Can You Do a 1031 Exchange on Inherited Property?
Understand the unique tax implications of an inherited property and the strategic actions required before pursuing a tax-deferred exchange.
A 1031 exchange, named after Section 1031 of the U.S. Internal Revenue Code, allows for the deferral of capital gains taxes. It permits an owner to postpone paying tax on a gain, provided the sale proceeds are reinvested in a “like-kind” property. For those who acquire real estate through inheritance, applying this strategy depends on navigating specific tax rules and investor intentions.
Understanding the “Held for Investment” Requirement
A primary rule of a 1031 exchange is that the property being sold must have been “held for productive use in a trade or business or for investment.” This requirement focuses on the taxpayer’s intent for owning the property. For individuals who inherit real estate, this presents a challenge.
The Internal Revenue Service (IRS) scrutinizes the circumstances surrounding the sale to determine if the property was held for investment purposes or if it was simply held for immediate resale. If an heir takes possession of a property and immediately lists it for sale, the IRS is likely to conclude that the intent was never to hold it as an investment. This is analogous to a car dealership’s inventory; the cars are held for sale to customers, not for the dealership’s long-term investment.
This “held for investment” test is a subjective one, based on the facts and circumstances of each case. The issue for an heir is demonstrating that their primary purpose for holding the property shifted from a personal asset of the decedent to a business or investment asset for themselves. Without establishing this investment intent, a 1031 exchange is likely to be disallowed, triggering a tax liability on any gain from the sale.
The Impact of Stepped-Up Basis on Inherited Property
Before pursuing a 1031 exchange, an heir must understand “stepped-up basis,” as it may render the exchange unnecessary. When an individual inherits an asset, its cost basis is adjusted to its fair market value on the date of the owner’s death. This rule can reduce or eliminate the taxable capital gain upon the sale of the property.
For example, imagine a parent purchased a house for $100,000. At the time of the parent’s death, the house is appraised at $500,000, giving the heir a new “stepped-up” basis of $500,000. If the heir sells the property for $510,000, the taxable gain is calculated from the stepped-up basis, making it only $10,000.
In this scenario, the minimal tax liability means the complexity and cost of a 1031 exchange would likely outweigh the benefit. This step-up in basis forgives the capital gains tax on appreciation that occurred during the decedent’s lifetime.
Many heirs find they have little to no capital gain to defer. An heir should get a formal appraisal of the property to establish its fair market value as of the date of death. This valuation is necessary for calculating the stepped-up basis and determining whether a 1031 exchange is financially logical.
Establishing Investment Intent for the Inherited Property
To overcome the “held for investment” hurdle, an heir must take actions to demonstrate intent to treat the inherited property as an investment. The common method is to convert the property into a rental.
Renting the property to a tenant at fair market rates changes the asset’s character to an income-producing investment. While the IRS has not set a formal holding period, many tax professionals advise renting the property for at least one to two years before an exchange. This duration helps substantiate the claim that the property was held for investment.
Beyond renting, other activities can support investment intent. Making capital improvements to the property, such as renovating a kitchen or updating systems, are actions consistent with a long-term investment strategy. The goal is to create a record of activities proving the heir’s primary purpose was investment.
The 1031 Exchange Process and Timelines
Once an heir has established investment intent and determined an exchange is financially beneficial, they must follow procedural rules. The process is managed by a Qualified Intermediary (QI), a required third party for the exchange. An heir cannot have receipt of the sale proceeds; the QI must hold the funds until they are used to purchase the replacement property.
Once the inherited property sale closes, the heir has 45 days to formally identify potential replacement properties. This identification must be in writing, signed, and delivered to the QI. An heir can identify up to three properties of any value, or a larger number of properties as long as their total value does not exceed 200% of the sold property’s value.
From the date of the original sale, the heir has a total of 180 days to acquire one or more of the identified properties. These deadlines are absolute. Missing either the 45-day identification deadline or the 180-day closing deadline will disqualify the entire exchange, making the capital gain from the sale immediately taxable.
The replacement property must also be “like-kind” to the property sold. For real estate, this rule is broad. A residential rental house can be exchanged for a commercial office building, a piece of raw land, or an apartment complex.