Utilizing a 1031 Exchange to Avoid Capital Gains Taxes

If you are planning to leave an investment property to loved ones, a 1031 exchange may be a helpful estate planning tool for you. Because these exchanges allow you to defer taxes or limit taxes owed at the time of a sale, you can use the money that would have been spent on taxes to increase your real estate portfolio, rental income, and personal wealth.

What is a 1031 Exchange?

A 1031 exchange is a process in which you exchange one investment or business property for another, thus deferring capital gains taxes on any profits you make from selling the first investment property. Although you do not avoid capital gains, you can push a significant portion of capital gains taxes owed into the future. However, you must follow specific rules for a sale and purchase to qualify as a 1031 exchange.

Three Requirements

A 1031 exchange will be recognized by the Internal Revenue Service as long as the transaction meets specific criteria:

1. The main requirement is that the exchanged properties are both investment properties, regardless of whether they were the same type of property (for example, an apartment, a building, a multifamily, et cetera). There are also special rules when it comes to vacation homes.

2. Second, money from the sale of the first property must be held by a “qualified intermediary” until the second property is ready to be purchased. A qualified intermediary is a third party that escrows funds until a new property is ready for purchase. You cannot receive funds at any point in the sale of the first property and subsequent purchase of an exchange property. Thus, it is crucial to use a trustworthy and reputable company.

3. Third, the exchange needs to happen within a specific timeframe. You must designate, in writing to the intermediary, properties you’re interested in buying within 45 days of the sale of your first investment property. You then have 180 days to complete the purchase of the exchanged property.

The 1031 exchange process can be done back-to-back without limit on the number of transactions, as long as they are all done correctly. This means that many people can defer capital taxes for very long periods.

When you ultimately decide to sell your exchanged property for cash, you’ll pay taxes at the long-term capital gains rate. That can be much less than other tax rates. For example, in 2022, the tax rate is 0 percent, 15 percent, or 20 percent, depending on a person’s taxable income.

1031 Exchanges and Estate Planning

You may not realize that 1031 exchanges can be a valuable estate planning tool. For example, if you pass away without ever selling your replacement property, your heirs will inherit it at market value. Your loved ones won’t have to pay capital gains taxes on any property value appreciation.

Before determining whether a 1031 exchange is suitable for you, you must consider additional intricacies and rules. If you are considering a 1031 exchange as part of your estate planning process, it is a good idea to speak with an attorney in your area.

If You Don't Want an IRA Distribution, You Can Donate It to Charity and Save on Taxes

Not everyone wants to take the required minimum distributions from their retirement accounts right away. If you don’t want your distribution, one option is to donate it to charity and get a tax deduction. 

You are required to begin taking distributions from your tax-deferred IRA when you reach age 72 (70 ½ if you turned 70 ½ in 2019 or before) even if you don’t need the money. The distributions are added to your income and taxed at your highest marginal rate, perhaps even at a higher rate than your other income if you’re right at the threshold between two rates. You’re more likely to have to pay a higher rate on this income if you are still working. 

If you don’t need the distribution, you may want to consider donating it distribution directly to charity through a qualified charitable donation. By donating your required minimum distribution, the distribution won't be included in your gross income, which means lower taxes overall. 

A qualified charitable donation can also be a good way to get a tax deduction since after the 2017 tax law doubled the standard deduction, itemizing makes sense for many fewer people. If your charitable contributions along with any other itemized deductions are less than $12,950 a year (in 2022), you will no longer get a deduction for your contributions to charity (which can be a disincentive to donate to charity). However, substituting a qualified charitable donation for your required minimum distribution is a way to make a donation and receive a tax benefit from it.

In order for the donation to count as a required minimum distribution, there are a few conditions:

• The donor must be 70 ½ years old.

• There is a $100,000 annual limit on donations.

• The donations may only be made from an IRA or rollover IRA account. Donations from other retirement accounts, such as a 401(k), do not qualify.

• If you donate less than your required minimum distribution, you will need to take the remainder as a distribution.

• The organization receiving the donation must be a qualifying public charity. Donations to private foundations, supporting organizations, trusts established for both charitable and non-charitable purposes, or other funds over which the donor may have some advisory control (including donor advised funds) do not qualify.

• The transfer must be made directly from the IRA account to the qualifying organization. This is ordinarily done by instructing the brokerage firm holding the IRA to make the transfer or by writing a check from the account directly to the charity, if the brokerage firm allows it. If the donor receives the funds from the IRA and then donates them to charity, they will be subject to the income tax.

For more information from the IRS about distributions from IRAs, click here.

How Changes to Portability of the Estate Tax Exemption May Impact You

On July 8, 2022, the Internal Revenue Service issued new guidance that allows a deceased person’s estate to elect “portability” of their unused gift and estate tax exemption for up to five years after their death. So, if your spouse passed away less than five years ago, you may be able to file an estate tax return to transfer their unused estate tax exclusion to yourself.

