Building a Lasting Legacy with 1031 Exchanges

When thinking about 1031 exchanges, it’s crucial to adopt a long-term perspective — often stretching far into the future.

As Benjamin Franklin wisely noted, death and taxes are the only guarantees in life. While we can’t avoid the former, astute real estate investors have uncovered an appealing loophole for the latter: taxes can be deferred, sometimes for a lifetime, using the strategic advantages of 1031 exchanges.

By leveraging these like-kind exchanges, investors have found numerous ways to postpone capital gains taxes — and in some cases, eliminate them entirely. This powerful tax-saving tool has become such a staple that many seasoned investors now rely on it as a core part of their estate planning strategy.

What is a 1031 Exchange?

A 1031 exchange allows investors to defer capital gains taxes when selling one investment property and reinvesting the proceeds in another like-kind property. By following the guidelines set forth in the Internal Revenue Code, an investor can sell a property and purchase another of equal or greater value, deferring not only capital gains taxes but also depreciation recapture taxes.

While some circumstances require selling investment real estate before death (which can trigger hefty tax liabilities), for those who can hold their assets, a 1031 exchange becomes a powerful tool for preserving and passing on financial gains without burdening their heirs with significant tax obligations.

Preserving Wealth Through the Step-Up in Basis

One of the most powerful benefits of utilizing a 1031 exchange as part of your estate planning is the ability to take advantage of the step-up in cost basis upon death. This unique feature can dramatically reduce or even eliminate the tax burden for your heirs when they inherit your real estate assets, allowing you to pass on your wealth more efficiently.

What Is a Step-Up in Basis?

The step-up in basis refers to the adjustment of the value of an inherited asset for tax purposes to its fair market value at the time of the original owner’s death. In the case of real estate, this means that your heirs won’t owe capital gains taxes on the property’s appreciation during your lifetime. Instead, they will only be taxed on any gains that occur after they inherit the property.

For example, let’s recap the story of Dennis Miller, who purchased an apartment building for $65,000 several decades ago. By the time Dennis reaches retirement, the property’s value has skyrocketed to $3.5 million. Had Dennis sold the property during his lifetime without engaging in a 1031 exchange, he would face substantial capital gains taxes on the $3.435 million in appreciation, as well as taxes from depreciation recapture. These combined tax liabilities could eat into a large portion of the profit Dennis has accumulated over the years.

Deferring Taxes with 1031 Exchanges

Instead of selling and paying hefty taxes, Dennis utilizes a 1031 exchange to defer those taxes. He exchanges the apartment building for three new rental properties, each valued at $1.2 million. Not only does this maneuver allow Dennis to defer the capital gains and depreciation recapture taxes, but it also offers him the flexibility to distribute these properties to his three children in his estate plan.

Now, let’s consider what happens upon Dennis’s passing. Each of his children inherits one of the properties, which are now collectively worth $3.6 million. Under the step-up in basis rule, the children won’t owe capital gains taxes on the increase in value during their father’s ownership. Instead, the cost basis of each property is “stepped up” to its current fair market value, which is $1.2 million for each child.

How This Benefits Heirs

This step-up in basis is an enormous tax-saving tool. The heirs are free to sell the properties at their stepped-up value with no tax liability on the gains Dennis experienced over his lifetime. If they choose to hold onto the properties, they will only be taxed on the appreciation from the date of their inheritance to the date they decide to sell.

In this case, each of Dennis’s children has two primary options:

1. Sell the inherited property: They can sell their property at the new stepped-up value, potentially walking away with a tax-free inheritance, as they are not liable for any capital gains taxes on the $3.435 million in appreciation that occurred during Dennis’s ownership.
2. Continue the 1031 exchange strategy: If they wish to keep building their wealth, the children can engage in their own 1031 exchanges. By exchanging their inherited properties for new like-kind investments, they can defer capital gains taxes indefinitely, following in their father’s footsteps.

Multigenerational Wealth Preservation

By strategically using 1031 exchanges in conjunction with the step-up in basis, Dennis has not only preserved his wealth but has also provided his children with a flexible, tax-efficient means of managing their inheritance. In many cases, this approach can lead to multigenerational wealth building, as the cycle of deferring taxes through 1031 exchanges can continue with each generation.

If Dennis’s children decide to follow his example, they can repeatedly defer taxes on their real estate gains by engaging in subsequent 1031 exchanges. Over time, a relatively modest original investment, like Dennis’s $65,000 apartment building, can be converted into millions of dollars in assets — all while deferring taxes for decades, and possibly forever.

