A 1031 exchange allows real estate investors to defer taxes on the sale of investment property, provided they reinvest the proceeds into another like-kind property. The replacement property must also be a real property held for business or investment purposes, not a personal residence. An exchange defers, but doesn’t eliminate, the taxes from the sale. When the replacement property is eventually sold, the deferred taxes will become due.

A 1031 exchange isn’t just a powerful investment strategy; it can also help you maximize what you leave to your heirs. Understanding how 1031 exchange rules and inheritance work together can benefit your long-term estate planning goals.

Step-Up in Basis

Some investors choose to sell their replacement property before they pass away to make things easier for their heirs. However, this can actually reduce the value their loved ones inherit.

When heirs inherit a replacement property, its value is “stepped up” to its fair market value at the time of inheritance. This step-up means the taxes deferred through the 1031 exchange are no longer due, and the heirs’ cost basis is reset. This step-up in basis applies whether you’ve completed one exchange or used the “swap till you drop” strategy.

The “swap till you drop” strategy means continuing to exchange one investment property for another throughout your lifetime, deferring taxes again and again. While this can be a useful estate planning tool, it’s not always common. Life circumstances and goals often lead investors to sell or hold properties for different reasons.

Same Taxpayer Rule

A 1031 exchange must follow the same taxpayer rule, meaning the person or entity selling the investment property must be the same one buying the replacement property. If an investor passes away during an exchange, their estate can complete the exchange during probate.

However, the heirs cannot complete the exchange after they receive their interests. Once the estate completes the exchange, the heirs will inherit the replacement property as if the investor had completed the exchange before passing.

Can Heirs Complete a 1031 Exchange With Inherited Property?

Heirs can complete a 1031 exchange with inherited property, but keep in mind that estate or inheritance taxes may still apply, depending on the state. Since these taxes can’t be deferred, some heirs sell inherited property right away to cover those taxes.

Sometimes, some heirs want to keep the property while others want to sell and do a 1031 exchange. Whether this is possible depends on who holds title to the property. If the heirs each have an undivided interest as tenants in common (TIC), they can each decide whether to sell or hold their interest.

If the property is in a trust or partnership, it’s possible to dissolve the entity and transfer ownership into undivided TIC interests so each person can do what they wish with their share. Alternatively, heirs who want to keep the property could buy out those who want to sell, or everyone could agree to stick together.

Estate Planning With Delaware Statutory Trusts (DSTs)

A Delaware Statutory Trust (DST) is a legal entity that allows multiple investors to own fractional interests in large, professionally managed properties. Many real estate investors choose to exchange into DSTs as part of their retirement or estate planning. DSTs offer passive income and professional management, which is ideal for those ready to escape the hassles of day-to-day property management. With DSTs, investors can own a fractional interest in high-quality commercial properties, such as apartment buildings, senior living facilities, or industrial spaces, often with lower minimum investments.

DSTs can also make estate planning easier. You can exchange into several DSTs and leave different interests to different heirs. Even if you only invest in one DST, your shares can be divided among your heirs, letting each person choose whether to cash out or do their own 1031 exchange. This flexibility helps prevent disagreements about what to do with inherited property.

1031 exchanges can be both a powerful investment and estate planning tool for real estate investors. If you have questions about the exchange process, reach out to Land 1031 or your local Land Professional today!