1031 Exchange Estate Planning: What Happens If the Owner Passes Away

Posted Nov 20, 2023

1031 Exchange Estate Planning: What Happens If the Owner Passes Away

Real estate investors have long used 1031 exchanges to reposition and diversify their real property holdings, potentially defer capital gains taxes, or pursue likely assets that might offer greater value and equity.

A 1031 exchange also can be a strategic aspect of estate planning. Taxpayers and heirs can benefit when investment properties are relinquished for like-kind assets in a 1031 exchange. In this article, we’ll look at what happens when a property owner passes away after completing a 1031 exchange.

The Like-Kind Exchange to Minimize Disputes

Real estate investors often face difficult choices when planning the distribution of significant assets like commercial real estate, especially when multiple heirs are involved. Splitting ownership of an investment property can generate ugly disputes among heirs. For instance, one heir might want to continue operating and managing the asset for the potential revenue stream. Another heir might want to sell the real estate and walk away with the proceeds.

A successful 1031 exchange into one or more investment properties could help avoid these disputes. Here’s how:

  • One asset could be exchanged into two or more like-kind properties. This would leave each heir free to chart their course.
  • The relinquished property could be swapped for shares of Delaware Statutory Trusts (DSTs), with each heir named as a trust beneficiary. The heirs could hold their shares. Or they could potentially cash in on the proceeds through a secondary DST resale market. 

The Like-Kind Exchange as a Wealth Preservation Tool

Well-positioned and well-performing commercial investment properties can generate significant capital appreciation over time.

That’s the good news. 

Investors selling their properties for a profit generally pay capital gains taxes. That tax could be as high as 20%, depending on the income bracket and tax-filing status. The depreciation recapture tax, at 25%, can also erode profitability margins.

Furthermore, the property sale could boost an investor’s adjusted gross income (AGI), meaning they might face the Medicare income-related monthly adjustment amount or IRMAA. This is a surcharge on Medicare Part B or Medicare Advantage premiums. 

But, investors who opt for a 1031 exchange can defer that tax burden. Remember that the like-kind exchange defers taxes. The process doesn’t eliminate them. But there’s a way in which investors’ heirs can avoid being stuck with a significant tax liability.

If the investor should die during a 1031 exchange, the heirs might receive a stepped-up basis on the replacement property. Under these circumstances, the replacement property is valued at the current market prices rather than when the investor purchased it. This can potentially eliminate accumulated capital gains or pre-existing tax liabilities.  

The Bottom Line

Estate planning to preserve wealth for future generations can be a detailed and exacting undertaking. If real estate makes up a significant portion of an investor’s financial estate, the 1031 exchange could be helpful in the estate planning process. Be sure to check with a qualified financial professional to determine if and how a like-kind exchange might be beneficial.

This material is for general information and educational purposes only. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions. It should also not be construed as advice meeting the particular investment needs of any investor.

Realized does not provide tax or legal advice. This material is not a substitute for seeking the advice of a qualified professional for your individual situation.

Costs associated with a 1031 transaction may impact investor's returns and may outweigh the tax benefits. An unfavorable tax ruling may cancel deferral of capital gains and result in immediate tax liabilities.

No public market currently exists, and one may never exist. DST programs are speculative and suitable only for Accredited Investors who do not anticipate a need for liquidity or can afford to lose their entire investment.

Hypothetical examples shown are for illustrative purposes only.

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