A Win-Win for Investors and Their Heirs

The step-up in basis combined with 1031 exchanges is a win-win strategy. Investors like Dennis are able to maximize their lifetime wealth and pass on substantial assets to their heirs without burdening them with massive tax bills. By doing so, investors ensure that their hard-earned success benefits their families for generations to come.

In summary, the step-up in basis allows heirs to receive real estate at its fair market value at the time of the original owner’s death, potentially eliminating significant tax liabilities. When paired with the strategic use of 1031 exchanges, this tax benefit becomes a cornerstone of effective estate planning, helping to preserve and grow family wealth across generations.

The ‘Swap Till You Drop’ Strategy

The term “Swap Till You Drop” is a widely recognized strategy among savvy real estate investors who use 1031 exchanges to continually defer capital gains taxes throughout their lifetime. It refers to the practice of continuously exchanging one investment property for another, larger, or more lucrative property, thereby deferring taxes indefinitely — until the investor passes away. At that point, the step-up in basis eliminates the deferred capital gains tax, allowing heirs to inherit the property tax-free.

This strategy allows investors to grow their wealth significantly while legally deferring tax liabilities, and it can be repeated as many times as necessary or desired. Let’s break down how this works in practice and why it’s a powerful tool for long-term wealth creation.

Unlimited 1031 Exchanges

One of the most attractive features of the 1031 exchange is that there is no limit to the number of times an investor can utilize it. Whether you want to diversify your portfolio by moving into different types of real estate assets or upgrade to larger, more valuable properties, you can use 1031 exchanges repeatedly throughout your life to defer capital gains and depreciation recapture taxes.

For example, if you originally invest in a $500,000 rental property and that property appreciates to $800,000, you can sell it and reinvest in a more valuable property, say one worth $1 million, using a 1031 exchange. The taxes on the capital gains from your original property sale are deferred, and the cycle of deferring taxes continues as you move up to increasingly valuable properties.

Compounding Wealth with Successive Exchanges

The ability to exchange up to higher-value properties allows for compounding wealth growth. Let’s continue with the example of Dennis Miller’s family. Dennis utilized a 1031 exchange to trade his $3.5 million apartment building for three rental properties, each valued at $1.2 million, thereby deferring his capital gains and depreciation recapture taxes. But the true power of 1031 exchanges emerges when this strategy is passed down to future generations.

Imagine Dennis’s daughter, Tiffany, inherits one of the properties, now worth $2 million, with no tax liability due to the step-up in basis. Tiffany decides to embrace the “swap till you drop” strategy to grow her wealth. She follows these steps:

1. First Exchange: Tiffany sells her $2 million property using a 1031 exchange and purchases a larger investment property worth $2.5 million, deferring all capital gains taxes.
2. Second Exchange: After holding the $2.5 million property for a decade, it appreciates to $3 million. She once again uses a 1031 exchange to upgrade to a $3.5 million property, continuing to defer taxes.
3. Third Exchange: As she approaches retirement, Tiffany exchanges her $3.5 million property for a prime investment property in Southern California, valued at $4 million, using yet another 1031 exchange.

By the time Tiffany reaches retirement, a fraction of Dennis’s original $65,000 investment has grown into a $4 million asset, all without incurring a single dollar in capital gains taxes. Tiffany can continue to enjoy the income from her investment, knowing that when she passes, the property will once again receive a step-up in basis, allowing her heirs to inherit it without tax liability.

The Power of Deferring Taxes

The key benefit of the “swap till you drop” strategy lies in the continuous deferral of taxes. By never selling a property outright and always engaging in a like-kind exchange, investors can:

• Avoid Capital Gains Taxes: Each time an investor sells an appreciated property, the capital gains taxes are deferred. Instead of paying taxes, the investor can use the entire proceeds from the sale to reinvest in a higher-value property, which increases their potential for future returns.
• Defer Depreciation Recapture: In addition to deferring capital gains taxes, investors also defer depreciation recapture taxes, which can be significant, especially for long-held properties.
• Expand and Diversify: With each exchange, investors can diversify their portfolios by moving into different property types, locations, or sectors. For example, an investor might start with residential rentals but later move into commercial real estate, industrial warehouses, or even vacation rental properties — all while deferring taxes.

This strategy is not only about increasing wealth but also about preserving that wealth for future generations. Investors can continue deferring taxes until death, at which point the step-up in basis eliminates all the deferred liabilities. In other words, the taxes that were deferred over a lifetime of exchanging properties are effectively erased when the property is inherited by the next generation.

A Legacy of Tax Deferral

For those looking to build a legacy, the “swap till you drop” approach is ideal. It allows investors to benefit from the appreciation of their properties without the burden of tax liabilities that often accompany such growth. Moreover, this strategy is particularly attractive for real estate investors who want to pass their wealth onto their children or heirs in a tax-efficient manner.

