Most investors think of wills, trusts, and beneficiary designations when it comes to estate planning. However, there are other tools at their disposal that can help with areas such as tax deferral and long-term planning. One of these is the 1031 exchange. This strategy is typically used for tax-deferral purposes, but it can also help during estate planning and settlement.
In this article, Realized 1031 discusses how incorporating 1031 exchanges into your estate and legacy planning can provide a wide range of benefits. Let’s take a closer look!
Named after Section 1031 of the Revenue Code, 1031 exchanges are transactions that allow an investor to exchange two like-kind properties. In this case, like-kind refers to the fact that both properties have been held for investment or business use. The exchange is not an official sale, so there is no taxable event. As such, the investor can defer capital gains taxes and depreciation recapture as they acquire the replacement property.
1031 exchanges may be repeated over time, allowing for continued tax deferral throughout the investor’s lifetime. If the property is still held at the time of death, the basis may be stepped up to fair market value, which can reduce or eliminate capital gains exposure for heirs. Due to these features, 1031 exchanges are sometimes used as part of broader estate planning strategies.
A key consideration in estate planning is maintaining the value of assets across generations. Selling a property outright typically results in capital gains tax liability, which can reduce the net proceeds available for reinvestment. A 1031 exchange, by contrast, allows for the deferral of capital gains taxes, enabling the full equity from the sale to be reinvested into like-kind property. This deferral can support the continued growth of real estate holdings over time.
1031 exchange properties experience a step-up in basis upon your passing, which can have meaningful tax implications for heirs.
The step-up in basis resets the cost basis of an asset to its fair market value upon your death. The step-up adjusts the cost basis of the property to its fair market value at the time of death, potentially eliminating previously deferred capital gains and depreciation recapture from the decedent’s ownership period.
This adjustment may reduce or eliminate capital gains tax for heirs who choose to sell the property shortly after inheriting it. As a result, more of the property's value could potentially transfer to the next generation without immediate tax consequences, depending on individual circumstances and applicable tax laws.
You may also be considering a revocable living trust to own your assets, which can help streamline their distribution and may reduce the need for probate in certain situations. Properties acquired through a 1031 exchange can often be transferred to and held by a revocable living trust or other estate planning vehicle, depending on the structure and applicable legal and tax considerations.
You can also pair 1031 exchanges with Delaware Statutory Trusts (DSTs). These are investment vehicles that own underlying income-generating properties, and you own fractional interests. DSTs may be suitable for those seeking limited involvement in property management and broader diversification.
DSTs offer one more advantage: DSTs can also support legacy planning by offering a structure that may simplify the division of assets among heirs. Real estate can be challenging to divide among your children, and shared ownership may only lead to conflicts. DST fractional interests are typically easier to quantify, which can make distribution more straightforward. Plus, since the DST is under the control of the sponsor, heirs who have no real estate experience won't need to learn as much about how the specific real estate investment works.
While no one likes to think about it, planning for incapacity is important, especially when your real estate holdings involve active management or complex tax planning strategies like 1031 exchanges.
Consider designating a power of attorney (POA) or successor trustee who understands your goals and is prepared to manage or continue exchange strategies on your behalf if needed. Because 1031 exchanges are time-sensitive (you must identify a replacement property within 45 days and close within 180 days), delays caused by legal incapacitation could cause a failed exchange, and trigger tax consequences.
1031 exchange estate planning can serve as one component of a broader strategy focused on tax deferral and asset transition. Features such as the potential step-up in basis, optional professional management through a DST, and structures that may reduce the need for probate can support the efficient transfer of assets to heirs. While individual outcomes vary based on planning decisions and legal structures, 1031 exchanges may offer tools to help manage tax exposure and address estate planning 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://smartasset.com/investing/delaware-statutory-trusts-dsts