Inheriting real estate is both a blessing and a financial puzzle, especially for assets that have been previously involved in transactions like 1031 exchanges. If your parents left you such properties, you may be wondering if there are any taxes you need to pay or processes you need to continue. In this article, Realized 1031 discusses 1031 exchange inherited property to help you understand what to do next. Let’s take a closer look.
Understanding What a 1031 Exchange Is
For heirs who aren’t familiar with 1031 exchanges, these are tax-deferred transactions that allow an investor to exchange one qualifying property for another without recognizing capital gains at the time of the transaction—provided all IRS requirements are met. The tax deferral benefits let you delay capital gains tax payments. In theory, an investor can continue exchanging one property for another to maintain the tax-deferred status. If the replacement property is eventually sold, the deferred gains may become taxable at that point. Under current tax law, if the property is held until death, it may receive a step-up in basis, potentially reducing or eliminating capital gains tax for heirs. However, individual tax outcomes depend on a variety of factors and should be reviewed with a qualified tax professional or estate advisor
What Happens When You Inherit a 1031 Exchange Property?
In most cases, you won’t owe taxes upon receiving a property that was part of a 1031 exchange, due to what’s commonly referred to as a step-up in basis. When a property owner passes away, the cost basis of the 1031 exchange property is typically adjusted to its fair market value (FMV) at the time of death. This adjustment can reduce or eliminate capital gains tax liability if the property is sold shortly thereafter.
Let’s say that your parents owned an apartment complex before their passing. This building is the replacement property of a previous exchange. The apartment complex had an FMV of $900,000, and the proceeds from the last 1031 exchange resulted in $200,000 in capital gains.
If your parents sold the apartment complex before they died, they may have owed up to 20% in capital gains taxes on that $200,000—depending on their individual tax situation. After you inherit the property, however, the FMV of $900,000 generally becomes your new cost basis. If you decide to sell the apartment complex soon after, and the sale price is close to the FMV, there may be little to no capital gains tax due—though actual tax outcomes depend on timing and other factors.
Some heirs may ask: Is continuing the 1031 exchange needed after inheriting the property? The answer is no. Inherited properties do not require you to continue the 1031 exchange process. The exchange cycle ends with the original investor’s passing, and you receive the property as a new asset.
This example is hypothetical and for illustrative purposes only. Actual tax outcomes depend on a variety of factors, including fair market value determination, holding period, and individual tax status.
Can You Begin Another 1031 Exchange With the Same Property?
If you want to follow in the footsteps of your parents and exchange the asset you inherited, you may initiate a new 1031 exchange, provided the transaction meets current IRS requirements. In this case, this transaction will be a new 1031 exchange, and it will be under your name, following the same taxpayer requirement.
Initiating a 1031 exchange for a property that’s already been a part of one can have some potential benefits. First, the property has already been proven to have been held for investment or business use. However, you will need to maintain the investment at the time of the exchange. If the property has appreciated and you intend to sell it, a 1031 exchange may allow for tax deferral on recognized capital gains.
Before you proceed with a 1031 exchange, consider the following best practices.
- Educate yourself on 1031 exchange rules and risks. If you’re new to 1031 exchanges, take time to understand how they work—including potential benefits (e.g., tax deferral) and limitations (e.g., illiquidity, reinvestment constraints). This foundational knowledge can help prevent missteps and support better decision-making.
- Understand the procedural requirements and engage a Qualified Intermediary (QI). A valid 1031 exchange must meet specific IRS rules, including the 45-day property identification and 180-day closing timelines. A Qualified Intermediary is also required to facilitate the exchange and must be engaged before the sale of the relinquished property. Working with an experienced QI helps ensure the process complies with applicable regulations.
- Get a professional appraisal to support your new basis and protect yourself in case there are future audits.
- Consult with a tax attorney or tax advisor, especially if there are multiple heirs. This practice helps you navigate probate and potential estate taxes.
- Make sure to evaluate the investment potential, especially with regard to how the market has changed before and after your parents’ passing. Is the location still in demand? Are you still in a high-growth market?
Wrapping Up: What Heirs Should Know About Inherited 1031 Exchange Properties
As an heir, it’s important for you to understand how taxation works on the assets you received. Under current law, these assets typically receive a step-up in basis, which can reduce or eliminate capital gains tax if the property is sold shortly after inheritance. Whether you want to start a new exchange or sell the asset, understanding your options and working with professionals can help you make informed decisions that align with your personal financial goals.
The tax and estate planning information offered by the advisor is general in nature. It is provided for informational purposes only and should not be construed as legal or tax advice. Always consult an attorney or tax professional regarding your specific legal or tax situation.
Article written by: Story Amplify. Story Amplify is a marketing agency that offers services such as copywriting across industries, including financial services, real estate investment services, and miscellaneous small businesses.
Sources:
https://www.investopedia.com/financial-edge/0110/10-things-to-know-about-1031-exchanges.aspx
https://www.investopedia.com/terms/s/stepupinbasis.asp
https://www.americanbar.org/groups/real_property_trust_estate/resources/real-estate/1031-exchange/
