Depreciation Is a Loan. Your Estate Plan Decides Whether the Balloon Ever Comes Due

Randall A. Denha, Esq.

A tax adviser’s whiteboard sketch has been making the rounds: depreciation is a loan, and recapture is the balloon payment. The line is memorable and it is correct as far as it goes. It stops one step short, though, of the part that matters most to families who have built serious wealth in real estate.

The balloon payment is not inevitable. There is exactly one event in the Internal Revenue Code that forgives the loan in full, and that event is death. Everything else, whether a sale, an installment sale, a gift to the children, or a transfer into an irrevocable trust, either pays the balloon or quietly hands it to somebody else.

That single fact turns depreciation into an estate planning question.

The loan, restated in estate planning terms

Every dollar of depreciation reduces adjusted basis, and lower basis means larger gain on exit. At the closing table the bill arrives in layers:

• Unrecaptured Section 1250 gain, representing depreciation taken on the building, is taxed at a federal rate of up to 25 percent.
• Section 1245 recapture on personal property, land improvements, and other components broken out in a cost segregation study is taxed at ordinary rates reaching 37 percent.
• The 3.8 percent net investment income tax generally applies on top for passive owners.
• Michigan adds 4.25 percent.

For a client who has held a portfolio for twenty-five years, accumulated depreciation often exceeds the original cost of the building itself. The liability is real, it is large, and it appears on no balance sheet the client ever reviews.

The One Big Beautiful Bill Act made 100 percent bonus depreciation permanent for qualifying property acquired after January 19, 2025. Paired with cost segregation, that provision pulls decades of deductions into a single tax year. The loan is drawn faster. The balloon is larger. And this is now permanent policy rather than a phasedown that solves itself.

Section 1031 does not repay the loan. It refinances it.

Real estate clients treat the exchange as the answer, and for cash flow purposes it is. But a like kind exchange carries the old basis forward into the replacement property. Depreciation continues the reduced carryover basis and the deferred gain travels from deal to deal. After three or four exchanges a client may own a $12 million dollar asset with a $1.5 million dollar basis and no clear memory of where the deferral came from.

This is the swap till you drop strategy, and it works. It works only if the last word is honored. An exchange chain that ends in a taxable sale during life delivers the entire accumulated balloon in one year, usually when the client is oldest, least willing to redeploy, and least able to absorb the hit.

The forgiveness event: Section 1014

At death, property included in the gross estate generally receives a basis adjustment to its fair market value under Section 1014. The result can be extraordinarily powerful for appreciated real estate.

Built-in depreciation recapture and deferred appreciation can effectively disappear, including unrecaptured Section 1250 gain, Section 1245 recapture, and deferred gain from prior Section 1031 exchanges. The beneficiaries start with a new basis and can generally depreciate that basis over a new 27.5-year or 39-year recovery period, depending on the property. A new cost-segregation study may also allow portions of that stepped-up basis to be allocated to shorter-lived assets and potentially accelerated through applicable bonus-depreciation rules. There is very little else in the Internal Revenue Code that provides a comparable reset of built-in appreciation.

That is why, for a real estate client in their 70s or beyond with substantial appreciated property, the exit-planning conversation should rarely begin with, “What price can we get for the property?”

The better question is: “What is the after-tax value of selling today compared with continuing to hold the property and receiving a basis adjustment at death?” That calculation can fundamentally change the answer.

The collision that most plans get wrong

Estate tax planning pushes assets out of the estate. Basis planning pulls them back in. For real estate families these objectives are in direct conflict, and the balance has shifted decisively in the last year.

The federal estate and gift tax exemption is $15 million per person and $30 million per married couple in 2026, permanent under current law and indexed for inflation beginning in 2027. Michigan imposes no estate or inheritance tax. A married couple holding $25 million of net worth, most of it in low basis real estate, faces no federal estate tax at all. For that couple, every dollar of low basis property pushed out of the estate is a dollar that forfeits the basis adjustment and preserves the recapture liability, in exchange for no transfer tax benefit whatsoever.

Section 1015 governs gifts, and the donee takes the donor’s basis. The gift of a fully depreciated apartment building does not eliminate the balloon. It hands the balloon to the children along with the keys.

The arithmetic is not complicated. Below the exemption, basis wins. Above the exemption, a 40 percent estate tax generally outweighs a combined income tax cost in the range of 25 to 35 percent, so removal still wins, but only as to the excess and only if the plan is designed so that basis is preserved where it does the best.

The most valuable clause in the file: the substitution power

Many real estate clients transferred property into an intentionally defective grantor trust when the exemption was widely expected to be cut in half. The property is out of the estate. The basis carried over. Under current exemption levels a number of those clients no longer have a taxable estate, and the trust now holds an asset that will never receive a basis adjustment.

Section 675(4)(C) is the repair. A properly drafted power to reacquire trust property by substituting property of equivalent value allows cash, high basis marketable securities, or a promissory note to go into the trust while the low basis building comes back into the estate, where death cures the depreciation history. The exchange is not a recognition event between the grantor and a grantor trust.

Every irrevocable grantor trust holding real estate deserves a reading this year against three questions. Is the substitution power in the document? Is it held in a nonfiduciary capacity without the trustee’s consent? Does the client hold, or can the client borrow, assets of equivalent value to fund the swap? Where the power is missing, decanting, a trust protector modification, or a nonjudicial settlement agreement may still supply flexibility.

