Turn Real Estate Into a Legacy Your Kids Will Thank You For
As a CPA, I have dedicated countless hours to tax planning for my clients, navigating both unexpected situations like last-minute strategies due to client deaths and carefully crafted, proactive plans. However, one evening, as I was reading a book to my children, it struck me that while I have spent so much time planning for others, I had neglected to plan for them. What would their lives look like when they enter the real world without my guidance?
This realization set my mind into motion. I needed to develop a strategy—one that would ensure their long-term happiness and financial security long after I finished reading bedtime stories. I reviewed traditional options, such as retirement accounts and savings plans, but none of them felt like enough. I wanted something more substantial. That’s when I discovered the power of the 1031 exchange.
What is a 1031 Exchange?
A 1031 exchange is a tax strategy that allows real estate investors to defer capital gains taxes on the sale of an investment property, provided the proceeds are reinvested into another like-kind property. Rather than paying taxes on the profit immediately, investors can roll the full amount into a new property, allowing their money to continue working for them. This strategy can be a highly effective tool for building wealth over time.
One key advantage of a 1031 exchange is tax deferral, which enables investors to preserve capital and reinvest in higher-value properties. By avoiding immediate tax liabilities, they can acquire larger or more profitable properties, ultimately accelerating portfolio growth. This makes the 1031 exchange especially beneficial for those focused on long-term wealth accumulation through real estate.
A 1031 exchange isn’t just a powerful tool for deferring taxes; it can also be a valuable estate planning strategy when coupled with the step-up in basis rule.
The Step-Up in Basis Strategy
Here’s how it works: when you use a 1031 exchange, you continuously defer capital gains taxes by reinvesting the proceeds from one property into another. This allows your real estate portfolio to grow tax-deferred, enhancing your wealth over time.
The major benefit arises if you hold onto the property until your passing. When your heirs inherit the property, they receive a step-up in basis, meaning the property’s value is reset to its fair market value at the time of death. This adjustment effectively eliminates any capital gains taxes that had been deferred throughout the years, providing your heirs with a tax-free inheritance.
For example, if you originally purchased a property for $200,000 and executed multiple 1031 exchanges, growing its value to $1 million, you would have deferred taxes on that appreciation. If your heirs inherit the property at its $1 million valuation, they can sell it immediately with little to no capital gains tax liability.
By strategically using 1031 exchanges and never selling, you are not only building wealth for yourself but also creating a tax-efficient legacy for the next generation.
Creating a Financial Legacy for My Children
Another strategy I have considered is using rental properties to help my children build financial independence. When my first child moves out for college, I could purchase a property in that area, where she could live with roommates who pay rent. This would provide her with free housing while teaching her valuable lessons about property management. Rather than selling an existing rental property, I could execute a 1031 exchange, swapping a property from my home state for one near her school, keeping the tax benefits intact.
When my second child heads off to college, I could implement the same strategy, exchanging another rental property for a house near their school. This setup would provide both children with free housing and give them the experience of managing real estate and tenants—all while building their financial independence.
The final piece of this strategy involves never selling these properties. My spouse and I would hold them for the long term, and upon our passing, the estate would benefit from the step-up in basis. This would reset the property values to fair market value, allowing our children to inherit them without any capital gains tax liability. They would inherit a fully tax-free portfolio of real estate, ensuring a legacy of generational wealth.
Convert Rental Property to a Primary Residence
Moving into a rental property I own and using the Section 121 exclusion can reduce my taxable gain on the sale. This strategy can be beneficial but requires careful planning to manage tax implications.
IRS Section 121 allows homeowners to exclude up to $250,000 ($500,000 for married couples) in capital gains on the sale of a primary residence if they meet the two-out-of-five-year rule for ownership and residency. A 1031 exchange can also defer capital gains taxes by reinvesting in a similar property. Using both strategies wisely can minimize taxes.
Making this move with my kids adds further value. Beyond the tax benefits, it offers them stability, a chance to explore the neighborhood, and create lasting memories. The tax savings can be redirected toward their education, extracurriculars, or even a family vacation.
Proper documentation of rental agreements, income records, and evidence of rental activity is essential to comply with IRS rules. Working with a financial advisor can help optimize the plan and avoid unexpected taxes or penalties. By leveraging Section 121 and 1031 exchanges, I can reduce my tax burden and turn a rental property into a cherished family home.
Published On: April 22, 2025
