Don’t Gift That Property — Step-Up in Basis & Estate Tax Planning for Highly Appreciated Real Estate

00:00] Welcome back everyone. Stefan Morris here with advisory. And today, we're gonna dive a little further into estate taxation, specifically around the topic of what happens to real estate as it is highly appreciated, and what are some tax planning strategies to avoid a certain trap. Today, have Ashton Asher here with Asher Law Group, and he's gonna give us a little bit of a primer on what to do in terms of estate taxation planning on your highly appreciated real estate assets. So let's dive into this here.

[00:26] Here's the typical play, and especially here in Los Angeles, we've seen a huge surge in valuations. Let's call it over the past thirty to forty years, and maybe your mom or dad bought a piece of property in the nineteen eighties, a rental property perhaps, a duplex or a triplex. It's been generating some very good rental income. They bought it for $300,000. And today, the broker comes up to you and says, do you know I could sell your property for $3,000,000?

[00:53] Does that interest you at all? Of course. It sounds like a great outcome to me. What are some considerations around this highly appreciated asset as it relates to when your parents are transferring it to you, either through life or through the estate taxation? It's amazing how often I have prospective clients reach out to me and say that I wanna avoid the estate tax, so I'm gonna transfer my property to my kids while I'm alive, and then we don't have to worry about it.

[01:21] That seems easy. Right? Easy enough. Yep. You find a deed and you've transferred it over.

[01:25] Big loophole around this the death tax. Right? And I'm not even gonna get into property taxes at this juncture. Yeah. The estate tax is only applicable to individuals with estates over $15,000,000.

[01:37] Okay. Or couples with some basic planning and a tax return filed, a couple can transfer 30,000,000 without estate taxes. So a fair number of people are not subject to estate taxes. Yeah. So that shouldn't be their motivation for making a transfer.

[01:53] And we should pause here. If that is a big problem for you, you've done pretty well in life, just to be very clear here. That's a that's called a quality problem to consider. Right? Absolutely.

[02:01] In the LA area, especially, a good portion of our clients have estates over $30,000,000. Yep. But let's just focus in on the typical person Yep. Like myself who doesn't have an estate over $30,000,000. In my opinion, bar none, the biggest loophole in the tax law is what we commonly refer to as the step up in basis.

[02:21] Yep. And essentially that means that the government is gonna forgive all the taxes on the appreciation of your assets when you pass away. I reiterate, when you pass away. Yep. And so when you transfer something while you're alive and you it's no longer your asset when you pass away, you forego that loophole.

[02:43] And so essentially, I don't have to explain it to you. What that means is that if you buy a property for 300,000 and it's worth 3,000,000 and your children inherit that property, it's as if they bought it for $3,000,000, not 300,000 like you did. In contrast, if you give it to them while you're alive, then from that point forward, whatever your cost basis is will be their cost basis. If it was 300,000, it'll be 300,000 for them. In the context of rental real estate, it'll even be worse than that because you take depreciation deductions every year Yep.

[03:18] To lower your income tax from the rental income, and so your cost basis actually drops below $300,000 over time. And you may have a very low cost basis, and then you transfer it to your children, and they're straddled with that same low cost basis. By keeping it and letting them inheriting it after you die, you completely avoid that. Your children get a new step up in basis. They can sell it for 3,000,000 or if they want to, they if they're keeping the property, they can start depreciation deductions all over again.

[03:49] At the $3. Is much more advantageous So to so let's be clear here. If there's one thing to take away from all this, if you were under that lifetime exclusion, that lifetime exemption of the $15,000,000 per person or $30,000,000 jointly, you would never, never give away such highly appreciated assets like the situation we're talking about here. Let's say you own the 300,000 asset. It's worth $3,000,000 today.

[04:15] You have 5,000,000 or $6,000,000 in assets, well under the exclusion. We would never give this away during life. We would wait till death, then it would pass down to the kids through the estate the estate method, and you would see the step up in basis move up to that amount. Just to be very clear, that's a TLDR in case you didn't wanna, like, watch all this video, This is the most important takeaway point that you gotta have here. And you certainly shouldn't use it as an alternative to writing a trust because you just think it's easier to just transfer to your children while you're alive and not have to do it.

[04:46] Yeah. Absolutely. Okay. So that covers what happens if you're under that lifetime exclusion. But what happens if you're over it?

[04:53] Your parents are over $30,000,000, you're over $30,000,000 with your spouse. What what then? What's the consideration? Well, the estate tax on the amount over the about 15 or $30,000,000 is 40%. It's fairly hefty.

