Part I · Asset Classes · No. 10

Trophy real estate

A $50 million townhouse, a Palm Beach oceanfront, an Aspen ranch. Real property remains the most tax-favored luxury asset class — §1031 exchange survived the 2017 amendment, the §121 principal-residence exclusion shelters substantial gain, and the §1014 step-up extinguishes lifetime appreciation.

The asset class in tax terms

Real property held for personal use is a non-depreciable capital asset under §1221. Real property held for productive use in a trade or business or for investment is §1231 property — depreciable, eligible for §1031 like-kind treatment, and subject to §1250 recapture on disposition. A primary residence may qualify for the §121 exclusion of up to $250,000 ($500,000 for married couples) of gain on sale.

Acquisition

State and local transfer and recording taxes are material:

• New York City "mansion tax" — graduated rate from 1% up to 3.9% on residential transfers above $1 million, applied at the buyer level under Tax Law §1402-a.
• State transfer tax — 0.4% New York State; 0.7% Florida; 0.5% California (varies by county); none in Texas.
• Recording fees.
• Mortgage recording tax in certain states.

Foreign-buyer transfer taxes apply in select jurisdictions: British Columbia and Ontario impose foreign-buyer taxes; New York City has considered but not enacted a comparable measure.

Holding and operation

Annual costs:

• Property tax. The dominant ongoing cost, varying widely by jurisdiction. California Proposition 13 limits annual increases for resident property. Texas has no income tax but materially higher property tax.
• Mortgage interest. Deductible on acquisition indebtedness up to $750,000 for principal residence (post-2017 amendment); pre-2017 mortgages grandfathered to $1 million cap.
• SALT cap. The $10,000 cap on state-and-local tax deduction under §164(b)(6) limits the federal benefit of property tax deduction on high-value residential property.
• Depreciation on rental or investment property under §168: 27.5-year recovery (residential rental) or 39-year recovery (nonresidential).

Income from the asset

Rental income from investment property is real-estate rental, generally passive under §469 absent material participation. Net rental income is subject to §1411 NIIT for high-income taxpayers. Active real-estate professional status under §469(c)(7) permits passive losses to offset ordinary income.

Short-term rentals (Airbnb-style) below the seven-day threshold are not rental activity under Treas. Reg. §1.469-1T(e)(3)(ii)(A) — they are treated as a trade or business, with consequences for self-employment tax, material-participation analysis, and depreciation timing.

Disposition

Sale of a personal residence: §121 excludes up to $250,000 ($500,000 joint) of gain, subject to two-out-of-five-year ownership and use tests. Gain in excess of the exclusion is long-term capital gain at the 20% rate plus 3.8% NIIT plus state.

Sale of investment property: long-term capital gain plus 3.8% NIIT plus state, with §1250 unrecaptured gain taxed at the 25% rate.

§1031 exchange remains available for real property after the 2017 amendment. See like-kind exchanges. Real-property exchanges allow indefinite deferral with eventual §1014 step-up at death — the most tax-favored disposition path for appreciated real estate.

Installment sale under §453 is available; particularly useful for non-dealer real property where the seller is willing to hold paper.

FIRPTA: foreign sellers of U.S. real estate are subject to withholding under §1445 at 15% of gross proceeds, with adjustment to actual liability on filing. Buyers from foreign sellers are liable for the withholding.

Gift and estate

Inclusion at fair market value. Valuation discounts apply for fractional interests; Estate of Bonner and successors allow modest fractional-interest discounts for joint-tenancy and TIC interests. Family-limited-partnership and LLC discounts are more aggressive but more litigated.

The §2702 special valuation rules constrain GRATs and similar retained-interest structures. The §2036 retained-enjoyment rule has been heavily litigated in family-real-estate-partnership cases; Estate of Strangi, 417 F.3d 468 (5th Cir. 2005), is the leading case.

Charitable contribution of a conservation easement on trophy real estate may qualify for §170(h) deduction. The IRS has pursued syndicated easements aggressively; non-syndicated traditional easements remain a workable structure. See conservation easements.

Common structures

• Personal ownership. Primary residences typically held personally to preserve §121 exclusion.
• Single-member LLC. Investment property; preserves disregarded-entity character.
• Partnership / LLC. Joint ventures, family ownership, syndications.
• Qualified opportunity fund. Real-estate investment with deferred and partially excluded gain. See opportunity zones.
• Foreign-buyer structures. Foreign acquirers of U.S. real estate routinely use blocker corporations to manage FIRPTA, estate-tax, and disclosure exposure.
• Dynasty trust. Long-term family holdings sited in South Dakota or Delaware.

Audit and enforcement landscape

Real-estate audit attention focuses on (a) §1031 exchange substance and timing; (b) basis and improvement substantiation; (c) FLP/LLC valuation discounts on estate returns; (d) conservation-easement valuations; and (e) FIRPTA compliance.

The 2022 Form 1099-K expansion brought short-term rental income reporting more squarely into IRS view. State-level enforcement of short-term rental occupancy taxes has been aggressive in tourist markets (New York City, San Francisco, Honolulu).

Jurisdictional notes

• Florida. Homestead exemption, no state income tax, popular trophy market.
• New York. Mansion tax, state estate tax with low exemption, urban market concentration.
• California. Proposition 13 property-tax cap, high state income tax.
• United Kingdom. SDLT stamp duty rates up to 17% for non-resident or additional-property purchases.
• Switzerland. Cantonal-level property tax; restrictions on foreign ownership under Lex Koller.
• Italy. IMU annual property tax; rural-property regimes.
• UAE. Limited freehold zones; no property tax in Dubai.

Reviewed May 2026