Trying to wrap my head around tax implications

5 Replies

I'll preface this by saying I've already taken these questions to three separate professional accountants.  One straight up told me he has no clue, and the other two gave conflicting answers.  So hopefully the internet brain trust can maybe give me some guidance. 

I manage two rental properties.  One is a two family house in New York City, the other is a single family house in the suburbs outside of NYC.  They were originally owned by my mother in law.  In 2017 they were placed into an irrevocable trust as a part of Medicaid planning/asset protection for her.  My mother in law is the grantor and my wife is the trustee and beneficiary.

The Queens house was purchased in 1980 for $80k, and the SFH was purchased in 1990 for $180k. FMV for them today is roughly $800k and $600k, respectively. They generate a positive cash flow, but only because there's no mortgages. The rents are nothing to write home about, and that assumes we even have tenants paying their rent in the first place.

My wife and I are getting kind of tired of being landlords.  Largely due to the low quality tenants these homes attract due to their geographic locations and being in a very tenant friendly state/city.

Now due to their very low cost basis, the trust would be on the hook for massive capital gains taxes if they were sold. I just got off the phone with an accountant, and things are bleaker than I had anticipated. I had a simplistic view of how cost basis is calculated, assuming it was just original purchase price + value of all improvements. But he informed me that you also have to subtract all the depreciation from over the years, which vastly lowers it. In fact that brings our cost basis to not much more than they were purchased for, approximating $120k for the Queens house and $190k for the SFH. In short, the trust would be looking at approaching $400k in capital gains taxes.

One of my big questions is - when my mother in law dies, does the trust receive a step up in basis on the properties?  One accountant said yes, the other said no, on the reasoning that she no longer owns the homes, so her being alive or dead is irrelevant.  Initially my plan was to maybe keep with it until she passes away and they could be sold for little/no capital gains, but if the cost basis doesn't change on her death, then that's irrelevant.

The other big option is a 1031 exchange.  Personally I'd like to 1031 them into a property that is in a closer and more desirable area.  The accountant was also telling us about Delaware Statutory Trusts.  I don't fully understand these, but I gather it's a way to get the tax deferment benefits of a 1031 exchange, but in a more hands off vehicle that doesn't require day to day landlording duties. 

Our decision largely hinges on the earlier question - is there a step up in basis when my mother in law passes away? That'd save us nearly $400k in potential capital gains taxes. If so, I'm in favor of doing a 1031 into another physical rental property. My wife is more in favor of a 1031 exchange into a DST; she wants to be hands off and doesn't like being a landlord. Either way we could wait for her mother to pass before selling the homes. If the answer is no, (and assuming there's no other creative way around the taxes), then we may as well just bite the bullet and sell and write a giant check for taxes. Then we'd probably toss the money into index funds, which would have far far far outpaced the rental income the trust has received.

I'm open to any advice or other suggestions that we haven't considered.

Originally posted by @Tyler Brown :

I'll preface this by saying I've already taken these questions to three separate professional accountants.  One straight up told me he has no clue, and the other two gave conflicting answers.  So hopefully the internet brain trust can maybe give me some guidance. 

I manage two rental properties.  One is a two family house in New York City, the other is a single family house in the suburbs outside of NYC.  They were originally owned by my mother in law.  In 2017 they were placed into an irrevocable trust as a part of Medicaid planning/asset protection for her.  My mother in law is the grantor and my wife is the trustee and beneficiary.

The Queens house was purchased in 1980 for $80k, and the SFH was purchased in 1990 for $180k. FMV for them today is roughly $800k and $600k, respectively. They generate a positive cash flow, but only because there's no mortgages. The rents are nothing to write home about, and that assumes we even have tenants paying their rent in the first place.

My wife and I are getting kind of tired of being landlords.  Largely due to the low quality tenants these homes attract due to their geographic locations and being in a very tenant friendly state/city.

Now due to their very low cost basis, the trust would be on the hook for massive capital gains taxes if they were sold. I just got off the phone with an accountant, and things are bleaker than I had anticipated. I had a simplistic view of how cost basis is calculated, assuming it was just original purchase price + value of all improvements. But he informed me that you also have to subtract all the depreciation from over the years, which vastly lowers it. In fact that brings our cost basis to not much more than they were purchased for, approximating $120k for the Queens house and $190k for the SFH. In short, the trust would be looking at approaching $400k in capital gains taxes.

One of my big questions is - when my mother in law dies, does the trust receive a step up in basis on the properties?  One accountant said yes, the other said no, on the reasoning that she no longer owns the homes, so her being alive or dead is irrelevant.  Initially my plan was to maybe keep with it until she passes away and they could be sold for little/no capital gains, but if the cost basis doesn't change on her death, then that's irrelevant.

The other big option is a 1031 exchange.  Personally I'd like to 1031 them into a property that is in a closer and more desirable area.  The accountant was also telling us about Delaware Statutory Trusts.  I don't fully understand these, but I gather it's a way to get the tax deferment benefits of a 1031 exchange, but in a more hands off vehicle that doesn't require day to day landlording duties. 

Our decision largely hinges on the earlier question - is there a step up in basis when my mother in law passes away? That'd save us nearly $400k in potential capital gains taxes. If so, I'm in favor of doing a 1031 into another physical rental property. My wife is more in favor of a 1031 exchange into a DST; she wants to be hands off and doesn't like being a landlord. Either way we could wait for her mother to pass before selling the homes. If the answer is no, (and assuming there's no other creative way around the taxes), then we may as well just bite the bullet and sell and write a giant check for taxes. Then we'd probably toss the money into index funds, which would have far far far outpaced the rental income the trust has received.

