Do Your Children Even Want to Inherit Your Rental Properties?
Building a portfolio of rental real estate has long been a favored strategy for families intent on creating generational wealth—often from scratch. Yet, parents who plan to pass their rental properties to their children sometimes overlook a fundamental question: Do your children actually want to inherit the properties you've spent decades managing?
All too often, parents spend significant portions of their lives building and managing real estate portfolios, dealing with the inevitable headaches such as tenants, maintenance issues, and regulatory requirements—only to have their children inherit and quickly sell the properties in the end. It's a scenario that happens more frequently than many parents realize, rendering their lifetime of hard work and financial discipline effectively moot.
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For those approaching retirement—or already there—owning a few rental properties can be a powerful tool for generating steady income. The monthly rent checks can help cover living expenses without you having to draw down retirement accounts, allowing investments in stocks, bonds, or other assets to continue compounding on a tax-deferred basis.
But over time, the calculus changes. The energy and attention required to manage a real estate portfolio can become increasingly burdensome. Rather than simply including the properties in a will and leaving the decision-making to your heirs, it is wise to have an open dialogue with your adult children about whether they're interested in inheriting these properties, and if necessary, begin developing a clear plan for how and when those assets will be liquidated during your lifetime.
You may find that your children prioritize flexibility and liquidity in their investments, rather than owning tangible assets. Unlike real estate, marketable securities such as stocks and bonds can be sold relatively easily without significant transaction costs, providing quick access to cash when needed. Real estate, however, can be notoriously illiquid, carrying significant costs and time commitments to sell.
Moreover, your children might not share your enthusiasm for dealing with the demands of property management. For those already balancing demanding careers, young families, and personal responsibilities, the idea of maintenance calls and unexpected repairs can seem daunting.
One common objection to selling real estate during your lifetime is the significant capital gains tax liability that could result. Rental properties often appreciate substantially over decades, making the tax bill from selling the properties a non-starter. For example, based on today’s tax rates, selling a property purchased for $250,000, now worth $1,000,000, would mean paying long-term capital gains taxes of as much as $150,000 on the $750,000 difference.
Fortunately, there is an alternative. A 1031 exchange is a tax-efficient alternative that would allow you to defer capital gains taxes when you sell investment properties and reinvest the proceeds into another "like-kind" property within specific time limits. Or, instead of buying another individual property to replace the one sold, you might consider investing in an exchange fund, which is a professionally managed real estate portfolio that can simplify your involvement while providing continued exposure to real estate investments.
With this strategy, you'd retain the benefits of owning real estate directly, but without the hassle of direct management. You can then strategically withdraw the amount you need each year to fund your living expenses—minimizing capital gains taxes along the way. Importantly, when your heirs eventually inherit your remaining shares in the exchange fund, they receive a stepped-up cost basis, eliminating much of the accumulated tax liability.
For those earlier in the wealth-building process, who have yet to accumulate significant unrealized gains in a real estate portfolio, a simpler approach might be to simply purchase life insurance instead. Rather than pouring a substantial portion of your monthly cash flow into mortgages, maintenance, and taxes over the next few decades, a life insurance policy can offer a more straightforward solution to the problem of how to pass along wealth to the next generation in a tax-efficient way.
By redirecting even a fraction of the money you would have spent on mortgages and maintenance each month into a life insurance policy, you could secure a substantial, guaranteed payout to your future generations upon your passing. Your heirs could ultimately receive a similar financial benefit to inheriting rental properties, but without any of the headaches.
Ultimately, determining the appropriate solution begins with an open dialogue. Rather than assuming your children share your vision of building wealth by holding onto properties for generations, explicitly asking about their interest level could help ensure that your estate planning strategy aligns with their actual desires. And involving your children in these conversations early and regularly reassessing their interest as their life circumstances change can lead to a more intentional and satisfying wealth transfer.
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Malcolm Ethridge is the Managing Partner at Capital Area Planning Group, based in Washington, D.C. His areas of expertise include retirement planning, investment portfolio development, tax planning, insurance, equity compensation and other executive benefits.
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Disclosures:
The information provided is for educational and informational purposes only, does not constitute investment advice, and should not be relied upon as such. Be sure to consult with your legal advisors before taking any action that could have tax and legal consequences.
Investments in securities and insurance products are:
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