How the Rich Create Generational Wealth Through Real Estate
Have you ever wondered why so many rich people invest in real estate? There are many reasons, but the biggest ones usually have to do with taxes. In this post, I won’t touch on all the benefits of real estate investing; instead, I’ll focus on one tax-efficient strategy that can truly create generational wealth -- assets passed down from one generation to the next. And the great thing about it is that anyone can use this technique, not just the wealthy!
Before I walk through the details, we first need to understand a few real estate investing concepts:
Depreciation. A technique that allows an investor to take a sizable tax deduction against their rental income due to the physical building “depreciating” over time, which can drastically reduce their tax burden over the years.
Depreciation recapture taxes are due when the investment home is sold. The total amount of depreciation taken by the investor over the duration of homeownership must be taxed as ordinary income (since they didn’t pay taxes on that amount during that time). Depreciation recapture taxes are currently capped at a 25% tax rate, even if your marginal tax rate for the year is higher than that - yet another neat tax benefit from real estate investing!
1031 Exchange. The process of exchanging an investment property for 1 or more properties of equal or greater value. When you do this, the investor is allowed to defer payment on their capital gains from the home sale and depreciation recapture taxes.
To clarify these concepts and how they’re used, let’s briefly walk through a hypothetical 1031 exchange where we pretend you’re the real estate investor!
Year 2016: $100,000 purchase price of an investment property
Year 2021: The property’s market value is now $150,000
The past 5 years of owning the investment property, you’ve depreciated roughly $15K of the physical home, effectively reducing your tax burden by $15K over that 5-year time period.
You decide to sell the property in 2021 to realize a $50K profit ($150K - $100K), which will be taxed as long-term capital gains since you held your investment for 5 years. Additionally, you have to pay depreciation recapture taxes on the $15K of depreciation you deducted on your property during the past 5 years. This amount would be taxed at your ordinary income tax rate. So the total amount you owe taxes on is $65K.. ouch!
To avoid paying both capital gains and depreciation recapture taxes this year, you decide to use a 1031 exchange. Doing so allows you to roll your invested money to a different property you will purchase in the coming months. Additionally, you get to defer payment on all your taxes until after you sell your soon-to-be-purchased investment property, thereby paying $0 in taxes for the current year!
Before we move on to the topic of using real estate to create generational wealth, I wanted to call out yet another reason to use a 1031 exchange. By deferring your capital gains taxes on the sale of your property, you’re essentially investing pre-tax dollars into your next property. If you don’t 1031 exchange, you’d have to pay taxes (assuming there’s a gain) and then use your post-tax dollars (a smaller amount leftover) to invest in your next property. Personally, I think the best reason to avoid a 1031 exchange is if the sale of your property results in a loss or a gain with an insignificant tax bill. Otherwise, I prefer to let a larger, pre-tax amount continue to roll into my next investment properties.
Alright, now that we understand the power of a 1031 exchange, imagine using them until the day you die, deferring your tax payments indefinitely. That begs the question, “Would your heirs be responsible for a giant tax bill when they inherit your real estate empire?” Fortunately, the answer is “no.” At least, not under current tax laws.
Your heirs receive a step-up in cost basis equal to the fair market value (FMV) at the time you pass. This means that if you purchased a property for $100K but it was worth $200K when you passed, your heirs would essentially be able to claim that their purchase price was $200K. So they could theoretically sell the property immediately & pay $0 in taxes ($200K cost-basis minus $200K sale price).
However, when your heirs inherit your assets, they would normally have to pay hefty taxes on the estate. For example, if you pass on hundreds of thousands or even millions’ worth of assets to your heirs, they’d have to pay a very large amount of taxes on that inheritance. However, under current 2021 federal tax laws (set to expire in 2026), married couples can leave up to $23.4 million to their heirs without them having to pay any federal estate tax! Granted, they’ll have to pay a flat 40% tax rate on anything over $23.4M, but I’d hardly consider that a “problem” at that point!
All in all, combining the power of the 1031 exchange and current inheritance laws is the ultimate tax-efficient strategy to build generational wealth. This real estate strategy is sometimes known as the “swap till you drop” method since you keep swapping property after property over the years until you die. While the phrase is a bit insensitive and the approach can be a tad morbid to think about, the goal of this method is to ultimately avoid paying taxes on a lifetime of capital gains and depreciation recapture taxes. Why else do you think the ultra rich love real estate so much?