I'm open to any advice or other suggestions that we haven't considered.

When property is transferred via inheritance, you will receive a step up in cost for the property. Also, you will not be on the hook for any depreciation recapture. It's good that these properties were placed in a trust, as you will not need to go through probate for the title transfer. 

I'm confused by your last paragraph though.  Doing a 1031 exchange would allow you to avoid cap gains and depreciation recapture. But since you will receive a step up in cost and no recapture, there really isn't any reason to do a 1031 exchange. In fact, you could just sell it at market value and take your time with selecting your new property. 

Also, if being hands-off and not requiring any landlording is what you are looking for, instead of a DST I would suggest looking into regular syndicated investments (i.e., Private Security offerings of partnerships that investment in RE or similar assets). I'm assuming you are an accredited investor? Since your accountant recommended a DST, I'll assume that you are. A DST essentially works like a syndicated investment, except they have to adhere to certain restrictions.

@Tyler Brown , I think you'll find that the irrevocable trust will not get a step up in basis.  Don't take my word as law.  I only know from the 1031 side of things. However, because the trust endures the death of the grantor trustee does not create a taxable event.  

So on one hand your analysis is correct - gain will be recognized by the trust upon a sale oF an asset.  

But it will be recognized whenever it is sold.  So every year you avoid a sale you'll be making income off of approximately $100K of deferred taxes.  So the longer you defer the more money you'll make off the govt's money.

And you've also identified a good way to get out of the landlord gig and still keep the use of the deferred tax for your benefit - a 1031 exchange into something passive like a DST.

Any tax paying entity can do a 1031 exchange. So the irrevocable trust could continue to defer that tax by 1031ing into a DST and continue that path indefinitely. I think this can go to and through your mother in law's death.

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The purpose of a trust is to shield assets and minimize estate taxes. Upon death, assets would step up in value. 

If your wife wants to be hands off - why not 1031 into a triple net lease? 

Originally posted by @Tony Kim :

When property is transferred via inheritance, you will receive a step up in cost for the property. Also, you will not be on the hook for any depreciation recapture. It's good that these properties were placed in a trust, as you will not need to go through probate for the title transfer. 

I'm confused by your last paragraph though.  Doing a 1031 exchange would allow you to avoid cap gains and depreciation recapture. But since you will receive a step up in cost and no recapture, there really isn't any reason to do a 1031 exchange. In fact, you could just sell it at market value and take your time with selecting your new property. 

Also, if being hands-off and not requiring any landlording is what you are looking for, instead of a DST I would suggest looking into regular syndicated investments (i.e., Private Security offerings of partnerships that investment in RE or similar assets). I'm assuming you are an accredited investor? Since your accountant recommended a DST, I'll assume that you are. A DST essentially works like a syndicated investment, except they have to adhere to certain restrictions.

 It looks like you're correct.  I reached out to the lawyer that set up the trust, and this was his response,

"From a taxable perspective, I can tell you with confidence that [wife], as beneficiary of the trust, will receive a step-up in basis for both properties upon the death of her mother. This is due to the fact that that type of irrevocable trust is a Grantor trust, meaning that it is treated as a disregarded entity by the IRS for tax purposes while the creator is alive, and [wife's] interest in the properties, as beneficiary of the trust, does not vest until the death of her mother."

I'm not sure what you mean by your middle paragraph though.  My understanding is that we only receive that step up in basis upon my mother in law's death.  She's currently alive and well and it could be a decade + before that happens.  If we sold it now without it being a 1031, I believe we'd be on the hook for a massive tax bill based on the low cost basis of the properties.

Originally posted by @Tyler Brown :
Originally posted by @Tony Kim:

When property is transferred via inheritance, you will receive a step up in cost for the property. Also, you will not be on the hook for any depreciation recapture. It's good that these properties were placed in a trust, as you will not need to go through probate for the title transfer. 

I'm confused by your last paragraph though.  Doing a 1031 exchange would allow you to avoid cap gains and depreciation recapture. But since you will receive a step up in cost and no recapture, there really isn't any reason to do a 1031 exchange. In fact, you could just sell it at market value and take your time with selecting your new property. 

Also, if being hands-off and not requiring any landlording is what you are looking for, instead of a DST I would suggest looking into regular syndicated investments (i.e., Private Security offerings of partnerships that investment in RE or similar assets). I'm assuming you are an accredited investor? Since your accountant recommended a DST, I'll assume that you are. A DST essentially works like a syndicated investment, except they have to adhere to certain restrictions.

 It looks like you're correct.  I reached out to the lawyer that set up the trust, and this was his response,

"From a taxable perspective, I can tell you with confidence that [wife], as beneficiary of the trust, will receive a step-up in basis for both properties upon the death of her mother. This is due to the fact that that type of irrevocable trust is a Grantor trust, meaning that it is treated as a disregarded entity by the IRS for tax purposes while the creator is alive, and [wife's] interest in the properties, as beneficiary of the trust, does not vest until the death of her mother."

I'm not sure what you mean by your middle paragraph though.  My understanding is that we only receive that step up in basis upon my mother in law's death.  She's currently alive and well and it could be a decade + before that happens.  If we sold it now without it being a 1031, I believe we'd be on the hook for a massive tax bill based on the low cost basis of the properties.

Gotcha. OK, that makes sense to me and I misunderstood your initial post. Yes, in that case, a 1031 exchange makes the most sense...either into another property or into a DST. Looks like @Dave Foster 's advice is correct (as always!). 😁