The negative capital account problem

This is one of the issues that separates sophisticated real estate investors from ordinary investors, and it is often overlooked. When a property has been heavily depreciated and still has significant debt, a partner can actually have negative capital in the investment. The partner’s share of the debt may still give the partner tax basis, but the property’s built-in gain can continue to grow. Eventually, that built-in gain can be greater than the actual equity value of the ownership interest.

That creates a significant problem if the owner gives the interest away during life. Because the recipient is taking on the owner’s share of the debt, the IRS can treat the transaction as part sale and part gift. The owner may therefore have to recognize taxable gain and pay tax in cash even though the owner received no cash from the transaction.

In other words, a client can end up paying a substantial tax bill simply for giving an investment away. Holding that same interest until death can produce a very different result. Generally, the ownership interest receives a basis adjustment to its fair market value under Section 1014. But there is an important additional step when the investment is held through a partnership or an LLC taxed as a partnership.

The partnership needs a Section 754 election in place, or it needs to make the election for the year of death. That election allows the partnership to adjust the deceased owner’s share of the inside basis of the underlying real estate under Section 743(b).

Why does that matter? Because without the Section 754 election, the family may receive a basis adjustment in the partnership interest but not receive the corresponding increase in the tax basis of the underlying real estate. In practical terms, the family may have a valuable tax benefit that it cannot fully use to generate additional depreciation.

For that reason, every operating agreement for a real estate partnership or LLC taxed as a partnership should consider requiring the manager to make or maintain a Section 754 election upon the death of a member. That single provision can be far more valuable to a family than pages of standard boilerplate.

Techniques worth modeling for this client base

Preferred freeze partnership. The senior generation retains a preferred interest carrying a fixed coupon and a liquidation preference while the growth interest passes to children or to a trust. Future appreciation shifts out of the estate. The preferred interest remains in the estate and receives a basis adjustment on that value at death. For clients already above the exemption, this captures transfer tax savings without surrendering the basis benefit entirely. Section 2701 must be respected with care.

Upstream planning. A client whose parents are living with unused exemption can grant a parent a general power of appointment over low basis real estate held in trust. On the parent’s death the property is included in the parent’s estate, absorbs the parent’s exemption, and receives a basis adjustment before passing to the client’s family. Section 1014(e) denies the adjustment where the property was acquired by the decedent by gift within one year of death and passes back to the donor or the donor’s spouse, so timing and structure require discipline. Family dynamics require more.

Charitable remainder trust. For the client ready to leave management behind, contributing an unmortgaged property to a charitable remainder trust before any binding sale commitment allows the trust to sell without immediate tax, converts the position into a lifetime income stream, and generates a deduction. Mortgaged property generally does not work here, and the recapture element keeps its character as it flows out through the income tiers.

Installment sales. A common misconception deserves correction. Section 453(i) requires Section 1245 recapture to be recognized in full in the year of sale regardless of when the payments arrive. A seller can owe the recapture tax well before receiving the cash to pay it. For heavily cost segregated properties this is a serious trap.

Life insurance. Where the family intends to keep the real estate, but the estate will owe tax, or where one child must buy out another, an irrevocable life insurance trust remains the cleanest source of liquidity that does not force a sale of the very asset whose basis was so carefully protected.

Opportunity zones. The permanent regime beginning in 2027 offers deferral and its own basis benefits, but it does not produce a lifetime basis adjustment and does not resolve the recapture question on the original property. Model it as one option among several rather than as an answer.

The equalization problem nobody models

Two children. One inherits an interest in the retail center under the trust. The other received an interest in the same center by gift ten years ago. Both interests are worth four million dollars. They are not equal. The inherited interest carries a $4 million dollar basis and can be sold with almost no gain. The gifted interest may carry a $400,000 dollar basis and roughly $900,000 dollars of embedded tax.

Equalization language drafted purely on fair market value produces unfair results across a depreciated portfolio. Consider directing the fiduciary to equalize after tax value, or to fund shares with attention to basis profile. Say it in the document. Do not leave the trustee to discover the problem at funding, with the beneficiaries watching.

A checklist for the next real estate client meeting

• Ask for the depreciation schedules, not only the appraisals. Request accumulated depreciation and adjusted basis by property, and the Section 1245 component of every cost segregation study.
• Build a schedule of embedded gain by asset next to fair market value, then rank the portfolio by basis to value ratio. The lowest ratios are the assets that should die with the client.
• Match assets to strategy. Low basis and low growth, hold to death. High basis and high growth, gift or sell to a grantor trust.
• Confirm a substitution power in every grantor trust and identify the substitution assets in advance rather than in a crisis.
• Confirm a Section 754 election obligation in every operating agreement, and confirm the election was filed where a member has already died.
• Measure total net worth against the $15 million and $30 million thresholds before recommending any further removal of appreciated real estate from the estate.

In summary, the whiteboard is right that depreciation reschedules tax rather than erasing it. The estate planning refinement is that the reschedule has an end date, and the end date is the client’s date of death. Handled well, the loan is forgiven, the next generation restarts depreciation on a fresh basis, and forty years of deductions are never repaid. Handled poorly, through a well-intentioned gift, an ill-timed sale, an installment note, or an operating agreement missing a single election, the family pays a balloon the Code never required it to pay. Know the due date. Then build the plan so that it never arrives.