If you are a real estate investor, and you are holding a property or properties for either appreciation or rental income, this is going to be very interesting for you.
Especially if you’re in the middle- to-later stages of your life.
Have you ever heard the story about a man who plants a tree, knowing he won’t be alive long enough to enjoy its shade?
This is one of those things.
If you think often about your children’s future as many of us do, it can be said that you do, in fact, benefit from this. You benefit from the indirect, satisfying knowledge that you’re taking excellent care of your descendants.
Here’s how this works: if you are either holding vacant property or leasing property for rental revenues, hang onto it until you pass over to the next realm.
We’re assuming, of course, you’re going to create a last will and testament, and have it properly notarized.
As long as the sum of all of your bequests to any one person is less than $12,920,000 in 2023, your heirs will pay no tax on the gains. That’s one thing, but that’s not even the really good part.
The really good part is that your property magically becomes more valuable upon your passing, meaning that if your daughter or children or spouse sells the property, they are going to pay less tax when they close that sale, too.
Potentially quite a lot less.
That assessment of value, by the way, is the original value. In other words, the amount you subtract from the sale price at closing. This is what’s known as a step-up in basis.
How it Works
Let’s say you are in your twilight years, like maybe 92 years old, and you bought property back in 1995 for $150,000. Now, 27 years later, it’s shot up in fair market value to $900,000.
We’re assuming from this example that this is an investment property you haven’t lived in yourself in the past five years. So…
If you sell it at this point, say to cover medical expenses, or just to travel the world one last time, you will pay tax on a gain of $750,000. Does that make sense? Your cost basis is $150K, you pocket $900K, the IRS wants their unfair share of the gain on that sale.
Yes, that would certainly be at a favorable capital gains rate, but 15% of $750,000 is $112,500, and 20% is $150,000. Ouch!
However, on the day you die your heir (let’s say for simplicity you have one daughter) takes possession of the property, the cost basis is “stepped-up” to $900,000.
If she chooses to sell the property later that year, and closes for $920,000, she pays tax on a gain of just $20,000. 15% of that is only $3,000.
That’s more like it. Right?
The Amazing Thing is…
The typical investment strategy of investing in IRA’s and 401k’s, or the market in general can yield some juicy compounding.
I went to an official data website on S&P statistics from 1995 to 2022 (27 years), and under their assertion that the ROI has averaged 9.8% per annum in that period of time, the same $150,000 left entirely alone would be worth $1,872,209.
The power of compounding. Einstein was quoted as saying, “Compound interest is the eighth wonder of the world. He who understands it, earns it … he who doesn’t … pays it.”
Nice.
This has a LOT of assumptions, not least of which is the investor’s stomach for leaving it the hell alone during periods like the Great Recession of 2008, but let’s say the math is sound.
With the investment, our dearly and recently departed grandfather got to enjoy the revenue-producing nature of the property while he was alive, plus one other biggie…
At 27 years he got to write off depreciation the entire time he owned it! Over $5,400 a year, in fact.
Let’s add to that the assumption that our S&P investor kept this juicy nest egg to himself well past the age of 80. Who does that?
Not me. I want to make a hard landing at the finish line, wipe off my brow, and say, “Man, what a ride!”
We could argue the merits of numerous investment strategies today, but I really just want to leave you with a thought to ponder.
If you’re over 55, and are already engaged in the ownership and renting of real property, you would do well to consider hanging on to it, ‘til death do you part.
Your children will have one more reason to thank you later.