Commercial Real Estate

Swap ‘Til You Drop: Multifamily Tax Avoidance Tips from Closing Table to Inheritance

Expertise: Personal Development, Commercial Real Estate, Real Estate News & Commentary, Landlording & Rental Properties
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I've written three recent BiggerPockets articles on tax avoidance strategies for multifamily (and other) investors. These articles covered tactics to employ before investing, in your first year of ownership, and in ensuing years of operating the asset.

In the first, I encouraged investors and syndicators to hire a tax stratelegist to set up your affairs to minimize taxes. In the second article, I unveiled the powerful strategy of employing cost segregation to slash taxes in the early years of ownership. In the third article, I discussed a variety of strategies to minimize taxes during your holding period.

If you read these articles, two obvious questions may have emerged:

  1. If you employ all these tactics, won’t your efforts just reduce your cost basis to a point where you’ll get absolutely crushed with capital gains and inheritance taxes later?
  2. Why is this guy obsessed with discovering the meaning of semi-boneless ham?

When I first heard about this arsenal of tools to cut taxes to virtually zero, I likewise wondered about the ramifications down the road.

Yes, I understand the time value of money and the power of deferred taxes. But I still hate the thought of eventually getting pounded with a huge IRS bill. Capital gains taxes are bad enough now. What if the rates are raised in the future? (Wait, they would certainly never do that, would they?)

Though the first strategy below is familiar to most of us, I’m guessing the second may surprise you as much as it did me and many I’ve discussed this with.

multifamily-benefits

Don’t Sell Your Apartments—Trade Them in

You’re probably familiar with the 1031 exchange. This is an IRS-sanctioned vehicle that allows you to effectively exchange one asset for another of “like kind.”

Capital gain taxes on the sale of the asset you are selling are not cancelled or avoided, but rather deferred until the sale of the second (or future non-exchanged) property at a later date.

At the time of the “final” (non-exchanged) sale, all of the accrued gain for previously exchanged properties will be paid at once.

You can learn more about selling your asset using a 1031 Starker exchange here.

I must say that this is one of the clearest explanations of the 1031 I have read.

While it may sound better to you to pay it as you go, remember that it’s always much better to avoid taxes for as long as you can. This is math—easily provable and well documented.

Related: 5 Amazing Benefits Multifamily Investments Offer (That Single Family Homes Don’t)

So what is this "like-kind" provision? Does that mean a 300-unit Dallas apartment complex must be traded for another 300-unit complex in Fort Worth? Not at all. The IRS regulations for real estate exchanges are actually very broad.

The website I cited in the link above is very helpful here:

Both the relinquished property you sell and the replacement property you buy must meet certain requirements. Both properties must be held for use in a trade or business or for investment. Property used primarily for personal use, like a primary residence or a second home or vacation home, does not qualify for like-kind exchange treatment. Both properties must be similar enough to qualify as “like-kind.” Like-kind property is property of the same nature, character, or class. Quality or grade does not matter.

Most real estate will be like-kind to other real estate. For example, real property that is improved with a residential rental house is like-kind to vacant land. One exception for real estate is that property within the United States is not like-kind to property outside of the United States. Also, improvements that are conveyed without land are not of like-kind to land.

Real property and personal property can both qualify as exchange properties under Section 1031, but real property can never be like-kind to personal property. In personal property exchanges, the rules pertaining to what qualifies as like-kind are more restrictive than the rules pertaining to real property. As an example, cars are not like-kind to trucks.

The law was derived from the possibility that properties could be swapped, and there would be no cash to pay taxes on the gain. But it was broadened to allow the sale of one property and the purchase of another within just under six months, with the funds from the sale of the first property held by an intermediary.

Time Limits to Complete a 1031 Deferred Like-Kind Exchange

Again from the IRS site:

While a like-kind exchange does not have to be a simultaneous swap of properties, you must meet two time limits, or the entire gain will be taxable. These limits cannot be extended for any circumstance or hardship except in the case of presidentially declared disasters.

The first limit is that you have 45 days from the date you sell the relinquished property to identify potential replacement properties. The identification must be in writing, signed by you, and delivered to a person involved in the exchange like the seller of the replacement property or the qualified intermediary. However, notice to your attorney, real estate agent, accountant, or similar persons acting as your agent is not sufficient.

