Johann Sebastian Bach and Wolfgang Amadeus Mozart are among the greatest Western composers who ever lived, and their lives were similar in many ways. Both came from families with a rich musical heritage. Both of their mothers died when they were children.
Both obtained their first court musician position at age 17. Both married women from musical families, and both left the world a rich musical legacy. Neither Bach nor Mozart was wealthy, but both left their children with musical legacies.
Bach was married twice and had 20 children, seven with his first wife and 13 with his second wife. Ten of Bach’s children survived to adulthood.
Four of Bach’s sons became composers whose work is still performed. Composition was not an option for women at that time, but one of his daughters was a singer, another married a composer, and a third (who never married) was closely acquainted with Beethoven. Also, one of Bach’s grandsons was a composer. Bach lived to the age of 65. His last known descendant died in 1871, 121 years after his death.
Mozart had six children, only two of whom survived to adulthood. One of Mozart’s sons was a musician. Mozart died at the young age of 35, and his sons had no children. So, Mozart’s genetic line ended in 1858, 66 years after his death.
Few can leave future generations with a musical legacy like Bach and Mozart. However, many hope to leave our children and grandchildren a financial legacy. This article discusses the role of real estate and the tax benefits associated with that long-term investment in building generational financial wealth.
How Families Can Build Wealth With Real Estate
The most basic real estate investment is a home; for many people, their home is their largest single asset. Since real estate historically has increased in value over time, buying a home can be a way to grow wealth while also providing shelter.
Most people pay only 20% of their home’s purchase price in cash and take out a mortgage loan to pay the rest of the purchase price. Known as “leverage,” using debt to purchase a home is one economic benefit of buying real estate; the purchaser benefits from 100% of the gain on the property’s value while investing only part of that amount in cash.
After someone has owned their home for many years, they likely have paid off their mortgage. At that point, they own the property “free and clear,” and the home is a valuable asset they can pass on to the next generation.
However, home ownership isn’t the only way someone can build wealth using real estate. People also may build wealth through commercial real estate.
Commercial real estate can build wealth when used in a family business, such as when a restaurant owner owns the building where their restaurant is located. People also may build wealth through real estate investments.
Someone may start small by buying two- or four-unit residential buildings they can rent. Others may pool their investments with friends to buy a larger property or a vacation home they can rent when they aren’t using it. Some might invest in a REIT or real estate fund.
How Inflation and Interest Rates Affect Real Estate
Real estate can help investors and even homeowners hedge against inflation since real estate often increases in value during inflationary times. Rents from investment real estate are likely to increase due to inflation, resulting in higher revenue. Expenses also can increase during inflation, but increases in some expenses, such as real estate taxes, may lag behind inflation, enabling investors to benefit. However, interest rate increases triggered by inflation may minimize or eliminate this benefit if the real estate is secured by a mortgage loan with a floating interest rate.
High interest rates may make it difficult to sell a home, which can put downward pressure on home values. Interest rates can even cause real estate values to drop during inflationary times since investment real estate usually is purchased based on a market capitalization rate (cap rate).
When interest rates are high, investors will require a higher return on their real estate investments for them to be more attractive than more secure investments like bonds. If net cash flow from the real estate doesn’t increase sufficiently to offset the higher cap rate, the real estate’s value may decrease.
For example, suppose a rental property produces $30,000 per year in net income when bonds pay 3.0% in interest. If inflation pushes the bond interest rates to 5.0%, investors will want a commensurately higher return on their real estate investment.
Real estate investors learn that some asset classes can better weather inflation than others. For instance, most apartment leases are only for one year, allowing the landlord to quickly adapt rental rates to inflationary market conditions. But most office and retail properties have longer-term leases of five years or more. Although longer leases can provide a more stable property revenue, they also can make it more challenging for owners to increase rental revenue to match inflation.
