxation, either!

  • Capital gains taxes on your property can be deferred for as long as you keep the units.
  • Once you convert operating partnership units into UPREIT shares (and from there, to cash), you will have to pay capital gains taxes.
  • If the original investor passes away, his or her heirs can inherit these units on a stepped-up basis.
  • This will eliminate any potential taxable gain when it comes to leaving a legacy that makes you proud.

For these reasons (and the others we covered above), UPREIT transactions can be a tremendous addition to your estate tax strategies.

At The Peak Group, when it comes to the hard work you've put into building your future, we don't think it should be dismantled by government taxation. The blood, sweat, and tears you put into your properties to leave a legacy of generosity is a cornerstone of the American Dream! Let us help you preserve that dream—and pass it along to those you cherish most. 

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Posted by The Peak Group on April 2, 2020