1. Tax-Deferred Exchanges
Real estate investors can offset real estate capital gains or losses with a tax-deferred exchange. Section 1031 of the Internal Revenue Code allows real estate investors to sell property, take a profit, and defer capital gains or losses, as long as the proceeds are reinvested in real estate. Most real estate investors use 1031s to build long-term tax-deferred (or even tax-free) wealth. There is no limit on the number of 1031 exchanges you can do. For example, Susan buys Building 1 for $200,000, and re-sells it for $400,000, with a profit of $200,000. At the time of the sale, she will owe taxes on this profit; unless she does a 1031 exchange, in which case she can take the entire $400,000, and invest it in a more expensive Building 2, without paying any tax. She can then repeat this process for the purchase of Buildings 3, 4, 5, and so forth, generating a multi-million dollar fortune in non-taxed wealth. Essentially, the taxes can be avoided forever, because when Susan dies her heirs will get an automatic step-up in basis as of the date of her death, under Internal Revenue Code § 1014, for purposes of calculating their gain upon sale.
2. Investments in Rural Land
All except 1 of the 50 states have a “use-value assessment,” which allows land-buyers to purchase land and sell it at its assessed “use-value” rather than the “fair market value,” as with other types of real estate. This tax credit was originally intended to help farmers retain their land, but wealthy investors now use it as a tax shelter. In 2011, billionaire Michael Dell reportedly qualified his $71.4 million 1,757-acre ranch in Austin, Texas for this tax shelter (because family and friends occasionally use it to hunt deer) — reducing its assessed value to $290,000 (and saving him well over $1 million per year). Steve Forbes reportedly reduced the assessment of his multi-million dollar estate in New Jersey by approximately 90%, by putting a few cows on it. Former Presidents George W. Bush and Ronald Reagan have taken full advantage of these credits as well. Of course, this loss of property tax revenues can severely impacts schools, public services, and less wealthy taxpayers.
3. Dynasty Trusts
Dynasty Trusts are a form of irrevocable trust used by wealthy families to create generational wealth, by allowing descendants to remain exempt from estate, gift, and generation-skipping transfer tax for the life of the trust. The trust can be funded while you’re alive, or upon your death. In either case, your assets, like real estate, are placed within the trust. The biggest advantage of a dynasty trust is that it can save your descendants a significant amount of money in estate taxes. The assets you put in the trust (plus any increase in their value over the years) are subject to the federal gift/estate tax just once, when you transfer them to the trust. They are not taxed again, even though multiple generations benefit from them. By contrast, if you simply left a very large amount of money to your children (without a trust), it would be subject to the estate tax. And whatever they left to their children would be taxed again. For example, if you and your spouse leave $10 million to your daughter, and that inheritance grew, over 20 years, to $30 million, it would be subject to estate tax at her death—and if federal estate tax rates and exemptions in effect then were about what they are in 2015 ($5.43 million exemption, 40% top rate), more than $9 million would go to pay the daughter’s estate tax. That $9 million tax would not be owed if the money were in a dynasty trust.[This post is not intended to provide tax advice.] Read more