Estate Planning: What heirs need to know about inherited Delaware Statutory Trust (DST) real estate and IRS Section 1031 Exchanges.
When it comes to estate planning, many questions arise about how inherited investment real estate is managed, particularly regarding the implications of DSTs and IRC Section 1031 exchanges. This article delves into the key considerations for heirs who inherit such properties and the potential tax ramifications they may encounter.
Imagine a scenario where Grandpa owns an investment DST acquired for $200,000, with an adjusted basis of $100,000, and a current market value of $500,000. If he sells the property using a 1031 exchange before passing away, he can defer capital gains taxes. However, if he opts to sell outright without utilizing a 1031 exchange, he will face a 25% depreciation recapture tax on the $100,000 depreciation, along with a 20% capital gains tax, and a 3.8% Affordable Care Act tax on the $300,000 gain—resulting in a total tax burden of $96,400, not including possible state taxes.
Upon Grandpa’s death, the DST interest transfers to his heirs with a “step-up in basis.” This crucial provision adjusts the property’s basis to its fair market value at the time of death—in this case, $500,000—effectively deferring capital gains and depreciation recapture taxes indefinitely.
If Grandpa has a valid will, the DST property interest will be distributed according to his wishes. However, without a will, or if the will is contested, the estate will go through probate. During this process, a court-appointed administrator will oversee the distribution based on state laws.
If Grandpa’s descendants inherit the $500,000 DST interest in Pennsylvania, for example, they will owe $22,500 in state inheritance taxes but no federal estate tax as long as the total value of Grandpa’s estate is less than the lifetime exclusion ($13.61 million for individuals for 2024). They could choose to sell the property to cover this tax, benefiting from the stepped-up basis that eliminates immediate capital gains tax. Alternatively, if they pay the tax from their own funds, they can retain the property as an investment, with future capital gains calculated based on the $500,000 basis instead of the original $100,000.
For estates exceeding $13.61 million, federal estate taxes come into play. States such as Oregon and Connecticut impose their own estate taxes above specific thresholds, while others, like Pennsylvania, levy inheritance taxes on heirs. For instance, in Pennsylvania, heirs might face a 4.5% inheritance tax on the value of the inherited property.
However, due to the illiquidity of most alternative real estate investments, the value of the portfolio is discounted by as much as 50% to reduce the investor’s estate value for estate and gift tax purposes. The lifetime exclusion for estate tax purposes is $13.61 million in 2024. The exemption is adjusted for inflation every year, and it is allowed for both spouses in a married couple. However, the exemption amount is set to sunset and return to pre-2018 levels of $5 million (indexed for inflation) in 2026, unless the tax law changes.
If the value of the estate is less than the lifetime exclusion, then the properties pass to the next generation tax-free. If the value of the investor’s estate including the alternative real estate investment portfolio is over the lifetime exclusion, then the 50% discount helps to bring the total value of the estate under the lifetime exclusion amount or provides for lower marginal estate tax rates
After holding the property for several years, heirs may consider a 1031 exchange to defer capital gains taxes. This strategy allows them to relocate the property, invest in new assets, or explore a Delaware Statutory Trust for more passive management.
Inherited investment DST real estate poses intricate tax and estate planning challenges. It’s essential for investors to incorporate these assets into their estate planning strategies. Consulting with financial planners, attorneys, and accountants can provide valuable insights and guidance, helping heirs navigate these complexities with confidence.