When Tiffany’s children eventually inherit her $4 million property, they, too, will receive it with a stepped-up basis. They could:

1. Sell the property tax-free at the stepped-up value, reaping the full benefits of their inheritance.
2. Continue the 1031 exchange cycle, deferring taxes indefinitely by repeating their mother and grandfather’s strategy.

This continuous cycle of deferral and step-ups in basis ensures that the Miller family’s wealth continues to grow without the erosion of taxes, providing a strong financial foundation for generations to come.

The Flexibility of the 1031 Exchange

Beyond the tax deferral benefits, the “swap till you drop” strategy provides flexibility to investors:

• Portfolio Customization: Investors can use successive exchanges to reallocate their portfolios, shifting from properties with high maintenance costs or management demands to those that are easier to handle.
• Geographic Diversification: Real estate markets are constantly changing, and 1031 exchanges allow investors to shift their investments geographically to take advantage of growing markets or more stable investment environments.
• Adjustment to Life Stages: As investors grow older, they might want to transition from active property management to passive investments. 1031 exchanges offer the opportunity to move into passive real estate vehicles, such as Delaware Statutory Trusts (DSTs), where investors can receive income without the hassle of day-to-day management.

The “swap till you drop” strategy is an essential tool for real estate investors looking to grow their portfolios, defer taxes, and pass on wealth to future generations. By repeatedly using 1031 exchanges, investors can leverage the power of tax deferral to build a lasting legacy, while the step-up in basis at death provides a clean slate for their heirs. At 1031 Exchange Place, we’re here to help you explore and implement this strategy, ensuring your real estate investments continue to grow and thrive for generations.

Transitioning to a Passive Investment with DSTs & TICs

As real estate investors approach retirement or simply seek to reduce their day-to-day responsibilities, transitioning from active property management to a more passive investment strategy becomes increasingly attractive. While owning and managing investment properties can be lucrative, it often comes with significant time and effort — tasks like handling tenant issues, maintenance, and administrative work. Thankfully, 1031 exchanges offer solutions for investors looking to continue benefiting from real estate ownership without the operational headaches: Delaware Statutory Trusts (DSTs) and Tenants in Common (TICs).

Both DSTs and TICs allow real estate investors to maintain the tax-deferred benefits of a 1031 exchange while stepping away from the burdens of property management. Let’s explore how each option works and why they are attractive to investors seeking a more passive role.

The DST Solution: Simplifying Ownership

A Delaware Statutory Trust (DST) is a passive investment structure that allows multiple investors to purchase fractional ownership in large, professionally managed real estate assets, such as apartment complexes, office buildings, or industrial facilities. The key advantage of a DST is that investors can enjoy the benefits of owning high-quality real estate without any involvement in its day-to-day operations.

Key Benefits of DSTs:

1. Passive Income: As a DST investor, you receive a proportionate share of the income generated by the property (such as rental income), typically on a monthly or quarterly basis, without the need to manage tenants or property maintenance.
2. Diversification: By investing in a DST, you can own a fraction of large, institutional-grade properties that may be outside your reach as a sole investor. You also gain the opportunity to diversify across different types of properties, geographies, or real estate sectors.
3. Limited Liability: The DST structure shields investors from personal liability associated with property management, meaning your risk is limited to your investment in the trust.
4. Ease of Estate Planning: Since DST interests are fractional, they are easily divisible in an estate, making it simple to pass on ownership to heirs. Moreover, the same 1031 exchange tax benefits are available to the heirs, allowing them to defer taxes indefinitely if they wish to continue investing.
5. Hassle-Free Management: Professional property managers handle all the operational aspects of the DST property, including leasing, repairs, and legal matters, allowing investors to remain hands-off.

The Downsides of DSTs:

• Illiquidity: Once you invest in a DST, your capital is typically tied up for the life of the trust, which usually lasts between 5 to 10 years. Selling your share before the trust dissolves can be challenging.
• Lack of Control: Investors have no say in the management decisions regarding the property, such as when to refinance, sell, or make improvements. All decisions are made by the trustee.
• Limited Timeframe: DSTs are not designed to last indefinitely. Most have a pre-defined exit strategy, such as selling the property after a set period, which may force investors into a taxable event if they do not perform another 1031 exchange.

Despite these limitations, DSTs remain a popular option for investors looking to retire from active property management while continuing to benefit from the growth and income generated by real estate investments.

