Why exchange when capital gains taxes are so low?

In 1997, the Federal tax law was changed to lower the tax rates on long term capital gains. For some gains, for some people, the federal rate could be as low as 10%. However, if there was any depreciation claimed, or which could have been claimed, on the property, that portion of the gain will have a Federal tax of 25%. Toss in the state tax and you’re looking at a nominal tax of 30 to 35%. The actual effective tax is very often as much as 60% due to the higher adjusted gross income triggering the taxation of Social Security benefits and the loss of personal deductions and exemptions.

I often hear of people who think doing 1031 (aka Starker) exchanges on real estate is a waste of money because it just postpones and doesn't actually eliminate the inevitable payment of capital gains taxes.  It is not true that the tax will always eventually be due.   It will be if you end up selling the property before you pass away.  Likewise, if you gift the property to someone else, that person will also receive your cost basis and potential capital gain.

However, if you pass away and leave the property in your estate, all of the accumulated gains are literally wiped off the books.  Your heirs receive the property at a! stepped up cost basis of its fair market value as of the data of death.  Because inheritances are tax free to the recipients, your kids can sell inherited property and have no capital gain.  In fact, they often end up with capital losses after counting the selling costs, such as Realtor commissions.  We call this the ultimate escape from taxes.  The phrase we like to use to describe this is "swap 'til you drop."

This is definitely a big win-win deal for people whose estates are under the taxable threshold.  For those people with estates subject to estate tax, there is room for some tax strategizing in terms of valuations to use on the 706.  Since estate tax rates are higher than capital gains rates, lower values on the 706 generally reduce the overall tax hit.   

There may or may not be a change in this escape from taxes.  The currently phasing in changes to the estate tax is scheduled to eliminate the step-up basis in 2010 and require heirs to carry over the same cost basis as the decedents.  That will only become real if our rulers in DC don't mess with that law between now and 2010, which is not too likely to be the case.

KMK