A 1031 exchange can allow real estate investors to defer taxes when selling an investment property, as long as they reinvest the proceeds in qualifying like-kind real estate. The replacement property must be held for business or investment use, rather than personal use. The tax is deferred, not eliminated; it may become due when the replacement property is later sold.
A 1031 exchange may also support long-term estate planning. Understanding how exchange rules interact with inheritance can help investors consider what they may pass on to their heirs.
Step-Up in Basis
Some investors sell their replacement property during their lifetime to simplify matters for their heirs. Depending on the circumstances, doing so may reduce the value ultimately passed on.
When heirs inherit property, its tax basis may be adjusted to its fair market value at the time of inheritance. This is known as a “step-up in basis.” It may reduce or eliminate the deferred gain for tax purposes. The treatment can apply whether the investor completed one exchange or continued exchanging properties over time—a strategy often called “swap till you drop.”
With this strategy, an investor exchanges one investment property for another during their lifetime, deferring taxes from one sale to the next. It can be part of an estate plan, though investors’ circumstances and goals vary.
Same Taxpayer Rule
A 1031 exchange generally requires the same taxpayer who transfers the relinquished property to acquire the replacement property. If an investor dies while an exchange is underway, the estate may be able to complete it during probate.
Heirs generally cannot step in and complete the exchange after they receive their interests. If the estate completes the exchange, the heirs may inherit the replacement property as though the investor had completed the transaction.
Can Heirs Complete a 1031 Exchange With Inherited Property?
Heirs may be able to use inherited investment property in a 1031 exchange. Estate or inheritance taxes may also apply, depending on the circumstances and applicable state law. Since a 1031 exchange does not defer those taxes, some heirs may choose to sell inherited property to help cover them.
When some heirs want to keep a property and others want to sell, the options may depend on how the property is titled. If the heirs own separate undivided interests as tenants in common (TIC), each may be able to decide whether to hold or sell their share.
If the property is held through a trust or partnership, the ownership structure may need to be changed before heirs can make separate decisions. In some cases, interests may be transferred into TIC ownership. Other options may include heirs who want to keep the property buying out the others, or all heirs agreeing to continue owning it together.
Estate Planning With Delaware Statutory Trusts (DSTs)
A Delaware Statutory Trust (DST) lets multiple investors own fractional interests in a larger property managed by a professional sponsor. Investors may consider DSTs when planning for retirement or thinking about how to pass real estate interests to heirs.
DSTs can provide access to professionally managed commercial real estate, such as apartment communities, senior living facilities, and industrial properties. They may also offer a more passive ownership structure for investors who want to reduce their day-to-day management responsibilities. Minimum investments vary by offering.
DST interests may offer flexibility in estate planning. An investor could hold interests in multiple DSTs and leave different interests to different heirs. If an interest is divided among heirs, each may have options based on the ownership structure and their individual circumstances. Planning ahead can help families consider those choices and reduce disagreements about inherited property.
