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1031 and Estate Planning

4th May 2023

How a like-kind exchange can help you leave more behind for your heirs.

Owners of business and investment properties are able to take advantage of Section 1031 of the tax code, which allows for deferral of capital gains taxes and depreciation recapture by allowing sellers to exchange their real property for a “like-kind” property (provided they follow all 1031 rules). This method of tax deferral has existed for more than a century and is a useful tool for small business operators, commercial real estate investors, and rental property owners looking to build wealth.

We’ve previously discussed how 1031 can aid in retirement planning, but what about after your death? If you own a business or investment property that you want to bequeath to your loved ones in your will, how will 1031 affect the taxes they may pay? Is it better to sell the property before your death, or hold it? This post will cover the basics of 1031 estate planning and how to maximize what you leave behind when you’re gone.

What happens to a 1031 property when you die

When you perform a 1031 exchange, capital gains taxes on the sale of your relinquished property are deferred, but that doesn’t mean they are eliminated. When you eventually sell your replacement property, you’ll have to calculate the gain based on the original amount paid for your relinquished property when you purchased it. You’ll need to pay taxes on the entire realized gain, which includes what you deferred through your exchange as well as the increase in value of the replacement property since you acquired it.

If you sell your 1031 property before your death, this tax burden will reduce the amount you’re able to leave behind for your heirs. That’s why if you can, it may be prudent to keep your replacement property until your death.

When inheriting property, your heirs can take advantage of a step up in basis. This means that if they sell the property, their realized gain will be calculated based on the fair market value of the property at the time it was inherited, not when you originally purchased it. This effectively eliminates a large portion of the tax burden, and ensures you can leave as much behind as possible.

This is true no matter how many times you perform an exchange. If you currently own a business or investment property and exchange into another property, ten years from now you can perform another exchange and continue to defer taxes. If you keep performing exchanges until your death, the continued deferral followed by the step up in basis will mean you and your heirs will be exempt from the capital gains taxes on those transactions.

This “1031 until death” scenario, though advantageous, is not common. A 2020 study found that “the vast majority of Section 1031 exchanges are one-time events, followed by a taxable sale” and that “holding periods of 20+ years are rare.” Most exchanges (fewer than 20%) are followed by a subsequent exchange, and most replacement properties are not held for extremely long periods. A lot of things can happen between now and when you die that may affect your decision to hold a property. However, given the potential benefits, if you can pull this strategy off, it may be worth pursuing.

While there are no guarantees that a legislative change won’t eliminate the step up in basis procedure or eliminate 1031 exchanges altogether, this has been a viable estate planning tool for decades.

What happens when an exchanger dies mid-exchange

If you choose to pursue it, 1031 until death is one long-term strategy. But what about when death is sudden and unexpected? If you are in the process of completing a 1031 exchange when you die, can or should your heirs complete the exchange after you’re gone?

Let’s say you own a rental property and want to perform a 1031 exchange into a Delaware Statutory Trust that will be a more passive investment during your retirement. You’ve already sold your relinquished property and identified three replacement properties within the required 45 days. Under normal circumstances, you’d have 180 days from the date of sale of the relinquished property to complete the exchange.

But then, on day 50, you tragically pass away. Your exchange isn’t complete, but there may still be 130 days left. Can your estate complete the exchange?

The answer isn’t cut and dry, as the IRS has issued very few rulings on the matter. However, it has been done successfully. The key, it seems, is that the exchange must be completed by the estate in the process of probate, not by the heirs once they have received their interests.

A valid 1031 exchange must follow what is called the “same taxpayer rule,” which states that the seller of the relinquished property must be the same taxpayer as the purchaser of the new property. When an estate completes the exchange, it will fall under the decedent’s final tax return, meaning it will be the same taxpaying entity who purchased the replacement property. The heirs can then inherit the replacement property as though the decedent had completed the exchange before passing.

Because the death of an exchanger mid-exchange is quite rare and precedent is limited, it is essential to employ competent tax counsel should this situation arise.

1031 exchanges on inherited property

What if you pass away prior to starting your exchange? Can your heirs perform the exchange on your property after you’re gone?

Let’s say you leave an investment property to your three children in your will. Can they perform a 1031 exchange, either as a group or individually?

Despite the step up in basis mentioned above, inherited property can potentially be subject to estate taxes or inheritance taxes depending on where you live. This leads many heirs to sell the property right away in order to pay those non-deferrable taxes. Are there any options when one or more of the heirs want to hold on to the property?

The answer is: possibly. It mainly depends upon who holds legal title on the property. If the heirs each own undivided interests in the property as tenants-in-common, then they can each decide individually to sell their interests or hold on to them. But if the property was left in a trust or partnership structure, then either the heirs who wanted to hold on to the property would have to buy out the ones who wanted to cash out, or they would all have to stick together in selling or holding on to the property.

These are difficult decisions that require the right professionals to help you and your family navigate the intricacies of your situation. Understanding the potential benefits of a 1031 exchange could save you and your loved ones a lot of conflict in the future.

Getting peace of mind from a trusted partner

Ultimately, you want more than simply to leave as much wealth as possible for your loved ones when you die: you also want the process to be easy on them. That’s why it’s important to work with those who know 1031 inside and out.

In addition to seasoned tax and real estate professionals, your 1031 exchange will require a Qualified Intermediary. Since every exchange is different, it’s important to work with a QI that has expertise in all manner of exchange scenarios. JTC’s team offers decades of 1031 experience with tens of thousands of successful transactions, and provides a 24/7 online portal for round-the-clock access to exchange information. If you want the 1031 process to be as smooth as possible and give yourself the best chance for success, look no further.

Downloading our 1031 Exchange Solution Sheet.

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