It’s important to view real estate as a long-term investment. Homeowners and investors who hold their real estate investments through inflationary times and the recovery are likely to experience gains — especially if the real estate is secured by a fixed-rate mortgage with a below-market interest rate.
How Tax Laws Help Real Estate Owners Build Generational Wealth
Real estate can also provide owners tax benefits while building generational wealth. Passing a home to future generations can result in income tax savings for both generations. When someone sells real estate, they must pay income tax on the increase or gain in the home’s value over the purchase price after selling expenses.
For home sales, there is no tax on the first $250,000 ($500,000 with a spouse) in gain. But after that, depending on the homeowner’s tax bracket, anywhere from 10% to 37% of that gain in value will go to the federal government. Plus, depending on the home’s location, they may have to pay state or local income taxes on the gain.
However, if the owner doesn’t sell their real estate and it passes to their children upon their death, the children will receive a “stepped-up basis” on the real estate for income tax purposes. When the children sell the property, they will only pay income tax on the increase in value after the original owner’s death.
Assume an unmarried homeowner purchased their home in 1960 for $50,000, and in 2023, the home is worth $550,000. If the homeowner sells the home, there would be a gain of $500,000 (the $550,000 sale price minus the $50,000 basis). The homeowner would have to pay income taxes on $250,000 of that gain.
However, if, instead, the homeowner dies and their child inherits the house, the child’s basis of the home for tax purposes would be $550,000. If the child sells the home immediately for $550,000, they would not have to pay income tax because their gain would be zero.
Under current law, most real estate owners need not be concerned about federal estate taxes since the first $13.61 Million ($27.22 Million with a spouse) of an estate would be exempt from federal tax in 2024. The exemption is set to decrease to $5 Million per person ($10 Million with a spouse) after 2025. However, only the value over the exception is taxed. Some states have lower exemption amounts and will tax the value of the inherited property. However, estate tax rates usually are much lower than income tax rates.
For business or investment real estate, instead of a $250,000 exemption, only the first $47,025 of the gain is tax-free. However, if the seller owned the property for at least a year, their gain is considered a long-term capital gain for tax purposes.
Long-term capital gains are taxed at either 15% or 20%, depending on the amount of gain. For comparison, regular income above $47,150 ($94,300 for married couples filing jointly) is taxed at 22%. As income increases, the marginal tax rate increases up to a maximum rate of 35%.
Plus, using a Section 1031 exchange, owners of business and investment real estate can defer those long-term capital gains taxes by reinvesting the money in another real estate asset. Another less popular option is to exchange the real estate for interest in a REIT using an UPREIT. Both of these options are complex and are beyond the scope of this article. However, investors should know not all states recognize Section 1031 exchanges and UPREIT structures, so investors might have to pay state income taxes on gains from those transactions.
Another tax benefit for business and investment real estate is depreciation. The owner can offset a portion of the real estate’s purchase price against any income it produces. Depreciation can enable real estate investors to avoid taxes on income from investment real estate until the real estate is sold.
If there’s more depreciation than income from a real estate investment, passive real estate investors can’t offset the excess against earned income. However, they often can offset the excess against passive income from other investments and lawfully avoid taxes until the real estate is sold.
When selling business or investment property, any portion of the gain attributable to “recaptured depreciation” will be taxed at 25% instead of the long-term capital gains rate. Although this rate is higher than the 15% or 20% long-term capital gains tax rate, it is still less than the 32% marginal income tax rate for taxpayers with income over $101,525 ($201,050 for a married couple filing jointly).
Real estate can be an excellent way for families to build generational wealth – whether it be via home ownership or real estate investment. However, each person’s tax and financial situation is different. So, it’s crucial for all homeowners and real estate investors work with an experienced professional and to understand the impact that taxes, inflation and interest rates can have on their investments.
This series draws from Elizabeth Whitman’s background in and passion for classical music to illustrate creative solutions for legal challenges experienced by businesses and real estate investors.