1031 Exchange and Estate Planning

Why You Cannot Decide the Exchange Without Reading the Estate Plan

A 1031 exchange defers tax. It does not erase it. The deferred gain becomes a liability that travels with the replacement property through every future exchange. But that liability has an off switch: death. IRC § 1014 resets the cost basis of property included in a decedent's gross estate to its fair market value at the date of death — wiping out every dollar of accumulated unrealized gain, deferred recapture, and carryover basis reduction from prior exchanges.¹

If an investor plans to hold real estate until death, every dollar of tax deferred through a 1031 exchange becomes a permanent elimination — not just a postponement. If that same investor plans to sell at retirement in ten years, the deferred tax will eventually come due. These two outcomes require completely different exchange decisions today.

The §1014 Step-Up: How Much Can Disappear at Death

Under IRC § 1014(a), the basis of property acquired from a decedent is generally the fair market value of the property at the date of death (or the alternate valuation date under § 2032). For a 1031 exchange investor, the "carryover basis" that has been reduced by every prior exchange resets entirely to current market value.¹

Worked example: what step-up eliminates

An investor purchased a fourplex in 2002 for $350,000. Over 24 years of ownership and one prior 1031 exchange, the carryover adjusted basis stands at $90,000 (original basis minus accumulated depreciation, partly reset by the prior exchange). The current replacement property — a small commercial building — is worth $2.4 million.

The heirs inherit the building with a $2.4 million basis. If they sell immediately after the estate closes, they owe nothing — not on the original 2002 gain, not on the depreciation accumulated over 24 years, not on the deferred gain from the prior exchange. The entire tax liability is erased.

The 2026 Estate Exemption: Does Estate Tax Even Apply?

The One Big Beautiful Bill Act (OBBBA, enacted July 2025) permanently set the federal estate and gift tax exemption at $15 million per person — $30 million for a married couple with proper planning. This amount is indexed for inflation after 2025.²

For most real estate investors, the estate itself will remain comfortably below this threshold. An investor with $4 million of investment real estate and $3 million of other assets has an $7 million gross estate — well inside the exemption. In that scenario, the §1014 step-up eliminates the deferred income tax at death without estate tax offsetting the benefit.

Investors with larger portfolios — those with $15 million or more in real estate — need to consider both levers. A 1031 exchange that grows the real estate concentration may reduce income tax but increase estate tax exposure. That math requires a coordinated plan between estate attorney, CPA, and financial advisor.

How You Hold the Property Matters for §1014

Not every ownership structure qualifies for the §1014 step-up. Before deciding how to title exchange property, understand how each structure interacts with the basis reset at death.

The irrevocable trust trap is common: investors transfer appreciated real estate into an irrevocable trust to reduce estate tax exposure, but this removes the §1014 step-up. Heirs then inherit the trust's original (carryover) basis and owe capital gains tax on the full appreciation when they sell. For real estate with large embedded gains, losing the step-up can cost more than the estate tax saved.

DST as an Estate-Friendly Exit

A Delaware Statutory Trust (DST) is treated as real property for § 1031 purposes under Revenue Ruling 2004-86. Crucially, a DST interest is also real property for § 1014 purposes — which means DST interests held by a decedent get the same step-up in basis as directly owned real estate.³

For estate planning purposes, DSTs have three advantages over directly owned replacement property:

1. Fractional interests are easy to divide. A $2 million DST interest can be split among five heirs in equal $400,000 shares. A single-tenant commercial building cannot.
2. No management burden on heirs. DST's "Seven Deadly Sins" restrictions mean there is no active management responsibility — heirs receive a passive income stream from a professionally managed portfolio without having to operate real estate they may not want.
3. Liquidity event built in. Most DST sponsors sell the underlying assets within 5–10 years of the offering, delivering a cash or REIT-share exit to investors. Heirs who do not want to hold real estate long-term will get a natural exit without having to force a sale.

