What Happens to a 1031 Exchange When the Owner Dies?

A 1031 exchange, formally known as a like-kind exchange under Section 1031 of the Internal Revenue Code, is a tax-deferral strategy for real estate investors. It permits an owner to sell an investment property and reinvest the proceeds into a new, similar property without immediately paying capital gains taxes. This mechanism allows for the continuous growth of a real estate portfolio by postponing the tax liability that would otherwise be due upon the sale.

The Step-Up in Basis Rule

An asset’s tax basis is its original purchase price, adjusted for items like capital improvements or depreciation. When an investment property is sold for more than its adjusted basis, the profit is a capital gain subject to taxation. Federal capital gains tax rates can be as high as 20%, with an additional 3.8% net investment income tax for higher-income individuals, plus potential state taxes.

The “step-up in basis” is a provision in U.S. tax law that alters this calculation for inherited assets. When an individual inherits a property, its tax basis is adjusted to its fair market value on the date of the original owner’s death. This erases the built-up appreciation that occurred during the decedent’s ownership for income tax purposes. For example, if an investor bought a property for $200,000 and it was worth $1,000,000 upon their death, the heir’s basis becomes $1,000,000.

This revaluation of basis can transform a 1031 exchange from a tax-deferral tool into a tax-elimination strategy. All the capital gains that were deferred over numerous exchanges are wiped away upon the owner’s death. If the heir decides to sell the inherited property shortly after for its fair market value, there would be little to no capital gain to tax. This makes the “swap ’til you drop” strategy a method for preserving and transferring wealth across generations.

Death Occurring During a 1031 Exchange

The timing of an owner’s death during a 1031 exchange can lead to different outcomes. If the owner passes away before their relinquished property is sold, no exchange has formally commenced. The property transfers to the designated heirs, who receive it with a step-up in basis to its fair market value at the time of death. The planned exchange becomes irrelevant, and the heirs can decide whether to keep or sell the property.

If the owner dies after selling the relinquished property but before identifying a replacement, the transaction fails. The cash proceeds from the sale are held by a Qualified Intermediary, a required neutral party in a deferred exchange. Because the decedent can no longer meet the exchange requirements, the proceeds are returned to the estate, triggering a taxable event, and the capital gains must be reported on the decedent’s final income tax return.

If the owner dies after formally identifying a replacement property but before closing, the outcome is more nuanced. The ability of the estate to complete the transaction hinges on the language within the exchange agreement and the authority granted to the executor. If the agreement and legal documents permit, the executor may use the funds held by the Qualified Intermediary to acquire the identified property, completing the exchange and preserving the tax deferral.

Inheriting Property After a Completed 1031 Exchange

When an heir inherits a property acquired through a 1031 exchange, they benefit from the step-up in basis rule. As previously discussed, the property’s basis is adjusted to its fair market value at the date of the owner’s death. This new basis is not the price for which it was acquired in the last exchange or its carried-over basis from previous transactions.

This revaluation means that all the capital gains taxes that were deferred, potentially over decades and multiple property swaps, are forgiven. The accumulated tax liability that was postponed through the exchanges effectively disappears, providing the heir with financial flexibility.

If the heir chooses to sell the property immediately, they can do so for its current market value and incur little to no capital gains tax. The sale price would be offset by the newly established stepped-up basis. This allows the full value of the asset to be realized by the next generation without being diminished by the previous owner’s tax burdens.

Estate and Trust Considerations

The executor of an estate is responsible for filing the decedent’s final income tax return. If a 1031 exchange failed mid-process, this filing must accurately report the capital gains from the sale of the relinquished property. The resulting tax liability must be paid from estate assets.

To avoid the potential failure of an exchange upon death, investment properties can be held within a revocable living trust. When a trust is the legal owner of the property and conducts the exchange, the death of the grantor does not automatically terminate the transaction. The trust, as a legal entity, continues to exist.

This structure provides a transition of management. The trust document will name a successor trustee who is empowered to take control of the trust’s assets upon the grantor’s death. This successor trustee can then complete any in-progress 1031 exchange according to IRS timelines, which prevents the exchange from failing.