1031 Exchange Estate Planning: How to Maximize What You Leave Your Heirs

1031 exchange estate planning is one of the most powerful strategies for passing on maximum wealth to your heirs while minimizing capital gains tax. If you own investment or business real estate, understanding 1031 exchange inheritance rules and how IRC Section 1031 intersects with inheritance can make a significant difference to what your loved ones ultimately receive.

Owners of business and investment properties are able to take advantage of IRC Section 1031, which allows for capital gains tax deferral and depreciation recapture on the sale of real property when the taxpayer uses the sales proceeds to acquire like-kind replacement property (provided they follow all 1031 exchange rules).

This method of capital gains tax deferral through a 1031 exchange has existed for more than a century and is a useful tool for entrepreneurs, commercial real estate investors, and rental property owners looking to build long-term wealth.

We’ve previously discussed how Section 1031 can aid in retirement planning, but what about 1031 exchange after your death? If you own a property that you want to bequeath to your loved ones in your will, how will a 1031 exchange affect your estate plan and inheritance taxes? Is it better to sell the property before your death, or let your heirs to do that?

This guide will cover the basics of 1031 exchange estate planning and how to maximize what you leave behind.

What happens to a 1031 exchange 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 initial property when you purchased it. You’ll owe 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 hold the replacement property for the rest of your life.

How the Step-Up in Basis 1031 Exchange Eliminates Deferred Capital Gains

When your heirs inherit property, they receive a step-up in basis 1031 exchange to the fair market value at the time of inheritance, not your original purchase price. This can eliminate a large portion of the deferred capital gains tax liability entirely.

This step-up in basis benefit applies no matter how many prior exchanges you’ve completed. If you currently own investment real estate, exchange into a new property, then perform another exchange ten years later, you can continue deferring taxes indefinitely. When you die, the step-up in basis resets your heirs’ cost basis — effectively erasing the accumulated deferred gain.

The ‘swap till you drop’ strategy for estate planning explained

This approach, known informally as the “swap till you drop” strategy, 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.” Fewer than 20% of 1031 exchanges are followed by a subsequent like-kind exchange. 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 end 1031 exchanges altogether, this has been a viable estate planning tool for decades.

What happens if you die mid-1031 exchange?

What about when death is sudden and unexpected? If you are in the process of executing 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 generate passive income during your retirement. You’ve already sold your relinquished property and identified three replacement properties within the required 45-day identification window. 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 are still 130 days left. Can your estate complete the 1031 exchange?

The answer isn’t cut and dry, as the IRS has issued very few rulings on the matter. However, it has been done. 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.

Same taxpayer rule

A valid 1031 exchange must follow what is called the 1031 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 an exchange, it will fall under the decedent’s final tax return, meaning it will be the same taxpaying entity that 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 and a qualified intermediary (QI) should this situation arise.

Can heirs perform a 1031 exchange on inherited property?

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

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

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

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 and the different options you have could save you and your loved ones a lot of conflict in the future.

Simplifying estate planning with Delaware Statutory Trusts (DSTs)

Many 1031 real estate investors choose to exchange from rental properties to Delaware Statutory Trusts (“DST”) as part of their retirement and estate planning strategy. A DST provides professional management, allowing the exchanger to hand off those duties while investing in a broad portfolio of high-value properties that generate passive income during retirement.

DSTs can also make 1031 exchange estate planning simpler because of their fractional ownership and low barrier to entry. While a single-family rental home may be valued at $1 million or more, the minimum investment for many DSTs is around $100,000, meaning you can exchange into several DSTs and achieve immediate diversification. Then you can will each of those interests to a different relative, ensuring your heirs won’t have to deal with the conflict that often arises from decisions over whether to sell or keep an inherited property.

Even if you only invest in a single DST, it still might be easier on your heirs because shares can be split upon your death so each heir can decide for themselves whether to cash out or perform a 1031 exchange out of the DST. For more information, read our guide to DSTs and estate planning.

Working with the right qualified intermediary (QI) for estate-planning exchanges

Effective 1031 exchange estate planning requires more than just knowing the rules, it requires working with professionals who understand the full spectrum of exchange scenarios, from straightforward investment property swaps to complex estate situations involving multiple inheritors, mid-exchange deaths, and DST structures.

In addition to seasoned legal and accounting professionals, your 1031 exchange will require a Qualified Intermediary (QI). 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 has experience with complex exchange types like those involving DSTs and estates with multiple inheritors and provides the highest level of security for exchange funds along with 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 and your family the best chance for success, look no further.

Learn about 1031 exchange estate planning and DST strategies with JTC’s exchange services