Wealth Transfer Strategy for Real Estate Investors

As a real estate investor, you’ve likely spent years building a valuable portfolio. However, with significant changes to estate tax laws on the horizon, it’s crucial to start planning now to protect your legacy and minimize tax burdens for your heirs.

In this article we’ve provided a series of components of an effective wealth transfer strategy for real estate investors, focusing on both income tax considerations and estate tax challenges.

Understanding the Changing Tax Landscape

The current estate tax exemption stands at $13.61 million per person. This amount doubles for married couples, giving a married couple an exemption of $27.22 million. However, this exemption will sunset at the end of 2025 and is expected to drop to about $7 million per person.

This change will significantly affect many wealthy individuals and real estate investors, particularly those with estates valued above the new threshold. They may face substantial estate taxes with rates reaching up to 40% for taxable portions above the exemption amount.

Like-Kind Exchanges & The Step-Up in Basis: The Keys to Tax Efficient Wealth Transfer for Real Estate Investors

When planning for wealth transfer, real estate investors must navigate both income tax and estate tax implications. The goal is to minimize the tax burden for your heirs while maximizing the value of the assets they receive.

The playbook for effectively transferring wealth as a real estate investor is based on two key pillars: completing like-kind exchanges throughout your life to defer capital gains taxes, and the step-up in basis that your assets receive upon your death, which effectively eliminates these capital gains and resets the basis on which they are calculated to the value of your assets upon your passing.

Let’s take a closer look at how these strategies work.

Like-Kind Exchanges (1031 Exchanges)

Like-kind exchanges, also known as 1031 exchanges, are a valuable strategy that effectively allow real estate investors to defer capital gains taxes on the profits made through selling their real estate throughout their lifetime.

Here’s how it works:

1. When you sell an investment property, you can defer capital gains taxes by reinvesting the proceeds into another similar property within specific timeframes.
2. This process can be repeated multiple times throughout your lifetime, allowing you to continually upgrade your real estate portfolio while deferring taxes.
3. If you continue this strategy until death, your heirs will receive the properties with a stepped-up basis, potentially eliminating taxes on all the deferred gains.

Know that 1031 exchanges have strict rules and timelines. First, this strategy must be used for business or investment properties, not personal residences. Also, you must identify potential replacement properties within 45 days of selling your original property and complete the purchase within 180 days.

Working with experienced professionals is essential to navigate these requirements successfully.

Step-Up in Basis at Death

The step-up in basis is a powerful tool that can significantly reduce the capital gains tax liability for your heirs. This provision applies not only to real estate but also to other capital assets such as stocks, bonds and mutual funds.

Here’s how it works. When you pass away, the cost basis of your assets is “stepped up” to their fair market value at the date of your death. This effectively eliminates any capital gains tax on the appreciation that occurred during your lifetime.

For example, imagine you purchased an investment property for $500,000, and over the years, its value appreciates to $2 million. If you were to sell the property during your lifetime, you would owe capital gains tax on the $1.5 million gain. However, if you hold the property until death, your heirs inherit it with a stepped-up basis of $2 million. If they decide to sell the property for that same amount shortly after inheriting it, they would owe no capital gains tax.

This strategy is particularly beneficial for long-term investors with appreciated assets, as it allows them to pass on significant wealth to their heirs without also leaving them with substantial immediate tax liabilities. However, if heirs hold onto the inherited property and it continues to appreciate, they would owe capital gains tax on any appreciation that occurs after they inherit it.

While this provision offers significant tax advantages as a wealth transfer strategy, it has been a subject of debate and potential reform proposals in recent years. Therefore, it’s crucial to work with a tax expert and stay informed about any new legislation that may affect this strategy.

Strategies for Minimizing Estate Taxes

While the strategies described above can be extremely impactful, they don’t address the potential estate tax challenges that many investors will face, especially with the upcoming reduction in exemptions. If your estate is valued around or above these thresholds, there are several strategies to consider:

Annual Gifting

Annual gifting is a straightforward yet effective strategy for reducing your taxable estate over time. As of 2024, you can gift up to $18,000 per person, per year, without incurring gift taxes or using your lifetime exemption. For married couples, this doubles to $36,000 per recipient.

