Top Reasons Real Estate Investors Need a Financial Plan
Welcome to month two of our newsletter mini-series! For the month of May, we will explore strategic ways to leave a legacy and how to efficiently pass real estate property to your beneficiaries while maximizing your investment.
Leaving highly appreciated property to beneficiaries
Owning real estate in Denver and other major cities has meant major appreciation on your property(s). The shadow lurking behind this significant appreciation is the impending tax bill if you choose to cash in. Real estate with a high valuation and low basis can lead to large future tax due upon liquidation of that property. Check out last month’s post about real estate taxation for a quick refresher on understanding the tax impact of real estate ownership as an investment. With proper planning, taxes can be mitigated. Below you will find a couple simple planning ideas to remember as it relates to your legacy plan involving real estate.
Step-up in basis (for now...)
If the equity value of a real estate property is not needed to fund your own retirement, leaving the property as an inheritance will allow a step-up in basis and readjust the value of the appreciated property for tax purposes. Typically, an investment property has been depreciated over time which lowers the cost basis even more. The difference of sales price and basis would be the taxable gain. When a property is inherited, the basis is stepped-up to the value of the property on the date of death. The beneficiary of the property can then sell the property with the higher basis and minimize or eliminate the capital gain tax.
How about an example? Investor Dave bought an income-producing real estate property in 2005 for $200,000. After 15 years of renting and depreciating that property, Dave passed in 2020 and his daughter, Rachel, inherited the property. At the date of death, the property was worth $500,000 and Dave’s tax basis was now only $90,000 due to depreciation. Rachel had no interest in keeping the property, so she sold it for $600,000 in 2021. She paid taxes on the difference between the sales price and the stepped-up basis, or just $100,000 in capital gains. If Dave had gifted the property before he passed, Rachel would have inherited Dave’s tax basis of $90,000 and have paid taxes on the difference between the sales price and the current basis, or a massive $510,000 capital gain. This strategy saved Rachel over $100,000 in taxes due!
Legislative note: There is a current bill called the “STEP Act” that will remove this special tax treatment, eliminating the step-up in basis at death. If passed, the bill could be put into law immediately: some are speculating as early as fall, 2021. Stay tuned to our blog for updates!
Charitable Remainder Trust
More commonly, income or equity of a real estate property is needed to fund your own retirement and leaving the property as an inheritance is not an option. The tax situation remains an issue. Selling the highly appreciated property with a low basis will create a large tax bill and reduce the amount available to put towards retirement. Utilizing a Charitable Remainder Trust (CRT) can be a wonderful way to still use the property to fund retirement without having to pay a large capital gain upon the sale.
A CRT is a split interest irrevocable trust that allows the highly appreciated property to be donated to a qualified charity (or more specifically a trust that will end up going to charity at your death). In return, you will receive a tax deduction in the year of the donation (where excess deduction credits can be used for up to 5 more tax years) as well as an income stream for no more than 20 years or the lifetime of one or more non-charitable beneficiaries. The income stream can be used for everyday living expenses with no limitations.
A CRT can be set up in two ways:
- Charitable remainder unitrust (CRUT): CRUT income changes annually based on the balance of the trust asset and distributes a fixed percentage of the account balance each year. If you utilize a CRUT, additional contributions can be made.
- Charitable remainder annuity trust (CRAT): CRAT income is more straight forward as the income is fixed each year. If you utilize a CRAT, additional contributions cannot be made.
Donating a large asset like a highly appreciated real estate property does take the asset off your balance sheet, meaning it is no longer going to be passed on to beneficiaries, nor will it be subject to estate taxes (more legislation on estate taxes likely coming as well). A common way to replace the asset and still be able to leave a legacy is to purchase a permanent life insurance policy with the amount of death benefit equal to the value of the property that was placed into the trust. The life insurance premium can be funded by the CRUT or CRAT income, and the death benefit will pass on as a tax-free, liquid asset to your beneficiaries.
There are many nuances to executing a CRT so please make sure you hire a team around you familiar with the process. An important note is the real estate property must be owned by the trust before sale, so if this is a strategy you are considering, allow plenty of time for execution before sale of the property.
If you are interested in diving deeper into either of these strategies or would like to find out more information about Colorado Wealth Group, please reserve a free Initial Consult and please make sure you let us know you found us by reading this blog!
Lastly, stay tuned for next month’s mini-series topic: Optimizing Your Rental Portfolio.
