Owning real estate as an investment presents both benefits and unique challenges. For the fortunate investor who owns real estate that has appreciated significantly in value, minimizing the impact of income and estate taxes is a common concern. The exit strategy for a highly appreciated investment real estate property requires careful planning.
The income tax impact of selling appreciated real estate
Generally, when an investment is held for longer than a year and sold, the gain will be subject to federal capital gain tax at rates up to 20 percent, depending on the taxpayer's income level. The gain may also be subject to an additional 3.8 percent net investment income tax1. One benefit of investing in real estate is the ability to depreciate your property over time. Depreciation is an accounting calculation that allows one to deduct the cost of the asset over its useful life.2 Annual depreciation is a deduction that can offset rental income and is important when calculating the potential income tax due on the sale of a property; previously allowed depreciation reduces the tax basis3 and is later “recaptured” and taxed at a maximum federal rate of 25 percent4 when the property is sold.
Real estate investor Jane purchased an apartment building 28 years ago for $500,000 and has made no major improvements. She plans to sell to a buyer who will purchase the property for $4 million. Her federal tax owed would be approximately $977,000.
- Net sale price of $4,000,000 minus original basis of $500,000 = $3,500,000 taxed at 20 percent and 3.8 percent ($833,000)
- Full depreciation = $500,000 taxed at 25 percent and 3.8 percent ($144,000)
The simplified example above only illustrates the federal tax liability. However, depending on the location of the property, additional state income taxes may be due. The table below illustrates the wide range of combined federal and state tax rates by state. Many real estate investors with highly appreciated property and very low basis may be unwilling to trigger capital gains taxes. The potential capital gains tax liability is even larger for investors in high-income tax states such as California and New York.
|Highest marginal capital gains rate*||California||New York||Massachusetts||Florida|
|Top federal long-term capital gains rate||20.0%||20.0%||20.0%||20.0%|
|Net investment income tax||3.8%||3.8%||3.8%||3.8%|
|Top state income tax rate||13.3%||8.82%||5.05%||0.0%|
*Table excludes depreciation recapture
Real estate investors commonly seek to exit their current properties in order to diversify, increase their cash flow, or because they no longer want to manage the property. However, once the property is sold and after the capital gains taxes are paid, the remaining proceeds available to reinvest may be considerably less. An alternative approach would be to take advantage of Internal Revenue Code Section 1031, which allows an individual to exchange one investment property for another like-kind investment property without triggering capital gains recognition. Notably, a §1031 exchange does not eliminate the capital gains tax; instead, the exchange defers capital gains recognition and the cost basis from the original property carries over to the new property or properties.
Going back to the previous example of real estate investor Jane, below is a simplified comparison of selling the property versus a like-kind exchange. State income tax is not included in the chart below.
|Sell property||Like-kind exchange|
|Current market value||$4,000,000||$4,000,000|
|Debt on property||$0||$0|
|Federal capital gains tax||$977,000||$0|
|Value of new investment||$3,023,000||$4,000,000|
|Post-transaction cost basis||$3,023,000||$0|
Several nuances and requirements are involved in qualifying for a §1031 exchange, including the timing during which the exchange must be completed, the types of property that qualify and what is considered like-kind property. Taxable gain may also be triggered if the investor receives any cash or debt relief during the exchange transaction. Investors contemplating a §1031 exchange are strongly advised to work with a team of experienced professionals to prepare for and execute the transaction.
The estate tax impact of owning appreciated real estate
Each U.S. citizen is allowed to transfer up to a certain dollar amount tax-free to his or her heirs during his or her lifetime or at death. Any amount over the threshold is taxed at a federal rate of 40 percent. The current lifetime gift and estate tax exemption for 2020 is $11.58 million per person or $23.16 million per married couple (Note: The lifetime exemption is currently scheduled to return back to previous amounts at the end of 2025).