Replacement properties must be clearly described in the written identification. In the case of real estate, this means a legal description, street address, or distinguishable name. Follow the IRS guidelines for the maximum number and value of properties that can be identified.

The second limit is that the replacement property must be received and the exchange completed no later than 180 days after the sale of the exchanged property or the due date (with extensions) of the income tax return for the tax year in which the relinquished property was sold, whichever is earlier.

The replacement property received must be substantially the same as property identified within the 45-day limit described above.

So, what does this mean to you as a multifamily investor? It could mean that you are able to sell ("exchange") your property and after paying minimal taxes on your returns over a number of years, after paying no taxes on proceeds from a refinance, that you are able to defer the capital gains tax as well.

Here is a great example from an earlier BiggerPockets article by our own Brandon Turner:

In July of 2013, Jason Mak purchased an 81-unit apartment building in Riverside, California. Paying $3.1 million for the property, he immediately set out to improve the building. He worked on the business side, evicting bad tenants and improving management efficiencies, as well as on the physical condition of the property, adding a new roof and elevator, painting, landscaping, and more.

Related: 5 Reasons Single Family Investors Are Turning to Multifamily Apartments

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After increasing occupancy from 60% to 95% and stabilizing the entire operation, Jason sold the property for $5.5 million in the spring of 2015. Overall, he netted a final profit of $2 million on the two-year apartment turnaround!

Had Jason simply sold this deal, he would have needed to pay close to $600,000 in capital gains tax, but he knew better. Jason used a 1031 exchange to parlay his cash into two new properties, a 24-unit apartment building, and an upscale office building.

Although reducing the number of units, Jason was able to buy nicer properties in significantly better locations that will be easier to manage and increase his ability to grow wealth.

analyze-multifamily

Die and Pay Taxes?

Is it possible to completely avoid capital gains tax, too?

If you have enjoyed the tax benefits of depreciating your property for a number of years, then performed a 1031 exchange at the time of sale, then perhaps another, you will likely be faced with a very small tax basis—and a very large taxable gain. This is usually still better than paying taxes along the way.

But it may be possible for your heirs to reset the basis of the assets at the time of their inheritance. This is referred to as a step-up in basis.

Their assets could reflect the enormous growth possible from tax deferrals, and they could start with a clean slate: the opportunity to start depreciating these assets again from the beginning. This can often be more tax-efficient than gifting the property to heirs prior to death.

For example, suppose you find a trustworthy sponsor and invest $2 million in multifamily assets. The property basis depreciates down to $1 million over a number of years. In addition to whatever income you received, the property has appreciated to a value of $4 million.

Before your passing, one option is to sell your share in the property and pay a hefty $450,000 capital gains tax on the $3 million gain, leaving heirs with a $3.55 million net inheritance.

If you arrange to pass your direct investment in the assets to your heirs, however, they may be able to step-up their basis in the asset to the value at the time of inheritance of $4 million.

If they choose to sell the asset at that time, their gain would be zero and their net asset value around $4 million. If they hold on and sell later, they will still benefit from the stepped up basis that they received at the time of inheritance.

In an age of confiscatory taxation, I sincerely wonder why our government has allowed investors and their heirs this opportunity to avoid taxes one last time. But I’m not complaining.

Note that there are eight states (community property states) that allow this step-up in basis for your spouse, not just for next generation heirs. There are other ways that you can arrange your affairs to gain this benefit, but that is beyond the scope of this article. You need to ask BiggerPockets writer Brandon Hall about that.

Also note that there may be a cap on the step-up in basis. Ask your CPA or tax strategist for more details.

We’re republishing this article to help out our newer readers.

So what about you? Have you used a 1031 exchange to defer taxes on real or personal property purchases? And are you arranging your estate to allow heirs to take advantage of a step-up in basis?

We’d love to hear how you’ve done it. Have your heirs already inherited property from you? (We actually don’t expect to hear from you in this case.)

After graduating with an engineering degree and then an MBA from Ohio State, Paul entered the management development track at Ford Motor Company in Detroit. After five years, he departed to start a...
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    Andy Le Real Estate Investor from Huntington Beach, California
    Replied about 2 years ago
    Great article Paul. I read about 1031 and step up basis before but this is such a refresh for my knowledge. Thanks
    Paul Moore Investor from Lynchburg, VA
    Replied about 2 years ago
    Hi Andy, thanks for your comment. Let me know if you have any specific questions.