[05:11] And a lot of the strategies we employ to reduce that estate tax, unfortunately, is contradictory to what we just discussed about getting the step up in basis. Yep. So what we oftentimes do to reduce the estate taxes, unfortunately, involves transferring assets as we just told you not to do for families with smaller estates, and transferring your cost basis to your children. But I wanted to bring up one relatively simple strategy that high net worth clients can consider that could reduce estate taxes without too much complexity. The concept is a valuation concept.

[05:53] Yep. If you own a property that's worth a million dollars and you pass away, when we value it for the IRS, we have to say the property was worth a million dollars. On the other hand, if you own a property that's worth 2,000,000, let's say, but you have a 50% interest in that property. You have a partner, And so your 50% at that point is not worth 1,000,000 even though the whole property is worth 2,000,000. Sure.

[06:20] Under valuation principles and really common sense, nobody wants to be partners with someone else if they can avoid it. Yep. If you if you try to list your 50% interest in a property, you'll be hard pressed to find a buyer who's gonna be Your market's gonna be this small. Yeah. And so the idea is that the appraiser are gonna say, yes, the property is worth 2,000,000, but your 50% is worth less than 1,000,000.

[06:45] Sure. And so they take valuation discounts is what we refer to them for lack of control, lack of marketability, and so reduce it by about 30%, 35%. I've seen 37%. And so that that by in and of itself can reduce your potential estate tax liability. So our first step when we have families with high net worth over the $30,000,000 threshold is to make sure that they don't have a 100% interest in anything.

[07:16] Yep. We set up LLCs. We transfer at least small percentages of these LLCs to their children while they're alive so that when they die, they don't have a 100% interest and we can reduce the values that way. Yep. That makes perfect sense to me.

[07:32] And and again, it just makes logical sense. If you're trying to buy one third of a property, it's not gonna be worth one third of the whole property because the marketability is lower. You gotta get into bed with other owners theoretically. It's just not the right way to own real estate. This type of valuation method is probably one of the best ones.

[07:49] It doesn't help us on the income tax side though. Gotta warn you about that. So you're still gonna get this much smaller, much lower cost basis than even this discounted for market value would be in most circumstances. Right. Unfortunately, the more we're able to reduce the value of your estate for estate tax purposes, we also get the equivalent lower step up in basis.

[08:10] Yeah. So to be clear, when we're starting to move into this realm of getting past the lifetime exclusion, getting around to being subject to estate tax, we have to work together hand in hand to make sure all aspects are considered. We're talking about income tax planning and estate tax planning. We can work in tandem to kind of achieve the right results. Sometimes we have to pick and choose.

[08:29] We can't have our cake and eat it too. Well, what I enjoy working with you one of the one of the many reasons I enjoy working with you is that when properties are held in partnerships or LLCs, we have to adjust the basis when a person dies. Yep. And there are two types of basis, your shares in the LLC as well as the an underlying real estate. And to get that adjustment, you have to make what is called the seven fifty four election.

[08:54] Yep. And a fair number of accountants I've dealt with didn't even know what a seven fifty four election is. And so you're on top of it, and we make sure that we get whatever advantages we can when a person passes away. Yeah. And to be clear, if we're talking about the step up in basis, it's basically that that step up now gets this special allocation in partnerships.

[09:15] It's what we're talking about here, where then whoever's the heir of this particular share, this particular piece of property is now gonna have an increased basis. They can convey their portion of the property with less of of its income tax consequence. And more importantly, it unlocks more depreciation deductions as well. Yeah. On a step up basis.

[09:32] All the time, you get clients who lost someone, years have passed, and their accountant didn't talk to them about the seven fifty four election. And unfortunately, it's too late. It's way too late. You gotta do it the year it happens. If it's if another tax year crosses, it's over.

[09:47] You gotta wait till many, many years later when the property is ultimately disposed of, and it's it's a it's a really bad tax outcome overall. Yeah. We've seen that a lot. We've seen a lot of tax returns where seven fifty four elections were not taken, and we have to inform our clients sorry. Can't even go back and amend.

[10:02] It is what it is. So I hope you guys found this, really helpful, especially as it relates to what happens to your property when you're gonna pass it on to your heirs. What happens when real estate that becomes highly appreciated has certain tax consequences around it, not just income tax consequences. We're also talking about estate taxation. We learned overall that if you're under the exclusion, never wanna gift it.

[10:26] Never. Okay? However, if we're over the exclusion, then we start to bring in interesting concepts like valuation techniques, other sorts of considerations like that, which will greatly help your tax consequences out on the estate side. We do have to work together on this. And so if you start to have issues like this that you wanna consider, whether you're under or over, if you just wanna explore this topic more, then feel free to reach out to us right here, and we'll be more than happy to assist you as it relates to planning around your highly appreciated real estate.

[10:54] Thank you so much for watching.