What Is Portability, and How Does One Get It?

Portability is a way of transferring the amount of the gift and estate tax exemption that a deceased spouse did not use to the surviving spouse. It is only available to married couples.

To get the benefit of portability, the executor of an estate must file a federal estate tax return. Previously, this return had to be filed within two years of a person’s date of death, assuming an estate tax return was not required sooner. Because so many estates kept missing this window, the IRS decided to extend it to five years.

Let’s say your spouse has passed away, and you are the executor of their estate. If the total value of your spouse’s assets in their estate is below the threshold for federal estate taxation, you may assume that no estate tax return needs to be filed. While this is technically correct, if you do not file an estate tax return, there is no way to transfer over your spouse’s unused estate tax exclusion for your benefit.

The federal gift and estate tax exclusion as of 2022 is $12.06 million per person ($24.12 million for married couples). A person can give away — either during their lifetime or at death — up to this amount, tax-free.

In the above example, if your spouse’s estate were worth $2 million, that would leave an unused exemption of $10.06 million, which you could add to your own $12.06 million exemption, should you ever need it. But you must file an estate tax return for your spouse and complete the section of Form 706 currently entitled “portability of deceased spousal unused exclusion.”

Now Is a Good Time to Consider If You Could Benefit From Portability

The current federal gift and estate tax exemption will be reduced by half in 2026. So, if you have a spouse who died in the past five years, you should consider as soon as possible whether electing portability makes sense.

To be eligible, the deceased spouse must have been a U.S. citizen or permanent resident on the date of their death, and the executor must not have been otherwise required to file an estate tax return based on the value of the total estate and any taxable gifts. If an estate tax return was filed within nine months after the spouse’s death or an extended filing deadline, the portability option may also not be available.

For families with some wealth, this option could result in hundreds of thousands of dollars or more in tax savings. Many families might not have an estate tax problem now, under the gift and estate tax exclusion of 2022. However, if the second spouse dies after 2026, that spouse’s estate could owe hefty taxes. Portability allows you to plan ahead to avoid this problem. Reach out to your attorney to learn more. 

The Tax Consequences of Selling a House After the Death of a Spouse

If your spouse dies, you may have to decide whether or when to sell your house. There are some tax considerations that go into that decision. 

The biggest concern when selling property is capital gains taxes.  A capital gain is the difference between the "basis" in property and its selling price. The basis is usually the purchase price of property. So, if you purchased a house for $250,000 and sold it for $450,000 you would have $200,000 of gain ($450,000 - $250,000 = $200,000).

Couples who are married and file taxes jointly can sell their main residence and exclude up to $500,000 of the gain from the sale from their gross income. Single individuals can exclude only $250,000. Surviving spouses get the full $500,000 exclusion if they sell their house within two years of the date of the spouse's death, and if other ownership and use requirements have been met. The result is that widows or widowers who sell within two years may not have to pay any capital gains tax on the sale of the home.

If it has been more than two years after the spouse’s death, the surviving spouse can exclude only $250,000 of capital gains. However, the surviving spouse does not automatically owe taxes on the rest of any gain. 

When a property owner dies, the cost basis of the property is "stepped up." This means the current value of the property becomes the basis. When a joint owner dies, half of the value of the property is stepped up. For example, suppose a husband and wife buy property for $200,000, and then the husband dies when the property has a fair market value of $300,000. The new cost basis of the property for the wife will be $250,000 ($100,000 for the wife's original 50 percent interest and $150,000 for the other half passed to her at the husband's death). In community property states, where property acquired during marriage is the community property of both spouses, the property’s entire basis is stepped up when one spouse dies. 

To understand the tax consequences of selling property after the death of a spouse, contact your attorney. Find an attorney near you.

How Community Property Affects Estate and Tax Planning

In most states, spouses can purchase and own property separately from one another. However, in certain states – called community property states – if one spouse purchases property, it is considered the property of both spouses. How marital property is owned has implications for both estate and tax planning. 

There are currently nine community property states. They are: Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington, and Wisconsin. A few other states (for example, Alaska) allow couples to opt into community property arrangements. 

Community property is property acquired by a husband and wife during marriage. In community property states, property held in only one spouse’s name can still be community property. For example, the paycheck that a spouse brings home every week is community property even though only one spouse’s name is on the check. If that check is used to buy an asset, then that asset is community property, regardless of whose name is on the account or the asset. 

Property that is not community property is property that one spouse brings to the marriage, inherits, or is gifted. A spouse can turn separate property into community property by putting an asset owned by one spouse into both spouses’ names. 