With a few exceptions, most assets held inside the estate will receive a basis adjustment to the fair market value at the date of death. If the value is higher, the basis will “step-up”; if the value is lower, the basis will “step-down.” The chart below illustrates how the value of a step-up in basis varies for certain assets:
|Higher benefit||Fully depreciated real estate asset||Recapture plus long-term gain|
|Collectibles||28% maximum long-term gain|
|Low basis stock||20% top long-term gain|
|Lower benefit||Cash||Basis is generally market value|
|No benefit||Non-qualified annuity (acquired after October 20, 1979)||No basis step-up/ordinary income|
|Pre-tax retirement assets||No basis step-up/ordinary income|
For estates that fall under the estate tax exemption, the basis step-up can provide valuable income tax savings for heirs. However, for larger estates well over the estate exemption, the taxpayer must weigh the benefit of the cost basis step-up versus the additional estate tax burden caused by including the asset in the estate. Generally, the estate tax liability is due 9 months after the date of death. Estates that have a large portion of illiquid assets, such as real estate or business interests, may find it challenging to raise the cash needed to pay the estate tax liability in the short time frame.
Real estate investor Jane owns the apartment building with $0 adjusted basis and no debt. At her date of death, the property’s basis is adjusted to a fair market value of $4 million. If her heirs immediately sell the property, there may be minimal to zero capital gains taxes due. However, assuming that Jane’s estate exceeds her federal estate tax exemption, the federal estate tax liability associated with the apartment building may be $1.6 million ($4 million taxed at 40 percent rate). Jane must weigh the capital gains tax versus the estate tax as one may be higher than the other depending on the state location of the property.
Additional state-level estate taxes must be considered as well. A handful of states are decoupled from the federal estate tax laws; these states have their own state estate tax rates and exemption limits that are often not aligned with the federal estate tax system. Currently, 12 states (Connecticut, Hawaii, Illinois, Maine, Maryland, Massachusetts, Minnesota, New York, Oregon, Rhode Island, Vermont and Washington), along with the District of Columbia, levy an additional estate tax. Investors should understand the state tax laws when purchasing real estate outside their state of residency. For example, a California resident who owns real property in Oregon could potentially be subject to Oregon state estate tax.5
Gift and wealth transfer: Start planning now
For estates over the lifetime exemption now or in the future, it is worth exploring whether or not it is more beneficial to gift wealth today and allow the asset to appreciate outside of the estate.
There are many strategies available for those interested in maximizing wealth for their heirs or charity. One example is to structure gifts to certain irrevocable trusts in a way that provides the flexibility to “swap” a low-basis asset for high-basis asset. The goal would be to bring the previously gifted low-basis asset back into the estate in the future for the basis step-up and transfer the high-basis asset outside of the estate.
Planning ahead early to mitigate tax erosion is critical for investors considering an exit strategy or transferring wealth to the next generation, or for individuals inheriting wealth. The approach you take should be customized to fit your particular situation.
Although it is essential to plan around the estate tax and income tax challenges for real estate investors, keep in mind that taxes are only one piece in the overall planning strategy. Additionally, income and estate taxes at both the federal and state level will likely continue to change over time. We recommend that you periodically revisit your estate plan and partner with trusted advisors who maintain a comprehensive understanding of your financial, estate, and tax plan, unique family dynamics and philanthropic wishes.
1Net investment income tax of 3.8% is applied to the lesser of net investment income or the excess over the modified adjusted gross income (MAGI). The thresholds are as follows: $200,000 for single, $250,000 for married filing jointly or $125,000 for married filing separately. Net investment income may include interest, dividends, capital gains, passive business income or passive rental income.
2Residential rental property is depreciated over 27.5 years and commercial property is depreciated over 39 years.
3Typically, the basis includes the original purchase price, certain expenses associated with acquiring the asset and improvements to the property.
4Unrecaptured section 1250 gain
5Refer to each state’s rules surrounding estate tax treatment of real estate owned in a LLC for residents and non-residents.