To illustrate the power of this wealth transfer strategy, consider this scenario: You and your spouse have three children, each with two children of their own. That’s a total of nine recipients (three children, six grandchildren). By gifting the maximum amount to each recipient annually, you could transfer $324,000 out of your estate each year without using any of your lifetime exemption.

Over a decade, this strategy could move over $3 million out of your taxable estate. If these gifts include appreciating assets like real estate interests, the long-term impact could be even more significant.

Family Limited Partnerships (FLPs)

Family limited partnerships can be a powerful wealth transfer strategy for real estate investors with substantial holdings. By creating an FLP, you can transfer ownership interests in your properties to family members while maintaining control over the partnership. This strategy allows for valuation discounts on limited partner interests, enabling you to transfer more value within the annual gift tax limits.

For example, if you have a $10 million property in an FLP, you might be able to gift a 2% limited partner interest valued at only $170,000 (applying a 15% discount) instead of $200,000.

This approach allows you to gradually transfer significant wealth over time while maintaining control of the assets and staying within annual gift tax exclusion limits. By consistently gifting limited partnership interests year after year, you can substantially reduce your taxable estate while preserving your real estate portfolio’s integrity and management structure.

Irrevocable Trusts

Irrevocable trusts are sophisticated vehicles for moving assets out of your taxable estate while potentially maintaining some level of control or income. Here are three common types of irrevocable trusts used by real estate investors:

• Spousal Lifetime Access Trust (SLAT): This trust allows you to gift assets to your spouse while removing them from your taxable estate. You can indirectly benefit from the trust assets through your spouse during your lifetime.
• Grantor Retained Annuity Trust (GRAT): A GRAT lets you transfer appreciation on assets to beneficiaries while retaining the right to receive annuity payments for a set term. This can be particularly effective for rapidly appreciating real estate.
• Intentionally Defective Grantor Trust (IDGT): An IDGT allows you to sell assets to the trust in exchange for a promissory note, potentially freezing the value of the asset for estate tax purposes while allowing you to pay the income taxes on the trust’s income, further reducing your taxable estate.

Each of these trusts has specific rules and considerations, and their effectiveness can vary based on factors like interest rates and the performance of the real estate assets involved. Working with experienced estate planning attorneys and tax professionals is essential to determine which trust structure might be most beneficial for your specific situation and goals.

Life Insurance Strategies

Life insurance can play a crucial role in estate planning, especially for real estate investors who may have significant wealth tied up in illiquid assets. A well-structured life insurance policy can provide the liquidity your heirs will need to pay estate taxes, preventing them from being forced to sell valuable properties at inopportune times.

Consider this scenario: You own several valuable assets, and your total estate is worth $30 million. Upon your death in 2026, assuming there is a $7 million exemption and you are not married, your estate could owe about $9.2 million in federal estate taxes ($23m * 40% = $9.2m). Without proper planning, your heirs might need to quickly sell properties, potentially at a discount, to pay this tax bill.

To address this, you could establish an irrevocable life insurance trust (ILIT) to own a life insurance policy on your life. The ILIT keeps the insurance proceeds out of your taxable estate while providing your heirs with tax-free funds to pay estate taxes and other expenses.

Liquidity is a critical consideration in estate planning, particularly for real estate investors. Without adequate liquidity, heirs may be forced to sell assets to cover estate tax liabilities. Life insurance can provide a solution by ensuring that cash is available to meet these obligations without requiring the sale of valuable properties.

Want to dive deeper? The two-part video series below explores how to use life insurance to build wealth in real estate.

Using Life Insurance to Build Wealth in Real Estate (Part 1)

Using Life Insurance to Build Wealth in Real Estate (Part 2)

Create a Proactive Wealth Transfer Strategy for Your Real Estate Investments

The upcoming changes to estate tax laws present both challenges and opportunities for real estate investors. By understanding these changes and implementing proactive strategies, you can significantly reduce potential estate tax burdens while preserving wealth for future generations.

The key is to start early. Many of these wealth transfer strategies become more effective the sooner they’re implemented, since you can move assets outside of your estate at a lower valuation.

Don’t wait until it’s too late — begin your planning now to ensure your hard-earned wealth is passed on to your heirs in the most tax-efficient manner possible. James Moore’s expert team of real estate wealth advisors can help you lay out that plan so that your beneficiaries can reap the rewards of your investments without unnecessary tax burdens. Contact us today to start planning.