Depending on the state, partners may be able to change whether property is separate or community via pre-nuptial agreement, post-nuptial agreement, or exceptions in the law. Changing community property into separate property may be appropriate in second marriages or when one spouse is bringing significant separate property into the marriage. For example, if, at the time of the marriage, one spouse receives significant income from owning a business, the spouses may decide that it is appropriate that the business remain that spouse’s separate property and the income from that property will remain that spouse’s separate property. 

One advantage of community property is with regard to capital gains taxes. If one spouse dies, the cost basis of the community property gets “stepped up.” The current value of the property becomes the cost basis. This means that if, for example, the couples’ house was purchased years ago for $150,000 and it is now worth $600,000. The surviving spouse will receive a step up from the original cost basis from $150,000 to $600,000. If the spouse sells the property right away, he or she will not owe any capital gains taxes. In non-community property states, if one spouse dies, only the deceased spouse’s interest (usually 50 percent of the value) is stepped up. 

When estate planning in a community property state, it is important to fully review assets to determine which assets are community property and which are separate property. A surviving spouse in a community property state is entitled by law to half of the community property, regardless of what the spouses may have wanted to do with the property (such as pass it on to children). Community property can be a factor even in non-community property states if the couple owns property in a community property state. 

If spouses move from one type of state to another, it is especially important that they have their estate plan reviewed by an attorney in the new state to make sure the plan still does what they want. Find an attorney near you.

Irrevocable Dynasty Trusts: A Tax Efficient Generational Wealth Strategy

If you want to pass money to future generations without having it subject to gift and estate taxes, then a dynasty trust may be right for you. A dynasty trust allows trust assets to be used for the benefit of multiple generations while keeping the assets out of the grantor’s and the beneficiaries’ taxable estates. 

The main benefit of a dynasty trust is the avoidance of estate and gift taxes over many generations. In 2022, federal estate tax exemption is $12.06 million ($24.12 million for couples). Estates valued at more than the exemption amount will pay federal estate taxes, at a rate of between 18 percent and 40 percent. The lifetime gift tax exclusion – the amount you can give away without incurring a tax – is also $12.06 million in 2022. Note that you can give any number of people up to $16,000 each per year (in 2022) without the gifts counting against the lifetime limit. In addition, the generation skipping transfer (GST) tax affects assets passed to grandchildren. The tax is imposed even when property is left in trust for a grandchild. The GST exemption is the same as the estate and gift tax exemptions. If you transfer more than the GST exemption, the tax rate is 40 percent. 

Assets transferred to a dynasty trust are subject to estate, gift, and GST taxes only when initially transferred and only if they exceed federal exemption thresholds. While estate and gift tax exemptions are currently very high, in 2026 the exemption is set to drop to the previous exemption amount of $5.49 million (adjusted for inflation).

Another benefit of a dynasty trust is that the assets in the trust are protected from the beneficiaries’ creditors or in the event a beneficiary divorces. If the trust is properly structured, creditors cannot go after trust assets to pay the beneficiaries’ debts. 

How a dynasty trust works
A dynasty trust is an irrevocable trust, which means once it is created it cannot be changed. Funds transferred into the trust will be taxed if they exceed the lifetime gift tax exclusion. However, once funds are transferred to the trust, beneficiaries of the trust can pass assets to the next generation without those assets being subject to estate, GST, or gift taxes. In addition, the assets placed in the trust are removed from your estate and can grow outside of it. 

The trustee of the trust can be a beneficiary, but because the trust is designed to last for generations, it may make sense to have a professional fiduciary, such as a bank or other financial institution, serve as trustee. The trustee manages and distributes the assets in the way you set forth in the trust agreement. Usually, the trust provides for the beneficiaries’ support during their lifetimes. For example, it could direct the trustee to pay out income regularly, make periodic principal distributions, or make distributions contingent on the beneficiary’s need. 

The length of time the dynasty trust can continue to exist depends on state law. Some states allow trusts to run for hundreds of years or indefinitely, while others place limits on how long the trust can operate. Traditionally, the rule against perpetuities states that a trust can last 21 years past the death of the last beneficiary. However, many states, have opted out of the rule, allowing trusts to continue for many generations - in Arizona this period lasts for 500 years under Arizona state law. 

The general consensus regarding the downside of dynasty trusts is that they are inflexible. And while it’s true that once the trust is created, you lose access to the assets because they have been permanently gifted away, Arizona law provides the ability to modify irrevocable trusts through multiple methods, namely by utilizing a process called decanting, or through the use of a non-judicial settlement agreement. However, because dynasty trusts can potentially last for generations, they require specialized attention due to the sophisticated nature of their design to include considerable flexibility to ensure that they remain workable vehicle far after your death. 

Dynasty trusts are sophisticated instruments that must be designed correctly in order to provide benefits. Contact Ganser Law Offices to determine if a dynasty trust is right for you.