The limitation: heirs who want to continue deferring cannot make a subsequent §1031 exchange out of the DST directly. They must wait for the DST to sell the underlying property and receive their share, or convert to an UPREIT structure (see below). If the heirs do want to reinvest, a follow-on §1031 exchange using the DST sale proceeds is possible, provided they satisfy the identification and closing deadlines from their own position.

UPREIT Path: §721 Exchange for Estate Flexibility

An UPREIT (Umbrella Partnership Real Estate Investment Trust) allows an investor to contribute real property — including a DST interest after the 2-year DST-to-UPREIT safe harbor period — to a REIT's operating partnership (OP) in exchange for OP units under IRC § 721.⁴ No gain is recognized on a properly structured § 721 contribution.

OP units held at death receive a § 1014 step-up, provided they are included in the decedent's gross estate. Heirs can then convert OP units to publicly traded REIT shares (a taxable event, but starting from a stepped-up basis — potentially zero gain), sell REIT shares, hold them for dividends, or hold OP units for the same income they generated before.

The UPREIT path requires careful sequencing. The investor must hold the DST interest for at least 2 years before contributing to the REIT's OP (the safe harbor period from the 2-year DST-to-UPREIT conversion standard). The § 721 contribution must also satisfy the "no boot" requirement — if the REIT assumes mortgage debt that exceeds the investor's share of OP debt, the difference is taxable. For property with significant leverage, this planning requires coordination between the investor's CPA, estate attorney, and the REIT's legal counsel.

Charitable Exits: When the Mission Matches the Math

For investors with charitable intent, three structures can accomplish what neither the 1031 exchange nor the taxable sale can: eliminating the gain, generating income, and supporting a cause.

Charitable Remainder Trust (CRT)

The investor contributes appreciated real estate to a CRT. The trust sells the property without recognizing capital gain (the CRT is tax-exempt), reinvests the proceeds, and pays an income stream to the investor (and potentially a spouse) for life or a term of years. At the end of the trust term, the remainder passes to one or more charities. The investor receives a partial charitable deduction in the year of contribution, based on the actuarial present value of the charitable remainder interest.

The income stream from a CRT is taxable — the IRS uses a "worst-in, first-out" ordering rule that frontloads ordinary income and capital gain before tax-free return of basis. But the elimination of the gain on the initial sale can still beat both the 1031 exchange and the taxable sale when the investor has significant charitable intent, needs income rather than real estate concentration, and is prepared to give up the principal.

Donor-Advised Fund (DAF) with a Prior 1031 Exchange

A DAF does not work directly with real estate — a donor-advised fund typically requires liquid assets (cash, securities). However, an investor can 1031 exchange into a DST, wait for the DST to sell the underlying assets, receive cash, and then contribute some or all of those proceeds to a DAF. The combination defers gain during the real estate holding period and achieves the charitable contribution goal at the terminal event without requiring the investor to hold the real estate until death.

The Suspended PAL Trap at Death

Investors who have operated rental properties for years frequently accumulate suspended passive activity losses (PALs) — losses that could not be deducted against ordinary income because the investor was not a real estate professional and had no passive income to absorb them. These PALs can be large: a $1.5 million apartment with accelerated cost segregation might generate $200,000 or more in suspended losses over a few years.

A common expectation is that these suspended PALs will eventually be released when the property is sold. That is correct for a taxable sale (IRC § 469(g)(1)) — and it is even somewhat true for a 1031 exchange (boot can release PALs to the extent of recognized gain). But at death, the rules are different and far less forgiving.⁵

What §469(g)(2) says

When a taxpayer dies holding a passive activity interest, suspended losses are allowed only to the extent they exceed the increase in basis caused by the § 1014 step-up. Because the step-up equals the difference between FMV and adjusted basis — and for a 1031 exchange investor that difference is typically very large — the PALs are usually entirely eliminated at death rather than flowing through to the estate or heirs.

The $280,000 of suspended losses disappears. They cannot be deducted on the decedent's final return, they do not pass to heirs, and they cannot offset the estate's income. This is the estate planning equivalent of the § 121 exclusion for primary residences — some tax attributes that you expect to have value simply do not survive the transfer.