The TIC Solution: Retaining Flexibility with Shared Ownership

Another option for investors seeking a more passive investment approach through a 1031 exchange is the Tenants in Common (TIC) structure. Like DSTs, TICs allow investors to own a fractional share of a property, but the ownership arrangement differs in several key ways that offer more flexibility.

What Is a TIC?

In a TIC structure, multiple investors each own an undivided interest in a property, meaning that each co-owner has a percentage share of the entire property rather than owning specific units or sections. Each investor retains individual rights to their portion of the property and is considered a direct owner for tax purposes. While TIC investors may have varying levels of involvement in property management, many choose to delegate these responsibilities to professional managers, making it a largely passive investment.

Key Benefits of TICs:

1. Direct Ownership: Unlike a DST, a TIC investor holds a deeded interest in the property, providing a greater sense of control and ownership. You own a percentage of the actual property, giving you direct participation in income and appreciation.
2. Flexibility and Control: TIC structures offer more flexibility than DSTs in terms of decision-making. Investors may have a say in major property decisions, such as selling, refinancing, or leasing, depending on the agreement.
3. Potential for Active Participation: While many TICs are structured as passive investments with professional property management, investors who prefer to take a more hands-on approach can choose to be involved in the management and operations.
4. 1031 Exchange Eligibility: TIC ownership is eligible for 1031 exchange treatment, allowing investors to defer capital gains taxes when they eventually sell their interest in the property and exchange into another like-kind asset.

The Downsides of TICs:

• Shared Decision-Making: While having a say in major property decisions can be a benefit, it can also be a challenge. All major decisions typically require unanimous consent from co-owners, which can lead to delays or disagreements.
• Management Responsibilities: Depending on the TIC structure, investors may still be involved in some property management decisions, which can take away from the “passive” nature of the investment. If you prefer to be completely hands-off, a DST might be a better option.
• Limitations on Number of Investors: TIC structures are generally limited to a smaller number of investors (typically no more than 35), which can restrict the size of the investment pool and the type of property that can be acquired.

Comparing DSTs and TICs: Which Is Right for You?

Both DSTs and TICs offer solutions for real estate investors looking to transition from active property management to more passive forms of ownership. However, the choice between the two depends on the investor’s goals, preferences, and desire for control.

Choose a DST If:

• You want a truly hands-off investment with no responsibility for property management or decision-making.
• You’re seeking diversification into large, institutional-quality properties that you might not be able to afford on your own.
• You value the simplicity and ease of estate planning, as DST shares are easily divisible among heirs.

Choose a TIC If:

• You prefer direct ownership of property and want to retain some control over property decisions.
• You’re comfortable with shared decision-making and willing to collaborate with other co-owners on major property issues.
• You like the idea of flexibility, with the option to be involved in the property’s operations, either directly or through professional management.

Tailoring the Right Passive Investment Strategy

As you approach retirement or simply want to shift away from the demands of active property management, both DSTs and TICs offer viable paths to maintaining the tax benefits of 1031 exchanges while enjoying passive income from real estate investments. Each structure has its pros and cons, so the decision should be based on your investment goals, desired level of control, and the kind of flexibility you need.

At 1031 Exchange Place, we can guide you through the intricacies of both DSTs and TICs, helping you determine which passive investment option best suits your needs. Whether you’re looking to diversify your portfolio with institutional-grade properties through a DST or retain more control with a TIC structure, we’re here to support you in every step of your 1031 exchange journey.

The Power of Estate Planning with 1031 Exchanges

1031 exchanges are not only a tax-deferral strategy but a powerful tool for long-term estate planning. By allowing real estate investors to defer capital gains taxes indefinitely, they offer a way to preserve and grow wealth over generations. This strategy is particularly beneficial when combined with the step-up in basis, which eliminates tax liabilities for heirs, enabling families to inherit properties with no immediate tax burden. The combination of 1031 exchanges and the step-up in basis can help build and maintain generational wealth, ensuring that assets are passed on in a tax-efficient manner.

For investors seeking flexibility, 1031 exchanges provide countless opportunities to grow and diversify their portfolios. Whether you choose to upsize properties, expand into new markets, or shift to passive investments such as DSTs or TICs, the ability to continue deferring taxes with each exchange is invaluable. Additionally, the “swap till you drop” strategy enables families to defer taxes for decades while optimizing their investment returns, all without triggering significant tax events during an investor’s lifetime.

At 1031 Exchange Place, we specialize in helping investors leverage the full potential of 1031 exchanges to achieve both immediate financial goals and long-term estate planning objectives. Our team can guide you through the complexities of this strategy, ensuring that your assets are protected and your heirs are positioned to benefit from your investments without facing hefty tax liabilities. With the right plan in place, you can build a lasting legacy that endures across generations.