Planning around the PAL trap

If an investor has meaningful suspended PALs and does not expect to become a real estate professional, there are three main options before the losses disappear at death:

• Recognize passive income. Invest in passive activities that generate net income — a profitable rental, a DST distribution stream, or a REIT investment — to absorb the suspended losses against passive income each year.
• Accept strategic boot in a future exchange. As described in the passive activity losses guide, boot recognized in a 1031 exchange is treated as passive income from the activity. An investor with $280,000 of suspended PALs and an upcoming exchange could accept $280,000 of boot, recognize $280,000 of passive income from the exchange, and offset it with the suspended PALs — netting to zero tax on the boot while clearing the suspended loss position.
• Elect real estate professional status (REPS). If the investor (or their spouse on a joint return) can qualify as a real estate professional under IRC § 469(c)(7) — 750 hours in real property trades and more than half of all working hours — the PALs become non-passive and deductible against ordinary income. This is a material planning opportunity for investors approaching retirement who intend to spend more time managing properties.

Putting It Together: A Decision Framework

Before completing a 1031 exchange, the estate planning context should answer these questions:

1. What is the intended exit? If the exit is death, the exchange and every subsequent exchange is a permanent tax elimination. If the exit is a future sale, every exchange adds to the deferred liability.
2. What is the estate size relative to the $15M federal exemption? For most investors, the exemption far exceeds the estate. For others, exchange-amplified real estate concentration may push the estate over threshold and require estate tax mitigation.
3. How is the property titled? Revocable trust and individual ownership preserve the §1014 step-up. Irrevocable trusts generally do not.
4. Are there significant suspended PALs? If yes, quantify the cost of losing them at death. The loss of $300,000 in suspended PALs is not the same as $300,000 of cash lost — it is the loss of a potential deduction worth perhaps $111,000 at 37% — but it is still a cost to plan around.
5. What do the heirs want? Heirs who want to stay in real estate benefit from directly owned exchange property or DST interests. Heirs who want liquidity benefit from DST-to-UPREIT conversion or a CRT structure that converts real estate into a managed payout stream.
6. What is the investor's charitable intent? Significant charitable motivation may favor a CRT over an exchange, especially when the CRT income stream replaces the rental income the investor relies on.

Sources

1. IRC § 1014 — Basis of property acquired from a decedent (law.cornell.edu) — statutory text for step-up in basis to date-of-death fair market value; § 1014(a)(1) for general rule; § 1014(b) for property includible in gross estate.
2. IRS Estate and Gift Tax — current exemption amounts — 2026 federal estate exemption: $15,000,000 per person under OBBBA (One Big Beautiful Bill Act, enacted July 2025), indexed for inflation.
3. Revenue Ruling 2004-86 — DST interests as real property for §1031 purposes — confirms that beneficial interests in a Delaware Statutory Trust are treated as direct interests in real property; same characterization applies for §1014 basis step-up.
4. IRC § 721 — Non-recognition of gain on contribution to a partnership (law.cornell.edu) — statutory authority for contributing property to a REIT operating partnership in exchange for OP units without recognition of gain.
5. IRC § 469(g)(2) — Passive activity losses at death (law.cornell.edu) — suspended PALs allowed at death only to the extent they exceed the step-up in basis under § 1014; for highly appreciated 1031 exchange property the step-up typically exceeds accumulated PALs entirely.

Tax values verified against 2026 rules. OBBBA (One Big Beautiful Bill Act, July 2025): permanently raised estate and gift tax exemption to $15M per person, indexed for inflation; made §199A QBI deduction permanent; restored 100% bonus depreciation for qualifying property placed in service after January 19, 2025. Social Security Fairness Act (January 2025): repealed WEP and GPO. No changes to §1031 exchange mechanics, §1014 step-up rules, or §469(g)(2) passive activity loss treatment at death under OBBBA. Verify current values with a qualified tax advisor.

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